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Asymmetric Reporting

Christopher S. Armstrong
carms@wharton.upenn.edu

Daniel J. Taylor
dtayl@wharton.upenn.edu

Robert E. Verrecchia
verrecchia@wharton.upenn.edu

The Wharton School


University of Pennsylvania

This Draft: September 4, 2015

We thank Jeremy Bertomeu, Michael Carniol, Judson Caskey, Henry Friedman, Jack Hughes, Xu Jiang,
Camelia Kuhnen, Rick Lambert, Venky Nagar, Cathy Schrand (editor), Phil Stocken, Alfred Wagenhofer
(referee) and seminar participants at Drexel, Columbia, and Stanford Universities, the Universities of Michi-
gan and Texas at Austin, and the Junior Accounting Theory Conference for helpful comments. We are
especially grateful to Paul Fischer and Mirko Heinle for insightful discussions. We thank The Wharton
School for nancial support.
Asymmetric Reporting

Abstract: We extend the CAPM to a setting where a rm reports earnings prior to selling
shares to investors. We show that an entrepreneur, as representative of a rms initial owners,
will choose to report earnings that asymmetrically reect future cash ow. In modeling the
entrepreneurs reporting choice, we deliberately abstract away from the stewardship role of
accounting. In our model, the sole purpose of reported earnings is to facilitate valuation by
the rms equity investors. Nevertheless, we show that a rms earnings will reect future
cash ow to a greater (lesser) extent in bad states (good states) when that cash ow is
anticipated to be low (high). Importantly, we also show that the asymmetry in reporting
generates asymmetry in the rms systematic risk. When a rms earnings reect future
cash ow to a greater extent in bad states, the rms covariance with the market portfolio
will be lower in bad states.

Keywords: asymmetric reporting; reporting precision; the CAPM; Beta; systematic risk;
cost of capital;
JEL Classication: G11, G12, G14, G31
I. INTRODUCTION

One of the most studied properties of nancial reporting is the asymmetry in the extent
to which reported earnings reect future cash ow. In this paper, we develop a parsimo-
nious model to study a rms endogenous reporting choices, and whether those choices entail
asymmetric reporting of future cash ow. In modeling a rms reporting choices, we delib-
erately abstract away from the stewardship role of accounting the role of accounting in
mitigating agency conicts and facilitating e cient contracting. This ensures that our re-
sults are attributable exclusively to the valuation role of accounting the role of accounting
in facilitating valuation by equity investors. In our model, the sole purpose of reported
earnings is to facilitate valuation by the rms equity investors. Nevertheless, we show that
under fairly mild assumptions, a rm will endogenously report earnings that asymmetrically
reect future cash ow.1
We begin our analysis by extending the Capital Asset Pricing Model (CAPM) to a setting
where a rm reports earnings prior to selling shares to investors. A risk-averse entrepreneur,
as representative of a rms initial owners, chooses the extent to which the rms earnings
will reect future cash ow (i.e., reporting precision). We further assume that more precise
reporting requires greater eort by the entrepreneur. Importantly, we allow the entrepreneur
to condition his choice of reporting precision on the expectation of future cash ow, which
we assume is common knowledge.2 To facilitate our exposition of this feature of our model,
we refer to the rm as being in a bad state if its expected future cash ow is low and,
conversely, in a good state if its expected future cash ow is high. In this regard, we
explicitly allow for the possibility that the optimal reporting precision, and hence the extent
to which earnings reect future cash ow, diers across states. We show that under fairly
1
To be clear, we do not consider equity investors to be contracting parties. If one considers investors
to be contracting parties, then the notion of contracting becomes all-encompassing.
2
The common knowledgeassumption removes any information asymmetry and precludes the possibility
of an agency problem (e.g., Lafond and Watts, 2008).

1
mild conditions, earnings will reect future cash ow to a greater extent in bad states:
a property that we refer to as asymmetric reporting in favor of the bad state. In eect,
reporting is skewed endogenously toward anticipated unfavorable outcomes (e.g., anticipated
losses).3
The intuition for this result relates to how a risk-averse entrepreneur internalizes the
cost-benet tradeo in his choice of reporting precision. The benet of greater reporting
precision is that it reduces the risk premium that investors demand to compensate them for
uncertainty (i.e., the cost of capital) and thus boosts price. The costs of greater reporting
precision are twofold. First, it requires the entrepreneur to exert greater eort. Second, it
imposes greater risk on the entrepreneur because it causes investors to place more weight
on realized earnings, which are unknown at the time the entrepreneur chooses reporting
precision. Concavity (i.e., risk-aversion) implies that the marginal benet of an increase
in price is lower when the rms price is already high as a result of high expected future
cash ow. Lower marginal benet implies that the entrepreneur is less willing to invest in
providing investors with a more precise report of future cash ow.
Explicitly articulating the cost-benet tradeo highlights the generality of the economic
intuition that underlies our results. The key assumptions in our model are: 1) the en-
trepreneur and investors have concave preferences (i.e., risk-aversion); and 2) more precise
reporting requires greater eort. These assumptions seem to describe a broad range of cir-
cumstances, suggesting that the benets of asymmetric reporting are pervasive and exist
even in the absence of agency problems, contracting considerations, and information asym-
metry. For example, risk aversion is a fundamental attribute of human behavior.4
3
Although our analysis is couched in terms of an entrepreneur choosing reporting precision at the time
of the rms initial public oering (IPO), our analysis can easily be extended to an overlapping generations
model where each generation of the investors chooses reporting precision in anticipation of selling their shares
to the next generation of investors: see Bertomeu and Cheynel (2015, 380-382) for such an extension. In
other words, our results need not be interpreted as pertaining exclusively to the time of the rms IPO.
4
See e.g., Preuscho, Bossaerts and Quartz (2006), Kuhnen and Chiao (2009), and Zhang, Brennan, and
Lo (2013).

2
Having established the condition for asymmetric reporting in favor of the bad state, we
solve for the optimal reporting precisions in both states when this condition is met, and
show that the magnitude of the asymmetry is decreasing (increasing) in expected future
cash ow in the bad (good) state. We also show that when reporting is asymmetric in favor
of the bad state, reporting costs dierentially aect reporting in the two states. While an
increase in reporting costs reduces the extent to which earnings reect future cash ow in
both states, the extent of the reduction is greater in the bad state. Consequently, an increase
in reporting costs reduces the asymmetry in the extent to which earnings reect future cash
ow. As technological improvements decrease the cost of reporting (ceteris paribus), our
model predicts that reporting will evolve to be increasingly asymmetric in favor of the bad
state.
Next, we show that when reporting is asymmetric in favor of the bad state, the rms
systematic risk (i.e., investorsassessments of the rms covariance with the market portfolio)
is also asymmetric. The intuition for this result is that reporting is more precise in the bad
state, and, in the CAPM, more precise reporting reduces investorsassessment of the rms
systematic risk. Consequently, the rms systematic risk is lower (higher) in the bad (good)
state. Prior literature does not consider the possibility of asymmetric reporting within the
context of the CAPM, and much of this literature focuses on settings where investors are
risk-neutral a setting where there is no notion of priced risk or a cost of capital. Our
model can be viewed as a Conditional CAPM in which investorsassessments of the rms
covariance is not static, but is instead endogenously inuenced by both nancial reporting
decisions and the state. In this regard, our paper answers Cochranes (2013) call to allow
investorsassessments of systematic risk to be endogenous as opposed to treating it as an
exogenous parameter.
Finally, the purpose of this paper is to examine the conditions under which earnings
might asymmetrically reect future cash ow from an economic perspective not to model

3
the accounting measurement process. Nevertheless, our model provides a parsimonious for-
mal framework for thinking about some of the issues raised in the literature on accounting
conservatism. In this regard, we discuss how our results comport with the adage anticipate
no prots but anticipate all losses. We make three points. First, the adage can be inter-
preted within the more general economic framework of asymmetric reporting the notion
that the provision of information about future outcomes depends on whether those outcomes
are anticipated to be unfavorable. Second, the valuation role of accounting alone can gen-
erate earnings that asymmetrically reect future cash ow. This is not to suggest that the
stewardship role of accounting is not important, but rather that it is not necessary: earnings
that asymmetrically reect future cash ow can be valuable even in the absence of agency
problems, contracting considerations, and information asymmetry. Third, empirical nd-
ings have been interpreted almost exclusively through the lens of stewardship. Our results
provide an alternative, valuation-based explanation for some of the empirical results in the
literature (i.e., an explanation not premised on agency problems), and suggest that a fruitful
avenue for future empirical work is to examine asymmetry in rmssystematic risk.
Ultimately, the extent to which asymmetric reporting and conservatism are comparable
phenomena depends on how one denes conservatism. While there is a large empirical
literature that speaks to conservatism, there is considerably less formal economic theory on
the topic. Consequently, popular notions of conservatism in the empirical literature are often
couched in terms of less formal verbal descriptions, as opposed to more formal mathematical
characterizations. For example, in our model, the entrepreneur issues an unbiased earnings
report: it is simply a question of the extent to which earnings reects future cash ow. Thus,
if one views conservatism as suggesting that a rm provides more information when losses are
anticipated, then one can draw an equivalence between our notion of asymmetric reporting
and conservatism. Under this interpretation, our results posit that conservatism need not
arise from agency problems. However, if one views conservatism as suggesting that both

4
earnings (book values) are biased downward (a 1st-moment eect) and more information
is provided when losses are anticipated (a 2nd-moment eect) - then asymmetric reporting
and conservatism have comparable 2nd-moment aspects but are not equivalent. Under this
interpretation, the observation that more information is provided when losses are anticipated
is not, by itself, evidence of conservatism. In short, while our model explains why a rm
might provide more information when losses are anticipated, it may not be able to explain
every phenomenon attributed to conservatism in the extant literature.
The remainder of the paper proceeds as follows. Section II provides an overview of our
model, describes the intuition for our results, and discusses our model in the context of prior
theory work. Section III derives conditions under which asymmetric reporting in favor of the
bad state is optimal. Section IV provides comparative static results, and Section V discusses
extensions of our model. Section VI interprets our results in the context of the traditional
notion of accounting conservatism, and Section VII concludes.

II. OVERVIEW

General Intuition
In this section we describe the intuition for why an entrepreneur might prefer to report
earnings that reect future cash ow to a greater (lesser) extent in bad (good) states. We
couch this discussion in a very simple setting, useful only for the purposes of developing
intuition about the primitive economic forces at work in our model. In doing so, we abstract
away from a variety of technical features covered subsequently in our formal analysis in
Section III. For example, the setting is not multi-asset, does not dierentiate between sys-
tematic versus idiosyncratic risks, and presumes that the optimization problem we describe
has a unique, interior solution.
We consider a setting where a rm reports earnings prior to selling shares to investors.
A risk-averse entrepreneur, as representative of the rms initial owners, chooses the extent

5
to which the rms earnings will reect future cash ow (i.e., reporting precision). The
entrepreneurs objective is to choose reporting precision so as to maximize his expected
utility as a function of the rms uncertain price (uncertain total value). Investors bid for
shares after observing reported earnings, and future cash ow is subsequently realized and
paid out to investors in the form of a liquidating dividend.
Although the entrepreneur does not observe the rms realized future cash ow at the
time he chooses reporting precision, we allow the entrepreneur to condition his choice of
reporting precision on expected future cash ow. Let P represent the price of the rm,
reporting precision, and the rms expected future cash ow. The level of the rms
expected future cash ow, , characterizes its state.To keep the discussion as transparent
as possible, we assume as is common in asset-pricing models and particularly the CAPM
@P
that price is increasing in both expected future cash ow (i.e., @
> 0) and reporting
@P
precision (i.e., @
> 0), but that the interactive eect of and on price is zero (i.e.,
@2P
@ @
= 0). To remove any information asymmetry between the entrepreneur and investors,
we assume that all of the parameters that characterize the economy including the rms
state and the entrepreneurs choice of reporting precision are common knowledge (we
return to this assumption in Section V).
If the entrepreneurs optimal choice of precision, denoted , is independent of expected
future cash ow (i.e., @@ = 0), then earnings reect future cash ow irrespective of the
state, and reporting is said to be symmetric. If is positively associated with expected
future cash ow (i.e., @@ > 0), then earnings reect future cash ow to a greater extent in
good states, and reporting is said to be asymmetric in favor of good states. Finally, if
is negatively associated with expected future cash ow (i.e., @@ < 0), then earnings reect
future cash ow to a greater extent in bad states, and reporting is said to be asymmetric in
favor of bad states. Our goal in this section is to motivate why one might reasonably expect
reporting to be asymmetric in favor of bad states.

6
Let U (P ) represent the entrepreneurs utility as a function of the price of the rm. Our
rst key assumption is that the entrepreneur has concave preferences, which implies that
the entrepreneur is risk averse. Concave preferences ensure that U (P ) is increasing in P
but at a decreasing rate (i.e., U 0 (P ) > 0 and U 00 (P ) < 0). Our second key assumption is
that reporting precision entails an explicit, non-state dependent and non-pecuniary, cost of
eort 21 c 2
(where c > 0) that being non-pecuniary resides outside the argument of the
entrepreneurs utility function.5 We discuss the roles of these assumptions in more detail
below.
Taken together, these assumptions imply the following objective function for the entre-
preneur:
1 2
max E [U (P )] c :
2

The rst-order condition that solves for the optimal choice of precision, , is given by
setting the marginal benet, E [U 0 (P )] @P
@
, equal to the marginal cost, c :

@P
E [U 0 (P )] c = 0;
@

which implies
1 @P
= E [U 0 (P )] :
c @

This illustrates that in our setting where there are no agency problems the entrepreneur
benets from reporting precision exclusively through the eect of reporting precision on
@P
price; @
represents the eect of reporting precision on price, and E [U 0 (P )] represents the
eect of price on the entrepreneurs utility.6 This highlights the importance of investors being
5
For example, it is common in the agency-theory literature to express a managers utility function as
being additively separable into a utility-of-wealth component and a non-pecuniary cost of eort: see, e.g.,
Holmstrom (1979). It is also common for accounting researchers to assume that managers incur personal,
non-pecuniary costs associated with choosing characteristics of the accounting system: see, e.g., Meth (1996)
and Dutta and Gigler (2002).
6
To facilitate the discussion in this section, we assume that the partial derivatives @P @ and @P
@ are

7
risk-averse. In the case of risk-neutral investors, the rm would be priced at its expected
@P
future cash ow, E[P ] = , reporting precision would not aect price, @
= 0, and hence
= 0 and reporting precision would be independent of the rms state ( ). Thus, our
results rely critically on the existence of a positive risk premium (i.e., risk-averse investors).
Next, consider how the entrepreneurs optimal choice of precision, , varies with .
Taking the partial derivative of the rst-order condition with respect to yields:

@ 1 00 @P @P 1 0 @ 2P 1 @P @P
= E [U (P )] + E [U (P )] = E [U 00 (P )] ; (1)
@ c @ @ c @ @ c @ @

@2P
where the last equality follows from the assumption that @ @
= 0.
In eqn. (1), it follows from concavity in the entrepreneurs utility (i.e., U 00 (P ) < 0) and
@P @P
the assumptions that @
> 0 and @
> 0, that the eect of a change in on is always
negative:
@ 1 @P @P
= E [U 00 (P )] < 0:
@ c @ @

The intuition for this result is that concavity (i.e., risk-aversion) implies that the marginal
benet of an increase in price is lower when the rms price is already high as a result of high
expected future cash ow. Lower marginal benet from an increase in price implies that the
entrepreneur has less incentive to provide investors with a more precise report of future cash
ow. This highlights the importance of the entrepreneur being risk-averse. Alternatively,
for a risk neutral entrepreneur E [U 00 (P )] = 0 and is independent of , and reporting is
symmetric.
Returning to the cost function, an artifact of CAPM-pricing is that the interactive eect
of and on price is zero.7 Thus, when the cost of eort is pecuniary (i.e., resides inside
deterministic, as opposed to random variables, and thus can reside outside the entrepreneurs expectation.
In our formal analysis starting in Section III, we are cognizant of the fact that the derivatives may be random
variables.
7
This results from the assumptions commonly used to derive CAPM prices, and specically the assump-

8
the argument of the entrepreneurs utility function), the rst-order condition that solves for
1 @P @P @2P
reduces to = c@
, and this expression (i.e., @
) does not rely on because @ @
= 0.
Hence, is independent of . Thus, similar to the role of risk aversion, a non-pecuniary
cost of eort ensures that the entrepreneurs choice of depends on the rms state ( ).
Relation to Prior Work
Having provided an overview of our model setup and the basic intuition behind our key
results, we now discuss how our model relates to some prior and contemporaneous theory
work.
Titman and Trueman (1986) also posit a model where an entrepreneur chooses the extent
to which a rms earnings will reect future cash ow prior to selling shares to investors.
While similar to this paper, there are two key dierences between our model and theirs.
First, in Titman and Trueman (1986), all investors are risk-neutral and there is no notion
of a risk premium or a cost of capital. This removes an important benet of reporting. In
the absence of a risk premium, the entrepreneur has no incentive to report more precisely
when he anticipates an unfavorable outcome. Second, in Titman and Trueman (1986), the
entrepreneur has private information the entrepreneur makes his reporting decision after
observing the realization of future cash ow (ex post). In contrast, in our model, the entre-
preneur does not have private information the entrepreneur makes his reporting decision
prior to observing the realization of future cash ow (ex ante). In Titman and Trueman
(1986), foreknowledge of the realization of future cash ow motivates the entrepreneur to
report earnings that reect future cash ow to a greater extent when expected future cash
ow is high.
Penno (1996) posits a model where a rm that is confronted with an unfavorable pre-
existing public report of future cash ow (e.g., a negative media report). Penno (1996) shows
that when the pre-existing report is unfavorable (i.e. is below expected future cash ow) the
tion that uncertainty has a normal (Gaussian) distribution with independent mean and variance.

9
rm will elect to provide a more precise subsequent report. This ensures that investors place
greater weight on the subsequent report, which in expectation will be more favorable
than the pre-existing report. Penno (1996) suggests that earnings will reect future cash
ow to a greater extent when the rm is confronted by unfavorable reports from external
parties.
Suijs (2008) studies information systems within the context of an overlapping generations
model. He shows that an information system where the report of low future cash ow is
more informative than the report of high future cash ow improves risk sharing (across the
two generations of investors) relative to an information system that is uninformative about
both low and high future cash ows. In Suijs (2008), the information system is costless and
exogenous it is not the result of a utility maximization problem thus, the incentives of
rms or their owners play no role.
Finally, we emphasize that our paper is not unique in suggesting that asymmetric re-
porting of future cash ow could be optimal outside of the stewardship role of accounting.
For example, Kirschenheiter and Ramakrishnan (2012) show that asymmetric reporting can
arise from intertemporal consumption smoothing it provides more information in bad
states, when such information is more valuable; Nagar, Rajan, and Ray (2014) show that
asymmetric reporting can arise from primitive preferences that behave according to prospect
theory; and Bertomeu and Magee (2015) show that, within the context of a median voter
model, asymmetric reporting can arise out of lobbying pressure. The models in these papers
deviate from the traditional, agency-theoretic framework and the standard, single-period,
exchange economy, and thus bear little resemblance to our approach. If anything, the litera-
ture suggests a diverse set of rationales that could give rise to earnings that asymmetrically
reect future cash ow.

III. Analysis

10
CAPM Pricing
Our next step is to discuss the derivation of asset prices and risk premia within the
context of the CAPM but in the absence of reporting. This serves as a useful benchmark
against which to compare our results in the presence of reporting. The derivation follows
Lambert, Leuz, and Verrecchia (2007, LLV henceforth).
In the absence of reporting, the entrepreneur plays no role in the model, and N identically
informed investors simply trade shares of J rms and a risk-free asset, where each investor
has constant absolute risk tolerance . Let V~j represent rm js future cash ow paid out to
investors in the form of a liquidating dividend, where henceforth we use a tilde (i.e., ~) to
denote a random variable. We assume that the future cash ows of the economys J rms
h i h i
have a multivariate normal distribution, where E V~j and V ar V~j represent the mean and
h i
variance of rm j, respectively, and vj represents the reciprocal of V ar V~j ; we represent
P
the market cash ow by V~M , where V~M = Jk=1 V~k . As is standard in a CAPM setting, we
assume that rmscash ows are correlated. As LLV show, these assumptions imply that
the price of rm j is given by Pj

h i h i
E V~j N
1
Cov V~j V~M
Pj = ; (2)
1 + Rf

h i
where: Cov V~j V~M represents the covariance of the rms terminal cash ow with that
of the market portfolio; N represents the economys cumulative risk-bearing capacity; and
Rf is the risk-free rate. As is standard in the literature, eqn. (2) makes clear that a rm
h i
is priced based on its expected future cash ow, E V~j , less a discount for its systematic
h i
risk (i.e., N1 Cov V~j V~M ), where both are adjusted for the risk-free rate. We provide the
derivation of eqn. (2) in Appendix A.
Reporting Environment

11
Although there are numerous ways to formalize the economic intuition that underlies our
results, we deliberately adopt the CAPM framework: a one-period frictionless capital market
where a large number of rational, risk-averse investors trade shares of multiple rms and a
risk-free asset. This setup has the virtue of producing a parsimonious pricing framework that
keeps the eect of endogenous asymmetric reporting transparent. However, because there
is no information structure in the standard CAPM and therefore no scope for nancial
reporting we begin by adding a generalized information structure.
To review the assumptions to this point, we consider a setting where rm j reports
earnings prior to selling shares to investors. A risk-averse entrepreneur, as representative of
rm js initial owners, chooses the extent to which the earnings of rm j reect future cash
ow (i.e., reporting precision). Figure 1 summarizes the timeline of our model. [INSERT
FIGURE 1 HERE.] In period t = 0, the entrepreneur of rm j chooses the extent to which
earnings reect future cash ow. In period t = 1, investors observe reported earnings and
subsequently trade shares of rm j along with the shares of other rms in the economy (and
a risk-free asset). In period t = 2, future cash ow is realized and paid to investors in the
form of a liquidating dividend (the rms terminal cash ow).
As is common in the theory literature, we model earnings of rm j as a noisy signal of
the rms future cash ow,
r~j = V~j + ~j ;

where r~j represents rm js reported earnings, V~j represents rm js future cash ow, and
~j represents the error or noise in reported earnings (insofar as it is unrelated to future cash

ow). By characterizing earnings in this manner, we abstract away from the component of
earnings that is backward-looking, and focus on the component of earnings that is forward-
looking the component that anticipates future cash ow, V~j . For now, we only consider the
activities of the entrepreneur of rm j; as such we assume that ~j has a (univariate) normal

12
distribution with mean zero, variance V ar[~j ], and precision j
, and that ~j is independent
of the cash ows of all rms in the economy, including rm j.8
As is standard in the literature, the entrepreneurs choice of reporting precision is oper-
ationalized by the choice of j
, where j
represents the extent to which earnings reect
future cash ow. For example, larger values of j
imply that reported earnings, r~j , are a
less noisyor equivalently, more precisemeasure of future cash ow, V~j . We also assume
that reporting precision must exceed a minimum threshold ?, where ? 0. The role of
this assumption is fairly benign: it allows for the possibility that the entrepreneur might be
required (by a regulator, say) to provide a minimum amount of information about rm js
future cash ow, where j
= 0 is equivalent to providing no information.
Although the entrepreneur does not observe the rms future cash ow at the time
he chooses reporting precision, he can condition his choice of reporting precision on the
h i
expectation of future cash ow, E V~j . To facilitate the discussion, we refer to the rm as
h i h i
being in a good state if E V~j = G and a bad state if E V~j = B , where G > B . If
the entrepreneur chooses the same j
in both the good and bad states, then we say that
reporting is symmetric. If the choice of j
depends on the state, then we say that reporting
is asymmetric. All parameters that characterize the economy are assumed to be common
knowledge, and the entrepreneur and investors all have homogeneous beliefs.
CAPM Pricing with Reporting
We now derive asset prices and risk premia in the context of the (endogenous) reporting
environment described above. Let Pj (rj ) represent the price of rm j conditional on the
realization of earnings (i.e., conditional on r~j = rj ). Using standard results from Bayesian
8
In Section V we discuss extending our model to consider strategic reporting by multiple rms.

13
statistics in conjunction with eqn. (2), conditional on rj prices are given by

h i h i h i
E V~j + E V~j Cov V~j V~M
j 1 vj
vj +
rj N vj +
j j
Pj (rj ) = : (3)
1 + Rf

Note that prices in the presence of reporting, eqn. (3), are similar to those in the absence
of reporting, eqn. (2), with two important distinctions. As in the benchmark case, the rm
is priced based on its expected cash ow less a discount for systematic risk except now
investorsassessment of the rms expected cash ow and systematic risk are conditional on
reported earnings.
h i
In particular, now there are two extra terms in the numerator. The rst, E V~j +
h i
vj +
j
rj E V~j , represents investorsassessment of the rm js cash ow conditional
j
h i
on reported earnings. The second, N1 v +j Cov V~j V~M , represents investors assess-
v

j j

ment of the rms systematic risk conditional on reported earnings. The additional term
vj
vj +
captures how an entrepreneurs choice of reporting precision, j
, aects investors
j

assessment of the rms systematic risk: more precise reporting (i.e., higher j
) implies a
lower assessment of systematic risk (see also LLV). In this regard, investorsassessment of
systematic risk conditional on observing reported earnings represents an amalgamation of
information risk and intrinsic systematic risk (where the latter is sometimes referred to as
fundamental risk).
It is important to emphasize the distinction between the intrinsic systematic risk of the
rm and investors assessment of the systematic risk of the rm conditional on observing
reported earnings. In our model, intrinsic systematic risk is exogenous, and determined
by the primitive correlation between the rm and the market. In constrast, investors as-
sessment of systematic risk is endogenous, and depends on the entrepreneurs (endogenous)
choice of reporting precision, j
. Thus, by allowing the choice of reporting precision to be
endogenous, we eectively make endogenous the rms systematic risk (as it manifests in

14
prices). To the best of our knowledge, ours is the rst model to derive endogenously both
reporting precision and the rms systematic risk in the context of the CAPM. We solve for
the entrepreneurs optimal choice of reporting precision in the next section.
Optimal Precision Choice
Let Pj (~
rj ) represent the price of rm j as a function of an uncertain future earnings
r~j and U (Pj (~
rj )) the entrepreneurs utility for Pj (~
rj ). The entrepreneurs objective is to
choose j
so as to maximize his expected utility as a function of Pj (~
rj ) at time t = 1 (when
investors convene to trade shares). As an aside, one might think that if it were possible
for the entrepreneur to invest in a diversied portfolio before releasing earnings information
about rm j, then he would be indierent to the choice of j
. This logic, however, misses
the point that the choice of j
aects the proceeds the entrepreneur receives from selling his
shares in rm j. Thus, allowing the entrepreneur to invest in a diversied portfolio before
releasing earnings information about rm j does not aect our results.
The entrepreneurs objective function is

1 2
max E [U (Pj (~
rj ))] c : (4)
j 2 j

In eqn. (4), the price of the rm, Pj (~


rj ), is uncertain (random) because the entrepreneur does
not know in advance the realization of r~j when he commits to his choice of j
. In other
words, through his choice of j
, the entrepreneur chooses the extent to which earnings
reveals the rms future cash ow ex ante; that said, he has no inuence over the ex post
realization of earnings, and thus has no inuence over the realization of Pj (~
rj ). In order to
be able to derive E [U (Pj (~
rj ))] in closed form, henceforth we assume that the entrepreneur
has constant absolute risk aversion (CARA): specically, a utility function U (x) of the form

U (x) = exp [ x] ;

15
where > 0 represents the entrepreneurs coe cient of absolute risk aversion.9 CARA utility
is more restrictive than concave utility in that the former has the additional feature that
U 000 (x) > 0.10 That said, and as suggested by the discussion in Section II, the intuition that
underlies our results is driven primarily by the fact that the entrepreneurs preferences are
concave.
As is standard in any optimization problem, in choosing the optimal level of reporting
precision, j
, the entrepreneur trades o the marginal benet of an increase in reporting
precision against the marginal cost. In our model, there are two costs and one benet. The
rst cost involves the explicit cost of eort associated with reporting earnings with precision
1 2
j
. This cost operates through the term 2
c j
and is straightforward: the marginal eect
of an increase in j
entails a marginal cost of eort of c j
to the entrepreneur.
The second cost is more subtle and operates indirectly through the entrepreneurs ex-
pected utility of price, E [U (Pj (~
rj ))]. More precise reporting creates an additional risk for
the entrepreneur at time t = 0 when the entrepreneur commits to a precision choice
because it causes investors to place more weight on reported earnings, whose realization
will only become known at time t = 1. Because the entrepreneurs preferences are concave,
the entrepreneur is risk averse, and risk aversion implies that an increase in risk reduces
expected utility. To explain this eect, consider the extreme case where the entrepreneur
provides no information to investors (i.e., j = 0). In this case, investors assess the rms
h i
expected cash ow to be E V~j . Alternatively, suppose that the entrepreneur provides some
information (i.e., > 0). In this case, investors assess the rms expected cash ow to
j
h i h i h i
be E V~j + v +j rj E V~j , which could be higher or lower than E V~j depending
j j
h i
on whether the realization of reported earnings, rj , is greater or less than E V~j . Thus,
9
Following LLV, we characterize prices in terms of investors risk tolerance ( ) but the entrepreneurs
utility in terms of risk aversion ( ). Risk tolerance is the reciprocal of risk aversion; as such, the character-
ization that one employs is simply a matter of convenience.
10
For example, Eeckhoudt and Schlesinger (2006) refer to the third derivative of utility being positive as
prudence.

16
from the entrepreneurs perspective, reporting is tantamount to participating in a lottery
(because earnings are unknown at the time the entrepreneur chooses reporting precision).
Because the entrepreneur is risk averse, he abhors lotteries: the entrepreneur prefers the
h i
sure thingof E V~j . The marginal eect of an increase in the lotteryas a consequence
of an increase in j
is not as straightforward to characterize mathematically as the cost
discussed in the prior paragraph because it involves calculating E [U (Pj (~
rj ))], and we defer
that to Appendix B; nonetheless, it represents a cost that is separate and distinct from the
1 2
explicit cost of eort (i.e., separate from 2
c j
).
The benet is that a more precise report reduces investors assessment of the rms
h i
systematic risk: in eect, an increase in reporting precision reduces N1 v +j Cov V~j V~M .
v

h i j j

Specically, an increase in j on N v + Cov V~j V~M yields a marginal benet (through


1 vj

j j
h i
a reduction in systematic risk) of N 1 vj
2 Cov V~j V~M . A standard interpretation of
( vj + j )
this benet is that it represents a reduction in information risk; as such, it increases the
price of rm j and reduces the rms cost of capital.
To summarize, in choosing the optimal level of reporting precision, the entrepreneur
trades o the marginal benet of reducing investorsassessment of the rms systematic risk
against the explicit marginal cost of eort and the indirect marginal cost of participating in
a lottery. Henceforth we refer to the marginal benet of reducing investorsassessment of
the rms systematic risk net of the indirect marginal cost of participating in a lottery (both
of which operate through E [U (Pj (~
rj ))]) as the net marginal benet of an increase in j
.
When the net marginal benet is negative, increased precision does not justify incurring the
explicit cost, and the entrepreneur will choose the lowest level of reporting precision allowed,

?. When the net marginal benet is positive, the entrepreneur will choose a j
such that
the net marginal benet that operates through E [U (Pj (~
rj ))] equals the explicit marginal
1 2
cost of eort that operates through 2
c j
(subject to the lower bound ? ).

Let j
represent the entrepreneurs optimal choice of precision. In Appendix B we prove

17
the following result.

Lemma. One can characterize the entrepreneurs optimal choice of precision, j


, as

1 d
= max rj ))] j
E [U (Pj (~ ; ? :11
j
cd j j

This characterization presumes that the optimization problem is well behaved insofar as
it yields a well-dened solution: we discuss this issue in Appendix B in conjunction with
proving this result.
Precision Choice in Good-versus-Bad States
The CAPM assumes that rmsexpected cash ows are common knowledge. Thus, we
begin by considering the binary case where the entrepreneur and investors of rm j both
know whether the rm is in a good state or a bad state at time t = 0. In Section IV, in
the discussion following Corollary 1, we extend the analysis to a continuum of states. We
h i h i
represent the good and bad states by E V~j = G or E V~j = B , respectively, where

G > B. In Appendix B we prove the following result.

Proposition. The entrepreneurs (unique) choice of reporting precision in the bad state is
never less than the choice in the good state, and is typically higher when the rms intrinsic
systematic risk is greater than one-half the entrepreneurs risk aversion times the variance
of the rms cash ow: h i
1 h i V ar V~j
Cov V~j V~M > : (5)
N 2 (1 + Rf )

Note our deliberate use of the word typically in the statement of the Proposition, as
well as other results that we report below. When eqn. (5) is satised, the entrepreneurs
preferred choice of reporting precision in the bad state is higher than in the good state. In
11 d
In words, the expression d E [U (Pj (~
rj ))] j means: the derivative of E [U (Pj (~
rj ))] with respect to
j j

j
, as evaluated at j
= j
.

18
other words, the entrepreneur prefers to report more precisely in the bad state. However,
this preference is subject to the requirement that the reporting precision exceeds the lower
bound of ?. When the choice of reporting precision in the bad state does not exceed ?,

the entrepreneur is forced to choose ? in both states (because the choice of precision is
always higher in the bad state than in the good state). Thus, the word typically relates
to the requirement that the choice of j
in the bad state exceeds the lower bound of ?.

The Propositions underlying intuition is that when the inequality in eqn. (5) is not
satised, the net marginal benet of an increase in j
on E [U (Pj (~
rj ))] is non-positive.
Consequently, and irrespective of whether rm j is in the good or bad state, the entrepreneur
chooses the lowest level of precision allowed, ?. Because the level of precision is identical
in both states, reporting is symmetric.
Alternatively, when the inequality in eqn. (5) is satised, the net marginal benet of an
increase in j
on E [U (Pj (~
rj ))] is positive. In the good state, however, the net marginal
benet of an increase in j
is lower than in the bad state. The reason why it is lower
is that the entrepreneurs utility is concave; concavity implies that the marginal benet
of an increase in price in the good state is less than a commensurate increase in price in
the bad state. An alternative way of stating this intuition is that concavity implies that
the entrepreneur becomes increasingly more sated as outcomes become increasingly better:
satiation implies that the entrepreneur derives less marginal utility from an increase in price
(and hence less marginal utility from a reduction in uncertainty). Because the net marginal
benet of an increase in j
is lower in the good state than in the bad state, the optimal
choice of reporting precision is higher in the bad state than in the good state (when eqn.
(5) is satised, and assuming that the former exceeds the lower bound ? ).

In Appendix C we explain why eqn. (5) is likely to be satised when rmscash ows
covary, and thus why the entrepreneurs choice of reporting precision is likely to be higher in
the bad state than in the good state. The discussion is detailed, however, and so we relegate

19
it to an appendix.

IV. COMPARATIVE STATICS

In this section we discuss three comparative static results. The rst comparative static
result speaks to how changes in expected future cash ow aect asymmetric reporting. The
second speaks to how changes in reporting costs aect asymmetric reporting. The third
speaks to how asymmetric reporting endogenously aects investorsassessment of the rms
covariance with the market portfolio. The proof of these results can be found in Appendix
B.
Expected future cash ow
With regard to changes in expected cash ow, the following corollary follows immediately
from the Proposition.

Corollary 1. Assuming eqn. (5) is satised, the magnitude of the dierence in levels of
precision in the bad versus good state for rm j typically increases as either: 1) B decreases;
2) G increases; or 3) G increases and B decreases simultaneously.

The intuition that underlies Corollary 1 is that a decrease (increase) in the rms expected
cash ow in the bad (good) state increases (decreases) the net marginal benet from an
increase in j
in the bad (good) state. Consequently, the entrepreneur chooses a higher
(lower) level of j
in the bad (good) state. This, in turn, increases the magnitude of the
dierence in the extent to which reports reect (terminal) cash ow in the two states.
It is not necessary to bifurcate the analysis into just two states (i.e., good and bad).
Corollary 1 implies that one could posit a continuum of states that correspond to gradations
h i
in expected cash ow, E V~j . The interested reader can generalize Corollary 1 to a setting

20
with a continuum of states by establishing that when eqn. (5) is satised,

@
h j i < 0:
@E V~j

The interpretation of a negative marginal eect is that the optimal reporting precision, j
,
is decreasing in the anticipated outcome of the report (i.e., decreasing in the rms expected
h i
cash ow, E V~j ).12
Reporting costs
There should be little controversy in suggesting that an increase in the explicit cost of
reporting, in the form of an increase in c, decreases the optimal reporting precision in both
the good and bad states. However, we also prove something more nuanced: as reporting
costs increase, the magnitude of the dierence in the bad versus good state decreases.

Corollary 2. Assuming eqn. (5) is satised, as c increases: 1) the optimal reporting


precision for rm j typically declines in both the good and bad states; and 2) the magnitude
of the dierence in rm js reporting precision in the bad versus good state also typically
declines.

To be clear, assuming eqn. (5) is satised, if the marginal cost of reporting were zero (i.e.,
c = 0), the entrepreneur would choose innite reporting precision in both the good and
bad states (in eect, choose full revelation) so reporting precision would be symmetric.
Similarly, if the marginal cost of reporting were su ciently high (i.e., c su ciently large), the
entrepreneur would choose the lowest level of reporting precision allowable ( ?) and, once
again, reporting precision would be symmetric. However, between these two extremes, the
magnitude of the dierence in precision in the bad versus good state declines as c increases
(until the point at which the entrepreneur chooses ? in both states).
12 @ j
Note that establishing @E [V~j ]
< 0 oers an alternative way to prove the claim in the Proposition.

21
The interested reader can generalize Corollary 2 to a setting with a continuum of states
by establishing that when eqn. (5) is satised,

@2 j
h i > 0:
@E V~j @c

The interpretation of a positive cross-partial is that the optimal reporting precision, j


,
declines as reporting costs increase (c increases), but at a slower rate as the anticipated
h i
outcome of the report, E V~j , increases. Because the decline is faster in the bad state ( B )
than in the good state ( G ), the magnitude of the dierence in precisions between the bad
state and the good state decreases as c increases.
Asymmetric Systematic Risk
Recall from eqn. (3) that investorsassessment of the rms systematic risk conditional
h i
1 vj
~ ~
on a report takes the form, N v + Cov Vj VM . This expression illustrates how in-
j j
h i
vj
~
vestorsassessment of the rms covariance with the market portfolio, v + Cov Vj VM ,~
j j

represents an amalgamation of (endogenous) information risk and (exogenous) intrinsic sys-


tematic risk. More precise reporting (i.e., higher j
) reduces investorsassessment of the
rms covariance with the market portfolio. Consequently, when earnings reect future cash
ow to a greater extent in the bad state (i.e., eqn. (5) is satised), investorsassessment of
the rms systematic risk is lower in the bad state than it is in the good state. Although
this result follows directly from the Proposition, we nonetheless codify it as follows.

Observation 1. Assuming eqn. (5) is satised, conditional on observing earnings of rm


j , investors assessment of rm js systematic risk is typically lower in the bad state and
higher in the good state.

One feature of our approach to allowing both reporting precision and systematic risk
to be endogenous is that it links the rms expected cash ow and priced risk. Because

22
the rms expected cash ow determines reporting precision, which, in turn, determines
investorsassessment of the rms systematic risk, our model predicts that higher levels of
expected cash ow will be associated with higher levels of systematic risk (as assessed by
investors). Although this observation follows directly from Observation 1 in conjunction
with Corollary 1, we nonetheless codify it as follows.

Observation 2. Assuming eqn. (5) is satised, conditional on observing earnings of rm


j , investorsassessment of rm js systematic risk typically increases as the rms expected
cash ow increases.

V. EXTENSIONS

In this section we briey discuss two extensions of our (parsimonious) model.


Unobservable States
We have assumed that the state of rm j is common knowledge to both the entrepreneur
and investors. An interesting extension is to assume that while precision choice remains
observable, the entrepreneur alone knows the rms state. As investors have no knowledge
of the state, let us assume that they believe that rm j is in the good state ( G) with
probability q and in the bad state ( B) with probability 1 q. In this circumstance, the
entrepreneurs choice of reporting precision is more nuanced than the characterization oered
so far. Specically, the entrepreneur must anticipate that his choice of precision potentially
reveals the rms type (i.e., whether the rm is in a good state or a bad state). For example,
G B
if the entrepreneur always chooses precision j
in the good state and precision j
in the
G B
bad state, and j
6= j
, then rational investors will always be able to infer the rms
state based on the entrepreneurs choice of precision.
Thus, as an alternative and irrespective of the state of the rm the entrepreneur
f ixed
might elect to x his precision choice at some level, say, j
, that maximizes his expected

23
utility conditional on the rms type not being revealed to investors. In this circumstance
f ixed
and despite knowledge of the entrepreneurs precision choice (i.e., j
) investors would
be unable to revise their unconditional beliefs of about the rms state. In other words,
investors would continue to believe that rm j is in the good state with probability q, and
in the bad state with probability 1 q. If the entrepreneurs expected utility from choosing
f ixed G B
j
exceeds his expected utilities from choosing j
in the good state and j
in the bad
f ixed 13
state, then the entrepreneur will always choose j
.
Stated more broadly, in the context of investors not knowing the state of the rm,
f ixed
choosing j
represents a type of pooling equilibrium for the entrepreneur, whereas
G B
choosing j
in the good state and j
in the bad state represents a type of separating
equilibrium. Thus, in the context of our analysis, one could interpret a pooling equilibrium
as an example of symmetric reporting, and a separating equilibrium as an example of
asymmetric reporting. This implies that in the event that investors are unaware of the
state of the rm, the entrepreneur only reports asymmetrically when the resulting separating
equilibrium dominates the pooling equilibrium.
As with most pooling versus separating equilibria, typically there exist parameter speci-
cations such that the entrepreneur will prefer a pooling equilibrium in some circumstances,
and a separating equilibrium in other circumstances. While one might be tempted to de-
rive the specic parameter specications in the context of the CAPM, in point of fact the
derivation of prices in the CAPM relies critically on the assumption that an investors ex-
pected utility can be expressed as a single moment generating function; alternatively, when
13
Note that the entrepreneurs expected utility from choosing fjixed has to exceed his expected utility
from choosing either Gj or Bj . For example, suppose choosing Gj in the good state yields a higher
expected utility than fjixed , whereas choosing Bj in the bad state yields a lower expected utility. Then
presumably the entrepreneur will always feel compelled to choose Gj in the good state, thereby revealing
to investors that the rm is in the good state when Gj is chosen, and in the bad state when any level of
precision other than Gj is chosen.

24
investors believe that rm j is in the good state with probability q, and in the bad state
with probability 1 q, then an investors expected utility can only be expressed as the sum
of two moment generating functions. This small dierence makes the CAPM a poor vehicle
for studying pooling equilibria of the type we describe and hence we make no attempt to
explore this issue further.
Strategic Reporting
Another possible extension of our model is to incorporate the reporting choices of other
rms. While conceptually straightforward, this extension is complex in detail. When the en-
trepreneur of rm j chooses his reporting precision, he does so based on some belief, or conjec-
ture, about the covariance of his rms cash ow with the market cash ow. For this conjec-
ture to be rational, rm js entrepreneur has to anticipate (rationally) the reporting precision
choices of other rms. To the extent that the states of other rms are common knowledge
(which is assumed implicitly in the CAPM because rmsexpected cash ows are common
knowledge) the entrepreneur of rm j, say, can anticipate the reporting precision choices of
other rms; as such, he can anticipate the covariance of his rms cash ow with the mar-
n h i h i h io
ket cash ow based on all the reports. For example, let V = E V~1 ; E V~2 ; :::; E V~J
represent the vector of J rmsstates, where dierent rms can be in dierent states, and
r = f~
~ r1 ; r~2 ; :::; r~J g represent a vector of rms reports, where ~
r depends on entrepreneurs
precision choices. By virtue of the fact that V is common knowledge, each entrepreneur can
anticipate other entrepreneurs reporting precision choices, and thus, in eect, anticipate
h h ii
E Cov V~j V~M j~ r , where the latter expresses the covariance of rm js cash ow with the
market cash ow conditional on all rms reports (~
r). While the intuition that underlies
h h ii
E Cov V~j V~M j~
r is straightforward, the expression itself is complex. For example, the
Appendix to LLV discusses the case where two rms report, and derives the covariance of
the two rmscash ows conditional on these reports (see in particular eqn. (A4) on p. 415).

25
h h ii
Thus, in principle one can derive the expression E Cov V~j V~M j~
r and, in eect, extend
the analysis to allow for the possibility of the J entrepreneurs explicitly conditioning their
reports on other entrepreneursreports but the derivation is complex and the expression
largely intractable in the absence of some simplifying assumptions.14

VI. RELATION TO ACCOUNTING CONSERVATISM

In this section, we discuss how our results relate to the traditional notion of account-
ing conservatism. We focus our discussion on the notion of conservatism embodied in the
adage anticipate no prots but anticipate all losses,which we believe to be the most rep-
resentative, if not the most common, notion of conservatism (Watts, 2003). Although the
purpose of our paper is not to model accounting conservatism per se, our model provides a
parsimonious formal framework for thinking about some of the issues raised in the literature.
Accounting conservatism is one of the oldest, and most controversial topics in nancial
reporting (Sterling, 1967). Much of the literature that attempts to provide a rationale for
conservatism does so from the perspective of the stewardship role of accounting the role of
accounting in mitigating agency problems and facilitating e cient contracting (Holthausen
and Watts 2001; Watts 2003; Ball, Robin, and Sadka 2008).15 For example, studies in this
literature typically adopt the standard principal-agent paradigm from agency theory (or
the Grossman-Hart-Moore paradigm of debt contracting), and posit that the rationale for
the conservatism is to ameliorate agency conicts and/or facilitate e cient contracting.16
Although evidence in the empirical literature is often interpreted as suggesting that conser-
vatism leads to more e cient debt contracts, there is no similar consensus in the theoretical
14
For example, LLV assume that errors in reports are conditionally correlated. Hence, one possible
simplication is to assume that errors are conditionally uncorrelated.
15
See Armstrong, Guay, and Weber (2010) and Kothari, Ramanna, and Skinner (2010) for reviews.
16
See Gigler, Kanodia, Sapra, and Venugopalan (2009), Gox and Wagenhofer (2009), and Caskey and
Hughes (2012) for theoretical analysis of the debt contracting role of conservatism, and Chen, Hemmer,
and Zhang (2007), Bertomeu, Darrough, and Xue (2013), Gao (2013), and Caskey and Laux (2015) for
theoretical analysis of conservatism as it relates to earnings management and managerial compensation.

26
literature, with some studies suggesting that conservatism actually leads to less e cient debt
contracts (e.g., Gigler, Kanodia, Sapra, and Venugopalan 2009). Against this backdrop we
make three points.
First, we interpret the adage as describing a reporting convention that provides more
information about future outcomes when those outcomes are anticipated to be unfavorable
(i.e., losses). For example, under current US GAAP, when property, plant, and equipment
(PP&E) is thought to be impaired, earnings reect the anticipated loss in the form of a
write-down. However, if the same PP&E is thought to have appreciated in value, earnings
do not reect the anticipated prot. The asymmetric requirements for recognition of antic-
ipated losses and anticipated prots result in earnings that reect more information about
anticipated losses than they do about anticipated prots (Ryan 2006; Kothari, Ramanna,
and Skinner 2011). In the extreme, earnings reect no information about anticipated prots.
In this regard, one can interpret the economic essence of conservatism within the context
of the broader framework of asymmetric reporting the notion that the provision of infor-
mation about future outcomes depends on whether those outcomes are anticipated to be
unfavorable or favorable.
Although this broader economic notion of conservatism is perhaps dierent from what is
typical in the literature, it should not be controversial. Indeed, our perspective is not unique.
For example, consider the following passage from Armstrong, Guay, and Weber (2010, 190):

...when one views conservative accounting as a commitment to more com-


plete disclosure [when bad news is anticipated], as opposed to an asymmetric
accounting practice for recognizing good news more slowly than bad news, the
potential economic benets of conservative reporting can be considered in a broad
array of contracting and governance settings as well as a valuation setting. Fur-
ther, we note that the potential for conservative accounting to assist investors in

27
valuation is an interesting area for future research, given the common perception
(or, possibly, misperception) that although conservative accounting may assist
rms in contracting and governance settings, such benets come at the expense
accountings role in valuation.

In the context of our model, one can think of anticipated losses as corresponding to the
bad state ( B) and anticipated protsas corresponding to the good state ( G ). The notion
that earnings reect more information about future outcomes in the bad state, when losses
are anticipated, and no information about future outcomes in the good state, when prots
are anticipated, corresponds to the special case of our model where j
> 0 in the bad state
and j
= 0 in the good state. Accordingly, one can interpret the adage as a specic type
of asymmetric reporting that favors the provision of information in the bad state.17
We hasten to add, however, that our model does not speak to bias in earnings or book
values. In our model, the entrepreneur always issues an unbiased earnings report: it is
simply a question of the extent to which earnings reects future cash ow. Nonetheless, a
report with zero precision (i.e., j
= 0) is uninformative to the point of being tantamount
to not reporting.
Second, and related to the foregoing passage from Armstrong, Guay, and Weber (2010),
the valuation role of accounting alone can generate asymmetric reporting of future cash
ow. This claim is not meant to imply that the stewardship role of accounting is not
important, but rather to emphasize that it is not necessary.18 Our analysis demonstrates
17
See also Kirschenheiter and Ramakrishnan (2012, 3) who explicitly dene information systems as being
conditionally conservative if they produce ner information at lower earnings levels. Similarly, Glover and
Lin (2015, 39) note that writing the asset down but not up to reect market prices can be thought of as
devoting additional attention to bad states. This additional attention comes in the form of resources devoted
to detecting these bad states and the granularity of disclosure. When the market price is higher than cost, we
are told no more. When the market price is lower than cost, we are given more information (or can recover
it) we know both the historical cost and the write-down. In this sense, traditional historical cost accounting
subject to write-downs is honed on bad news, since the communication channels are expanded when there is
bad news.
18
See also Kirschenheiter and Ramakrishnan (2012), Nagar, Rajan, and Ray (2014), and Bertomeu and

28
that asymmetric reporting can be valuable even in the absence of agency conicts, debt
contracts, and information asymmetry. Perhaps the most striking aspect of our analysis is
the simplicity of the model that is needed to generate our results. Our chief requirements are
twofold. First, we require concave preferences (risk aversion). Second, we require that more
precise reporting entails greater eort. These requirements seem to describe a broad range
of circumstances, suggesting that asymmetric reporting can be optimal from a valuation
perspective in a wide variety of settings. In this respect, the insights from our model can
potentially explain why various forms of asymmetric reporting existed long before organized
and regulated capital markets (e.g., Basu 1997; Basu and Waymire 2006; Waymire 2009).
For example, our analysis does not require a formal capital market and can easily be extended
to a simple exchange between a buyer and a seller: a setting where, by denition, there are
no contracts or agency conicts. Waymire (2009) refers to such a setting when arguing that
the fundamental demand for accounting arises from exchange guidance.
Third, the notion that asymmetric reporting of future cash ow could arise from the valu-
ation role of accounting has important implications for how one interprets existing empirical
ndings. Our interpretation of the literature is that a valuation role of accounting has been
largely excluded as a possible explanation: with rare exception, empirical work has been
interpreted almost exclusively through the lens of stewardship (e.g., Holthausen and Watts,
2001). While there is a substantial body of literature that documents robust empirical re-
lations between asymmetric reporting of future cash ow and various contracting outcomes,
such relations do not imply that the purpose of asymmetric reporting is to facilitate e cient
contracting. It is possible that the asymmetric reporting could have evolved from other
forces (independent of contracting), but may nevertheless facilitate e cient contracts.19
Magee (2015).
19
The notion that existing empirical work is consistent with a stewardship-based explanation and thus
inconsistent with a valuation-based explanation is premised on a false antithesis. Evidence of the former
is not a rejection of the latter. A more likely scenario is that both forces are at work. At a minimum, we
argue that it is premature to reject a valuation-based explanation.

29
For example, much of the empirical literature interprets a negative relation between
asymmetric reporting of future cash ow and the cost of equity (debt) capital as prima
facie evidence of a stewardship explanationthat asymmetric reporting mitigates agency
conicts between managers and shareholders and/or shareholders and debt-holders (e.g.,
Ahmed, Billings, Morton, and Stanford-Harris, 2002; Zhang, 2008; Kim, Li, Pan, and Zuo,
2013). Our analysis provides an alternative, but not mutually exclusive, explanation for
these relations. In our model, an increase in the extent to which earnings reect future
cash ow in the bad state (i.e., an increase in j
in the bad state) both reduces investors
uncertainty in the bad state, and reduces the cost of capital in the bad state. To the extent
that a reduction in uncertainty empirically reduces the cost of capital, our results oer a
potential explanation for the observed relations that is not premised on agency conicts.20

VII. CONCLUSION

We develop a parsimonious model to study a rms endogenous reporting choices, and


whether those choices entail asymmetric reporting of the rms future cash ow. Specically,
we extend the CAPM to a setting where a rm reports earnings prior to selling shares to
investors. We show that a risk-averse entrepreneur, as representative of the rms initial own-
ers, will choose to report earnings that asymmetrically reect future cash ow. In modeling
the entrepreneurs reporting choice, we deliberately abstract away from the stewardship role
of accounting. In our model, the sole purpose of reported earnings is to facilitate valuation
by the rms equity investors there are no agency problems, debt contracts, or information
asymmetries. Nevertheless, we show that a rms earnings will reect future cash ow to a
greater (lesser) extent in bad states (good states) when that cash ow is anticipated to be
20
See Garcia Lara, Garcia Osma, and Penalva (2011) for an example of an empirical paper that relates
asymmetric reporting of future cash ow to the cost of capital using a reduction in uncertainty to motivate
their predictions (as opposed to an agency or stewardship motivation).

30
low (high).
We also show that reporting costs dierentially aect reporting in the two states. While
an increase in reporting costs reduces the extent to which earnings reect future cash ow in
both states, the extent of the reduction is greater in the bad state. Consequently, as techno-
logical improvements decrease the cost of reporting (ceteris paribus), our results suggest that
reporting will evolve to become increasingly asymmetric in favor of the bad state. Finally,
we show that the asymmetry in reporting generates asymmetry in the rms systematic risk.
When a rms earnings reect expected future cash ow to a greater extent in the bad state,
investorsassessment of the rms covariance with the market portfolio will be lower in the
bad state.
The key tension in our model relates to how an entrepreneur with concave preferences
(risk aversion) balances the cost of eort associated with reporting against the benet of a
reduction in uncertainty. This fundamental tradeo highlights the generality of the economic
intuition that underlies our results. As such, the intuition from our model applies to any
setting where a risk-averse owner of an asset including physical, intangible, or even human
capital trades o the marginal cost of eort in providing more precise information against
the marginal benet of reducing buyersuncertainty about the assets value.

31
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34
Figure 1. Timeline

t=0 t=1 t=2

The entrepreneur of firm j Investors observe firm js Future cash flow is


chooses the extent to which earnings and subsequently realized and paid out
the earnings of firm j will trade shares of J firms to investors in the
reflect future cash flow. and a risk-free bond. form of a liquidating
dividend.

35
Appendix A

Derivation of eqn. (2). The derivation follows from LLV, with one minor renement.
Consider an economy with J rms, indexed by the subscript j = 1; 2; :::; J, and a risk-free
bond. We assume that the risk-free rate of return is Rf ; that is, an investment of $1 in
the risk-free bond yields a return of $1 + Rf . Let V~j and Pj represent the uncertain cash
ow of rm j and the market equilibrium price of rm j, respectively. Along with the J
rms, we introduce a perfectly competitive market for rm shares comprised of N investors,
indexed by the subscript i = 1; 2; :::; N , where N is large. Let U (c) represent investor is
utility preference for an amount of cash c. Each investor has a negative exponential utility
1
function: that is, U (c) is dened by U (c) = exp c , where > 0 describes each
investors (constant) tolerance for risk.
Now consider the market price for rm j that prevails in a perfectly competitive market
in which N investors compete to hold shares in each rm, as well as a risk-free bond. Let
Di = fDi1 ; Di2 ; :::; Dij ; :::; DiJ g represent the 1 J vector of investor is demand for ownership
in J rms, where Dij represents investor is demand for rm j expressed as percentage of
the total rm; let P = fP1 ; P2 ; :::; Pj ; :::; PJ g represent the vector of rm prices, where once
again Pj represents the price of rm j; and let Bi and Bi represent investor is demand for a
risk-free bond and her endowment in bonds, respectively. As distinct from LLV, we assume
that initially the shares of all rms are held by their respective entrepreneurs prior to trade:
in other words, investors have no endowed ownership in rms prior to trade. Su ce it to
say that this minor renement has no eect on the derivation of eqn. (2) because it has no
eect on the rst-order condition in eqn. (8) below.
Each investor solves

1
max E[ exp[ (Di fV~1 ; V~2 ; :::; V~J g0 + (1 + Rf ) Bi )]]; (6)
Di ;Bi

36
subject to the budget constraint
Di P 0 + Bi = Bi :

Taking the expectation of eqn. (6). and substituting in the relation Bi = Bi Di P 0 yields
the following expression

1 h i h i
maxf exp[ (Di fE V~1 (1 + Rf ) P1 ; E V~2 (1 + Rf ) P2 ;
Di ;Bi
h i 1 1
:::; E V~J (1 + Rf ) PJ g0 + (1 + Rf ) Bi ) + Di Di0 ]g; (7)
2 2
h i
where is an J J covariance matrix whose s; t-th term is Cov V~s V~t .
The rst-order condition that maximizes eqn. (7) with respect to Dij reduces to

h i 1X
J h i
0 = E V~j (1 + Rf ) Pj Dik Cov V~j V~k : (8)
k=1

Because collectively investors have claims to the cash ow of the entire rm, for each k it
P
must be the case that N i=1 Dik = 1. Thus, summing over both sides of eqn. (8) with respect

to i yields
h i 1 XX
N J h i
0 = N E V~j (1 + Rf ) Pj Dik Cov V~j V~k ;
i=1 k=1

or
h i 1X
J h i
0 = N E V~j (1 + Rf ) Pj Cov V~j V~k :
k=1

This, in turn, implies that the price for rm j is given by


h i h PJ ~ i
E V~j N
1
Cov V~j k=1 Vk
Pj = :
1 + Rf

Q.E.D.

37
Appendix B
h i
Proof of the Lemma. The report r~j has a normal distribution with mean E V~j and
1 1 vj + j
variance vj
+ = vj
. Thus, when
j j

h i h i h i
E V~j + E V~j Cov V~j V~M
j vj 1
vj +
rj vj + N
j j
Pj (rj ) = ;
1 + Rf

using standard results relating to moment generating functions, E [U (Pj (~


rj ))] reduces to

E [U (Pj (~
rj ))]
s
vj j
=
2 vj + j
Z 1 h i h i h i
vj 1
exp E V~j + j
rj E V~j Cov V~j V~M
1 1 + Rf vj + j vj + j
N
1 h i
vj
exp j
rj E V~j drj
2 + j
vj
h i 1 1 h i
vj
= exp[ (E V~j j
Cov V~j V~M )]:
1 + Rf 2 1 + Rf vj vj + j vj + j
N

This, in turn, implies that

d
E [U (Pj (~
rj ))]
d j
!!
1 h i 1
vj vj
= 2 Cov V~j V~M
1 + Rf vj + j
N 2 (1 + Rf )
h i 1 1 h i
vj
exp[ (E V~j j
Cov V~j V~M )]:
1 + Rf 2 1 + Rf vj vj + j vj + j
N

h i
Recall that vj
1
= V ar V~j . Thus, if

h i
1 h i V ar V~j
Cov V~j V~M 0, (9)
N 2 (1 + Rf )

38
then the entrepreneur chooses as his optimal level of reporting precision j
= ? because
the net marginal benet that operates through E [U (Pj (~
rj ))] is non-positive. Alternatively,
suppose h i
1 h i V ar V~j
Cov V~j V~M > 0. (10)
N 2 (1 + Rf )
1 2
Recall that the marginal cost that operates through 2
c j
is c j
. Thus, when eqn. (10)
holds the entrepreneur chooses as his optimal j

1 d
= rj ))] j
E [U (Pj (~ : (11)
j
cd j j

Eqn. (11) does not provide a closed-form expression for j


, but the solution is nonetheless
unique because when eqn. (10) holds, the optimization problem in eqn. (4) is concave. Of
course, it may be the fact that the j
computed in eqn. (11) is less-than-or-equal-to ?,

in which case the entrepreneur chooses j


= ?. Thus, one can characterize the choice of

j
as
1 d
= max rj ))] j
E [U (Pj (~ ; ? :
j
cd j j

Q.E.D.

Proof of the Proposition. To prove this result, one is only required to show that if
the j
computed in eqn. (11) is greater than ?, then j
is higher in the bad-state
than the good-state. Let Gj solve Gj = 1c d d E [U (Pj (~rj ; G ))] j G in the good-state
h i j j

~ B B 1 d
(i.e., E Vj = G ), and j solve j = c d E [U (Pj (~ rj ; B ))] j B in the bad-state (i.e.,
h i j j

~
E Vj = B ). Our proof is by contradiction. In other words, we assume Bj < Gj and
show this to be false when, in addition, B < G. When eqn. (10) holds, E [U (Pj (~
rj ))] is

39
B G
concave in j
. Thus, when j
< j
and B < G

G 1 d 1 d
= E [U (Pj (~
rj ; G ))] j G E [U (Pj (~
rj ; G ))] j B
j
cd j j cd j j
0 1
!
1 1 h i 1
B vj
~ ~ vj C
= @ 2 Cov Vj VM A
c 1 + Rf B N 2 (1 + Rf )
vj + j
2 0 13
1
B
1 h i
vj
exp 4 @ G
j
B
Cov V~j V~M A5
1 + Rf 2 1 + Rf + B vj + j
N
vj vj j
0 1
!
1 1 h i 1
B vj vj C
< @ 2 Cov V~j V~M A
c 1 + Rf B N 2 (1 + Rf )
vj + j
2 0 13
1
B
1 h i
vj
exp 4 @ B
j
B
Cov V~j V~M A5
1 + Rf 2 1 + Rf + B vj + j
N
vj vj j

1 d B
= E [U (Pj (~
rj ; B ))] j B = ;
cd j j
j

B G
where the rst inequality follows from j
< j
and concavity of E [U (Pj (~
rj ))], and the
second inequality follows from B < G; collectively these inequalities contradict the claim
B G
that j
< j
. Q.E.D.

1 d
Proof of the Corollary 1. Dene G j
; G = j cd
E [U (Pj (~
rj ; G ))] and
j
1 d G G
B j
; B = j cd
E [U (Pj (~
rj ; B ))]. Assuming eqn. (5), let j
solve G j
; G =
j

B B
0 and let j
solve B j
; B = 0. It is a straightforward exercise to show that both

@G G ; @B B ;
G B
G j B j
@ j @ G
@ j @ G
= < 0 and = < 0:
@ G @G G ;
j G @ B @B B ;
j B

@ G @ B
j j

G
Thus, an increase in G implies a decrease in j
, whereas a decrease in B implies an
B
increase in j
. Q.E.D.

40
1 d
Proof of the Corollary 2. Dene G j
; G = j cd
E [U (Pj (~
rj ; G ))] and
j
1 d G G
B j
; B = j cd
E [U (Pj (~
rj ; B ))]. Assuming eqn. (5), let j
solve G j
; G =
j

B B
0 and let j
solve B j
; B = 0. Although complicated in detail, nonetheless it is a
straightforward exercise to show

@G G ; @B B ;
G G B B
@ j
j
@c
@ j
j
@c
= < 0 and = < 0:
@c @G G ;
j G @c @B B ;
j B

@ G @ B
j j

In addition, one can show


B G
@ j
@ j
< 0;
@c @c
B G
thus, an increase in c implies a decrease in the dierence between j
and j
. Q.E.D.

41
Appendix C

Discussion of eqn. (5). Here we show why eqn. (5) is likely to be satised when rms
cash ows covary. The CAPM implicitly assumes that the variance of an individual assets
cash ow is nite, but the number of rms in the economy (J) grows in relation to the
number of investors (N ) such that the expression

1 h i 1 X
J h i
~ ~
Cov Vj VM = Cov V~j V~k
N N k=1

does not go to 0 (vanish) as N gets large: otherwise assets would simply be priced at their
expected cash ow (adjusted for the risk-free rate).
Consider the following simple illustration. Suppose the economy has J identical assets;
the cash ow of each (identical) asset has nite variance 2 . Because assets are identical,
h i h i h i
Cov V~j V~k = V ar V~j = V ar V~k = 2 . This, in turn, implies

1 h i 1 X
J h i J
~ ~
Cov Vj VM = Cov V~j V~k = 2
:
N N k=1 N

Because N must be large (countably innite) to ensure that markets are perfectly competitive
(as the CAPM implicitly requires), the number of rms in the economy (J) must grow in
J
relation to the number of investors (N ) such that the ratio N
does not vanish to 0. For
example, suppose J = N . Then eqn. (5) reduces to

h i
1 h iJ 1 2 V ar V~j
Cov V~j V~M = 2
= 2
> = ;
N N 2 (1 + Rf ) 2 (1 + Rf )

or
1
> :
2 (1 + Rf )

42
Thus, if the entrepreneur and investors have identical risk tolerance (risk aversion), then
1
= and the condition reduces further to

1
1> ;
2 (1 + Rf )

which is always satised for Rf 0.


Of course, it is also possible that rmscash ows are independent. In this circumstance
h i
Cov V~j V~k = 0 and eqn. (5) will never be satised.

43

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