Information Communication Through Distorted Earnings Reporting

Abstract

In this paper we study how discretionary managerial reports can be used for information communication about the firm’s value. Equilibrium reporting strategy and investment level are derived for strategic investor (i.e., VC), and competitive investor (i.e., IPO) market settings. It is shown that when direct truthful information communication is unreliable because of incentive misalignments, costly discretionary biased reporting still allows perfect information communication. Comparative static shows that the level of earnings management and amount of capital invested differs in these two cases. Our model justifies the existence of lock up period during IPO and provides some arguments supporting a pattern of VC-IPO sequence since getting initial financing from strategic investor reduces the cost of signaling for the firm during subsequent IPO procedure. Presented analysis generates several empirical implications regarding strategic choices of earnings management depending on the investment structure.