x
Journal of Accounting Research
Vol. 46 No. 5 December 2008
Printed in U.S.A.
On the Value Relevance
of Asymmetric Financial
Reporting Policies
J E R O E N S U I J S
∗
Received 25 June 2007; accepted 29 March 2008
ABSTRACT
This paper considers an overlapping generations model where investors
trade in a ﬁrm’s stock. Investment risk is partly determined by the volatility
of the stock price at which current investors can sell their shares to the next
generation of investors. It is shown that asymmetric reporting of good and
bad news is value relevant as it affects the allocation of risk among future
generations of shareholders.
1. Introduction
This paper analyzes the value relevance of ﬁnancial reporting policies in a
model withoverlappinggenerations of investors. Inoverlappinggenerations
models, a ﬁrm’s life cycle exceeds the investment horizon of shareholders,
implying that shareholders beneﬁt from investing mainly through changes
in a ﬁrm’s stock price. Consequently, it is the volatility of stock price that
∗
Department of Accounting and Control, RotterdamSchool of Management, Erasmus Uni
versity. The research of this author has been made possible by a fellowship of the Royal Nether
lands Academy of Arts and Sciences. This paper has beneﬁted from the helpful comments and
suggestions of an anonymous reviewer, Philip Berger (editor), John Hughes, Thore Johnsen,
Michael Kirschenheiter, Evelyn Korn, Brian Mittendorf, Jack Stecher, Alfred Wagenhofer; par
ticipants of the AmsterdamNyenrode Accounting Research Workshop, ChicagoMinnesota
Accounting Theory Conference, Workshop of Accounting and Economics V; and seminar par
ticipants at Catholic University of Leuven, Tilburg University, Norwegian School of Economics
and Business Administration, and Tel Aviv University.
1297
Copyright
C
, University of Chicago on behalf of the Institute of Professional Accounting, 2008
1298 J. SUIJS
determines the shareholders’ investment risk and not the volatility of the
ﬁrm’s future cash ﬂows. What separates the two is the ﬂow of information in
the capital market (see, e.g., Ross [1989]). As a result, the ﬁrm’s reporting
policy is a primary determinant of investment risk and may thus affect the
market value of the ﬁrm.
The model I analyze has the following structure. A ﬁrm starts as an invest
ment project that earns cash revenues in each period. Each generation of
investors owns the ﬁrm’s shares for one period only and then sells the shares
to the next generation of investors. At each date, just before trading takes
place, the current generation investors receive the cash revenues generated
in the prior period in the form of dividends and the ﬁrm’s accounting in
formation system (AIS) generates a ﬁnancial report on the cash revenues of
the next period (i.e., next period’s dividends). The role of the AIS is to al
locate the risk of each period’s cash revenues among the buying and selling
generations of investors. A more informative ﬁnancial report transfers risk
from the buying generation to the selling generation. It imposes less risk
on the buying generation as more uncertainty about the future dividends
is resolved at the time they buy the shares. However, it imposes more risk
on the selling generation as it increases the volatility of the stock price at
which they can sell their shares. This paper analyzes how the ﬁrm’s stock
price relates to the risksharing effects of its AIS.
This overlapping generations model is relatedtothe models inDye [1990]
and Dye and Verrecchia [1995]. Dye [1990] uses a twoperiod snapshot
of an overlapping generations model. The main difference is that Dye’s
[1990] model considers only symmetric ﬁnancial reporting, that is, good
and bad news is equally informative. In Dye and Verrecchia [1995], cur
rent shareholders contract with a manager who discloses information about
future expenses just before they sell their stock to a new generation of
shareholders. The return on investment for the new generation is deter
mined by an additional investment that they make based on the publicly
disclosed information. The manager’s disclosure must comply with gener
ally accepted accounting principles (GAAP) and the objective of their study
is to analyze the effect of discretion among GAAP. The major difference
with the study presented here is—apart from the agency problem—the in
vestment horizon of the new generation of shareholders. Investors hold the
ﬁrm’s stock until liquidation in Dye and Verrecchia [1995] so that their in
vestment risk is solely determined by the volatility of the ﬁrm’s ﬁnal cash
ﬂows.
The main result of this paper is that when the discount rate is not too
high, an AIS that reports bad news more precisely than good news results
in a higher ﬁrm value, that is, more efﬁcient risk sharing among genera
tions of shareholders, than an uninformative AIS while an AIS that reports
good news more precisely than bad news results in a lower ﬁrm value, that
is, less efﬁcient risk sharing. In fact, the value maximizing AIS perfectly re
ports bad news while the value minimizing AIS perfectly reports good news.
These results thus imply that full disclosure, that is, a perfectly informative
ASYMMETRIC FINANCIAL REPORTING POLICIES 1299
AIS, results in suboptimal risk sharing and therefore lower ﬁrm value. The
explanation for the value relevance of asymmetric ﬁnancial reporting is that
disclosing bad news more precisely than good news damps the dispersion in
future stock prices. When thereis lowinformation content in good news, the
buying generation of shareholders bears a considerable amount of risk fol
lowing the disclosure of good news. Hence, the stock price increase due to
the good news is limited as it is partly offset by a relatively high risk premium.
The stock price decrease following the disclosure of bad news is also limited
because the risk premium is relatively low; the high information content of
bad news imposes little residual uncertainty on the buying generation of
shareholders. In contrast, when good news is disclosed more precisely than
bad news, the dispersion in stock prices is high. The stock price increase
following the disclosure of good news is now offset by a small risk premium
while the stock price decline following the disclosure of bad news is further
reduced by a high risk premium.
Interpreting an AIS as a set of accounting standards has some interest
ing implications for the value relevance of accounting standards. The con
ventional wisdom is that accounting standards do not affect the market
value of the ﬁrm if they do not have any direct (e.g., taxes due) or indi
rect (e.g., economic consequences) effects on the ﬁrm’s future cash ﬂows.
This study shows that such cash ﬂow effects are not a necessity. In addition,
the value relevance of the asymmetric reporting of good and bad news is
precisely what accounting conservatism aims at. Reporting good news more
precisely than bad news is consistent with accounting conservatism as for
mulated in Basu [1997]; the higher veriﬁcation requirement for good news
implies that good news disclosures are more informative than bad news
disclosures.
This study also presents an alternative link between a ﬁrm’s disclosure pol
icy and its cost of capital. Disclosure reduces the cost of capital by improving
risk sharing across generations of investors. In contrast, Lambert, Leuz, and
Verrecchia [2007] link disclosure to cost of capital in a capital asset pricing
model (CAPM) model through a reduction in assessed covariances between
ﬁrms’ future cash ﬂows. Studies like Easley and O’Hara [2004]
1
focus on in
formationasymmetry among investors. Inthose models, investors require an
additional risk premium for the adverse selection problem that arises when
uninformed investors trade with informed investors. Public disclosure then
mitigates this adverse selection problem and lowers the corresponding risk
premium.
Asymmetric ﬁnancial reporting policies may also provide a rational ex
planation to empirical evidence of stock market underreaction to news (see
also Shin [2006]). When bad news is disclosed more precisely than good
1
For further examples, see Verrecchia [2001], Verrecchia [1999], Barth, Clinch, and
Shibano [1999], Huddart, Hughes, and Brunnermeier [1999], Baiman and Verrecchia [1996],
and Diamond and Verrecchia [1991].
1300 J. SUIJS
FIG. 1.—Overview of the overlapping generations model.
news, the disclosure of good news leaves more residual uncertainty and thus
imposes more risk on the shareholders of the ﬁrm than the disclosure of
bad news. Failing to correct for this change in ﬁrm risk in empirical tests
may produce positive abnormal returns for good news ﬁrms and negative
abnormal returns for bad news ﬁrms.
The paper proceeds as follows. Section 2 describes the overlapping gen
erations model and the ﬁnancial reporting policies. Section 3 derives the
equilibrium stock prices. Section 4 analyzes the relation among AIS choice,
risk sharing, and ﬁrm value. Section 5 presents a discussion of the results
and concludes. All proofs are provided in appendices.
2. An Overlapping Generations Model
Consider an overlapping generations model where investors of gener
ation t live from date t −1 until date t (ﬁg. 1 presents an overview of the
model). There is a single ﬁrmof which shares are traded among generations
of investors. Investors of generation t buy the ﬁrm’s shares from generation
t −1 at date t −1 and they sell the shares to generation t +1 at date t. Gen
eration t =0 represents the initial owners of the ﬁrm. The ﬁrm’s stock is
traded in a perfectly competitive market. The riskfree asset yields a return
r >1 and there are no constraints on borrowing in the riskfree asset. The
supply of the ﬁrm’s stock is normalized to one.
The operations of the ﬁrm are as follows. At date t =0, the ﬁrm starts
an investment project that generates cash ﬂow ˜ x
t
at date t =2, 3, . . . .
2
At
date t, before generation t sells the ﬁrm’s stock to generation t +1, the ﬁrm
pays the realized cash ﬂow x
t
in the form of dividends to generation t. The
2
The cost of this investment project is irrelevant for the problem at hand and is therefore
not speciﬁed. The ﬁrm does not pay dividends at date 1. Dividend payments at date 1 provide
incentives to the initial owners to disclose a ﬁnancial report on next period’s dividends before
they sell the ﬁrmto the ﬁrst generationof investors at date 0. Aﬁrm’s AIS choice is thennot only
inﬂuenced by the AIS’s risksharing effects among future generations of shareholders but also
by the AIS’s risksharing effects among the intitial owners of the ﬁrm and the ﬁrst generation
of investors. Because the former risksharing effect is the primary focus of this paper, I exclude
the latter risksharing effect by assuming no dividends at date 1. Subsection 4.1 discusses the
situation with dividends at date 1. Results are essentially the same.
ASYMMETRIC FINANCIAL REPORTING POLICIES 1301
dividend ˜ x
t
equals x >0 with probability p ∈ (0, 1) and zero with probability
1 − p. The future dividends ˜ x
t
(t = 2, 3, . . .) are mutually independent and
the distribution of ˜ x
t
is common knowledge.
At each date t =1, 2, . . . , before trading takes place, the ﬁrm publicly
discloses a ﬁnancial report, ˜ y
t
, that reveals information on the date t +1
dividend ˜ x
t +1
. The ﬁnancial report is generated by an AIS and the ﬁrm
commits to publicly disclosing this report truthfully.
3
The AIS can produce
two types of ﬁnancial reports, a good ﬁnancial report denoted by G or a
bad ﬁnancial report denoted by B. An AIS is characterized by the proba
bilities (q
H
, q
L
). Conditional on ˜ x
t +1
= x, the AIS produces the good ﬁ
nancial report G with probability q
H
and the bad ﬁnancial report B with
probability 1 −q
H
. Similarly, conditional on ˜ x
t
= 0, the AIS produces the
good ﬁnancial report G with probability q
L
and the bad ﬁnancial report
B with probability (1 −q
L
). In formal notation, q
H
= P(˜ y
t
= G  ˜ x
t +1
= x)
and q
L
= P(˜ y
t
= G  ˜ x
t +1
= 0). The AIS does not change over time. To be
consistent with the interpretation of the good ﬁnancial report G commu
nicating favorable information about the date t +1 dividend and the bad
ﬁnancial report B communicating unfavorable information, I restrict atten
tion to AISs that satisfy q
H
≥ q
L
. Observe that the AIS determines the in
formativeness of the ﬁnancial reports. For instance, the ﬁnancial reports
are perfectly informative to investors if (q
H
, q
L
) =(1, 0), whereas they
are completely uninformative if q
H
=q
L
. Further, observe that for q
H
=1
and q
L
∈ (0, 1), only the bad ﬁnancial report is perfectly informative. I
refer to such AISs as bad news AISs. Good news AISs are deﬁned analo
gously (i.e., q
H
∈ (0, 1) and q
L
=0). I assume that the ﬁrm’s AIS (i.e.,
the probabilities q
H
and q
L
) is publicly observable. At each date t, trade
is conditional on the disclosed ﬁnancial report y
t
. The ﬁnancial reports
disclosed in previous periods are irrelevant as these reports concern past
dividends.
The preferences of generation t investors are described by a linear mean
variance utility function U
t
(˜z) = E(˜z) −αVAR(˜z), with α ≥ 0 represent
ing the degree of risk aversion of generation t.
4
Because investors are
constant absolute risk averse, unconstrained borrowing implies that the
initial capital endowments of investors are irrelevant for their investment
decisions. Hence, without loss of generality I may assume that all capital
endowments are zero. One drawback of meanvariance utility functions
is that the implied preferences do not satisfy ﬁrstorder stochastic domi
nance. For example, any rational investor values the binary random payoff
3
Rock [2002] suggests that, in this respect, disclosure regulation, like the 1934 Securities
and Exchange Act, serves as a credible commitment device for a ﬁrm’s future disclosures.
4
While linear meanvariance utility functions are equivalent to exponential utility functions
when payoffs are normally distributed, this equivalence does not hold for the model under con
sideration. Meanvariance utility functions, however, are used for mathematical convenience.
Notice that the probability distribution of the future cash ﬂow ˜ x
t
is fully characterized by its
mean and variance, that is, p =
E(˜ x
t
)
2
VAR(˜ x
t
)+E(˜ x
t
)
2
and x =
VAR(˜ x
t
)+E(˜ x
t
)
2
E(˜ x
t
)
.
1302 J. SUIJS
˜ x
t
at at least zero, which is the lowest possible outcome. A meanvariance
utility function, on the other hand, results in an equilibrium price of
E(˜ x
t
) −2αVAR(˜ x) = px −2αp(1 − p)x
2
, which is less than or equal to zero
whenever 2α (1 − p)x ≥ 1. To rule out these cases, I assume that
2αx < 1. (1)
This regularity condition implies that E(˜ x
t
) −2αVAR(˜ x
t
) > 0 for any suc
cess probability p ∈(0, 1). Section 4.2 shows howthe main result may extend
to normally distributed cash ﬂows ˜ x
t
. Section 4.3 shows how the results ex
tend to exponential utility functions in order to show that the results do
not critically depend on assumption (1) or the use of meanvariance utility
functions.
3. Equilibrium Stock Prices
Denote by
t
(y
t
) the equilibrium stock price at date t =1, 2, . . . for
y
t
∈ {G, B}. When generation t +1 buys the ﬁrm’s stock at date t, they are
investing in a risky asset that pays ˜ x
t +1
 y
t
+
t +1
(˜ y
t +1
). Notice that ˜ x
t +1
 y
t
is the dividend that generation t +1 receives and that
t +1
(˜ y
t +1
) is the equi
librium price at which generation t +1 sells the stock to generation t +2.
Hence, generationt +1 faces twotypes of risk whenthey are buying the stock
at date t, namely, the dividend risk ˜ x
t +1
 y
t
and the price risk
t +1
(˜ y
t +1
).
Since the dividend ˜ x
t +1
 y
t
and selling price
t +1
(˜ y
t +1
) are stochastically
independent and the utility function features constant absolute risk aver
sion, the equilibrium price
t
(y
t
) is additively separable in ˜ x
t +1
 y
t
and
t +1
(˜ y
t +1
), that is,
5
t
(y
t
) =
1
r
(E(˜ x
t +1
 y
t
) −2αVAR(˜ x
t +1
 y
t
))
+
1
r
(E(
t +1
(˜ y
t +1
)) −2αVAR(
t +1
(˜ y
t +1
))) .
(2)
Deﬁne π
y
t
=
1
r
(E(˜ x
t +1
 y
t
) −2αVAR(˜ x
t +1
 y
t
)) for y
t
∈ {G, B}. It is the
equilibrium price that is paid for next period’s dividend conditional on
having received the report y
t
. Since investors’ posterior beliefs about the
revenue ˜ x
t +1
given a good ﬁnancial report equal
˜ x
t +1

G
=
¸
x, with probability p
G
,
0, with probability 1 − p
G
,
where p
G
=
pq
H
pq
H
+(1−p)q
L
, it follows that
π
G
=
1
r
p
G
x −
2α
r
p
G
(1 − p
G
)x
2
. (3)
5
A standard result for linar meanvariance utility functions is that the equilibrium price for
a risky payoff ˜ x equals
1
r
(E(˜ x) −2αVAR(˜ x)).
ASYMMETRIC FINANCIAL REPORTING POLICIES 1303
Similarly, the posterior beliefs given the bad ﬁnancial report equal
˜ x
t +1

B
=
¸
x, with probability p
B
,
0, with probability 1 − p
B
,
where p
B
=
p(1−q
H
)
p(1−q
H
)+(1−p)(1−q
L
)
. Hence,
π
B
=
1
r
p
B
x −
2α
r
p
B
(1 − p
B
)x
2
. (4)
Observe that q
H
≥ q
L
implies p
G
≥ p ≥ p
B
and π
G
≥ π
B
. Hence, a good
ﬁnancial report is indeed a better indication of a high date t +1 dividend
than a bad ﬁnancial report.
To derive an explicit expression for
t
(y
t
), I conjecture that
t
(y
t
) =
π
y
t
+
r
r −1
π where π is a constant and y
t
∈ {G, B}. Given an AIS
(q
H
, q
L
), the probability of receiving the good report y
t +1
=G equals
q =pq
H
+(1 − p)q
L
so that E((˜ y
t +1
)) = q π
G
+(1 −q )π
B
+
r
r −1
π and
VAR((˜ y
t +1
)) = q (1 −q )(π
G
−π
B
)
2
. Substituting this into equation (2)
yields
t
(y
t
) = π
y
t
+
1
r
q π
G
+(1 −q )π
B
+
r
r −1
π −2αq (1 −q )(π
G
−π
B
)
2
.
Combining this with the conjecture that
t
(y
t
) = π
y
t
+
r
r −1
π gives
π
y
t
+
r
r −1
π = π
y
t
+
1
r
×
q π
G
+(1 −q )π
B
+
r
r −1
π −2αq (1 −q )(π
G
−π
B
)
2
.
After rearranging terms one obtains
π =
1
r
q π
G
+(1 −q )π
B
−2αq (1 −q )(π
G
−π
B
)
2
. (5)
Observe that π =
1
r
(E(π
˜ y
) −2αVAR(π
˜ y
)). It thus equals the equilibrium
price that a generation of investors pays today for the opportunity to sell the
dividend to the next generation investors at price π
˜ y
t +1
.
To determine
0
, observe that generation 1 investors do not receive any
dividends. At date t =0, they buy a risky asset that is sold at date t =1 at
price
1
(˜ y
1
). Since
1
(˜ y
1
) = π
˜ y
1
+
r
r −1
π, it follows that
0
=
1
r
(E(
1
(˜ y
1
)) −2αVAR((˜ y
1
)))
=
1
r
(E(π
˜ y
1
) −2αVAR(π
˜ y
1
)) +
1
r −1
π
= π +
1
r −1
π =
r
r −1
π.
Summarizing,
1304 J. SUIJS
PROPOSITION 1. The equilibrium prices are given by
0
=
r
r −1
π (6)
and
t
(y
t
) = π
y
t
+
r
r −1
π, for t = 1, 2, . . . . (7)
Observe that
t
(y
t
) = π
y
t
+
0
, so that one can interpret π
y
t
as the ﬁrm’s
transitory value and
0
as the ﬁrm’s fundamental or permanent value. The
remainder of the analysis focuses on the effect of AIS on the permanent
value of the ﬁrm,
0
.
Notice that when generation t is buying the ﬁrm’s stock at date t −1,
they are effectively buying all future dividends, ˜ x
t
 y
t −1
and ˜ x
t +j
 ˜ y
t +j −1
( j =
1, 2, . . .). Generation t pays π
y
t
for the dividend ˜ x
t
 y
t −1
that they receive.
Furthermore, since generation t sells the dividend ˜ x
t +1
 ˜ y
t
to generation
t +1 at price π
˜ y
t
, they are buying ˜ x
t +1
 ˜ y
t
at date t at price π =
1
r
(E(π
˜ y
) −
2αVAR(π
˜ y
)). More generally, the future dividend ˜ x
t +j
 ˜ y
t +j −1
trades at price
π at date t + j −2 when generation t + j −2 sells ˜ x
t +j
 ˜ y
t +j −1
to generation
t + j −1. Discounting then implies that at date t −1, the future dividend
˜ x
t +j
 ˜ y
t +j −1
trades at
1
r
j −1
π. Hence, generation t pays
¸
∞
j =0
1
r
j
π =
r
r −1
π for
the future dividends ˜ x
t +j
 ˜ y
t +j −1
( j = 1, 2, . . .).
The price π that generation t pays at date t −1 for the dividend ˜ x
t +1
 ˜ y
t
includes two different risk premiums: one for price risk and one for div
idend risk. To see this, deﬁne ρ
S
=
1
r
E(π
˜ y
) −π =
2α
r
VAR(π
˜ y
) and ρ
y
=
1
r
E(˜ x
t
 y ) −π
y
=
2α
r
p
y
(1 − p
y
)x
2
for y =G, B. Then
π =
1
r
(E(π
˜ y
) −2αVAR(π
˜ y
)) =
1
r
E(π
˜ y
) −ρ
S
=
1
r
E
1
r
E(˜ x
t
 ˜ y ) −ρ
˜ y
−ρ
S
=
1
r
2
E (E(˜ x
t
 ˜ y )) −
1
r
E(ρ
˜ y
) +ρ
S
=
1
r
2
E(˜ x
t
) −
1
r
E(ρ
˜ y
) +ρ
S
.
(8)
The term E(ρ
˜ y
) refers to dividend risk. It is the buyer’s expected risk pre
mium and arises from the uncertainty in the dividend ˜ x
t +1
 y
t
that genera
tion t +1 faces when buying ˜ x
t +1
 y
t
from generation t at date t. The second
termρ
S
refers to price risk. It is the seller’s risk premiumand arises fromthe
uncertainty in the price, π
˜ y
t
, at which generation t sells the dividend ˜ x
t +1
 ˜ y
t
to generation t +1 at date t. Observe that the buyer’s risk premium, ρ
y
, de
pends on the informativeness of the ﬁnancial report y. A more informative
report results in less residual uncertainty and thus in a lower risk premium.
Also, observe that changes in the price, π, arise only because the AIS affects
the total risk premium
ρ =
1
r
E(ρ
˜ y
) +ρ
S
(9)
ASYMMETRIC FINANCIAL REPORTING POLICIES 1305
through the allocation of dividend risk and price risk. Indeed, if investors
are risk neutral, π equals the discounted expected value of the dividend
˜ x
t
and does not depend on the information generated by the AIS and the
corresponding allocation of risk.
4. Accounting Information System Choice
This section analyzes the effect of AIS choice on the risk premiumρ. Min
imizing the risk premium is chosen as the objective for two reasons. First,
from a social perspective one can consider the risk premium as a proxy for
risksharing efﬁciency. A lower risk premium implies a better risk allocation
among future generations of shareholders. Second, a lower risk premiumin
creases the date 0sellingprice of the ﬁrm, whichis inthe interest of the initial
owners who can choose the ﬁrm’s AIS. Finally, the date 0 selling price cap
tures the permanent as opposed to the transitory component of ﬁrm value.
The role of the AIS is to allocate price risk and dividend risk across con
secutive generations of investors. To illustrate the riskallocation effects of
disclosure, observe that a noninformative AIS imposes all of the ﬁrm’s risk
on the buying generation t +1. Since all uncertainty with respect to ˜ x
t +1
is
revealed at date t +1, the selling generation t bears no price risk. At date t,
they sell the ﬁrm’s stock to the next generation for the same price as they
bought it at date t −1. Conversely, a perfectly informative AIS imposes all of
the ﬁrm’s risk on the selling generation t. Since all uncertainty with respect
to ˜ x
t +1
is already resolved at date t, investing in ˜ x
t +1
 y
t
is riskless for the buy
ing generation t +1 so that they bear no dividend risk. Generally, disclosure
of information at date t increases the price risk to the selling generation t
and decreases the dividend risk to the buying generation t +1.
In analyzing the effect of AIS choice on the allocation of risk, I use the
uninformative AIS as a benchmark. I denote the corresponding stock prices
and risk premiums by means of an upper bar, that is,
¯
t
, ¯ π, ¯ π
y
t
, ¯ ρ, ¯ ρ
S
, and
¯ ρ
y
. An uninformative AIS is characterized by q
H
=q
L
. Since the ﬁnancial
report communicates no information, it holds that ˜ x
t
 y
t −1
= ˜ x
t
so that
¯ π
G
= ¯ π
B
=
1
r
px −
2αx
2
r
p(1 − p) and ¯ ρ
G
= ¯ ρ
B
=
2αx
2
r
p(1 − p). This in turn
implies that ¯ ρ
S
=
2α
r
VAR( ¯ π
˜ y
) = 0, that is, there is no price risk. Observe that
(permanent) ﬁrm value
0
≥
¯
0
if and only if ρ ≤ ¯ ρ.
There are two factors that determine the effect of the ﬁrm’s AIS on the
risk premium ρ. The ﬁrst is asymmetric reporting of good and bad news.
The second is the time value of money.
PROPOSITION 2. Relative to the uninformative AIS, an informative AIS induces
better risk sharing if and only if the bad ﬁnancial report is sufﬁciently more informative
than the good ﬁnancial report, that is, ρ < ¯ ρ if and only if 1 − p
B
> p
G
−
√
r −1
2αx
,
or equivalently, ρ
G
> ρ
B
−
√
r −1
r
x(p
G
− p
B
).
Proposition 2 is driven by the natural damping effect of more precise bad
news on price risk, ρ
S
. A good ﬁnancial report induces a low price increase
1306 J. SUIJS
as the price increase is partly offset by a high buyer’s risk premium, ρ
G
, while
a bad ﬁnancial report induces a low price decrease because the buyer’s risk
premiumis low. In contrast, more precise good news increases the price risk
ρ
S
. A good ﬁnancial report induces a high price increase as the buyer’s risk
premiumis low, whereas a badﬁnancial report induces a highprice decrease
as, in addition to the bad news, the stock price is even further reduced by a
high buyer’s risk premium.
For a strictly positive discount rate r >1, there is a tradeoff between asym
metric reporting and timely reporting. As the discount rate increases, the
beneﬁt of timely reporting outweighs the beneﬁt of asymmetric reporting.
This is because every generation of shareholders beneﬁts from the decrease
in dividend risk before they bear the price risk when selling the stock. More
informative good news results in a higher ﬁrmvalue provided that the asym
metry ininformativeness is not toohigh, that is, ρ
B
−ρ
G
<
√
r −1
r
x(p
G
− p
B
).
Whenthe discount rate is sufﬁciently high, timely reporting dominates asym
metric reporting so that any informative AIS increases ﬁrm value.
6
A complete characterization of riskmaximizing and riskminimizing AISs
is provided in the following proposition:
PROPOSITION 3.
(a) The AIS (ˆ q
H
, ˆ q
L
) that minimizes the total risk premium ρ is unique and
satisﬁes ˆ q
H
= 1 and
ˆ q
L
=
¸
¸
p
1−p
1+αx(1−p)−
1
2
√
(2αx(1−p)−1)
2
+3r
αx(2+p)−1+
1
2
√
(2αx(1−p)−1)
2
+3r
, if r −1 < 4αx(1 − p)
0, if r −1 ≥ 4αx(1 − p).
(10)
(b) The AIS (ˇ q
H
, ˇ q
L
) that maximizes the total risk premium ρ is unique and
satisﬁes ˇ q
L
= 0 and
ˇ q
H
=
¸
¸
1
p
2αxp+1−
1
2
√
(2αxp+1)
2
+3r
αx(3−p)+1−
1
2
√
(2αxp+1)
2
+3r
, if r ≤ (1 +2αxp)
2
0, if r > (1 +2αxp)
2
.
(11)
Consistent with Proposition 2, full disclosure (i.e., ˆ q
H
= 1 and ˆ q
L
= 0) is
optimal for sufﬁciently high discount rates r and asymmetric reporting is
optimal when the discount rate is sufﬁciently low. In particular, a bad news
AIS results in the best risk allocation and a good news AIS results in the
worst risk allocation.
AIS choice is a tradeoff between dividend risk and price risk. FromPropo
sition 2 we know that dividend risk dominates price risk when bad news is
disclosed more precisely than good news: A decrease in dividend risk results
in a relatively low increase in price risk so that total risk decreases. Mini
mizing dividend risk (conditional on ρ
G
>ρ
B
) thus results in optimal risk
6
This follows fromthe alternative condition 1 − p
B
> p
G
−
√
r −1
2αx
and the observations that
1 − p
B
≥ 0 and p
G
−
√
r −1
2αx
< 0 for sufﬁciently large values of r .
ASYMMETRIC FINANCIAL REPORTING POLICIES 1307
sharing. Since dividend risk equals
1
r
(qρ
G
+(1 −q )ρ
B
), the minimumis ob
tained for ρ
B
=0. Conversely, when good news is disclosed more precisely
than bad news, price risk dominates dividend risk. Since price risk equals
VAR(π
˜ y
t
) =
1
r
2
q (1 −q ) ((p
G
− p
B
)x −(ρ
G
−ρ
B
))
2
,
the maximum(conditional onρ
G
<ρ
B
) is obtainedfor ρ
G
=0 (i.e., p
G
=1).
The optimal AIS does not induce Pareto efﬁcient risk sharing among
the two different generations of investors. A Pareto optimal risksharing
arrangement allocates the risky cash ﬂow ˜ x
t +1
equally to generation t and
generation t +1, that is, each generation receives
1
2
˜ x
t +1
(see, e.g., Wilson
[1968]). However, there exists no AIS that can replicate this Pareto optimal
risk allocation (or any other proportional allocation of the risk). The main
reason for this is that generation t and generation t +1 receive their payoffs
at different points in time. To enable risk sharing in this setting, the payoffs
of generation t and t +1 should be imperfectly correlated, something that
is inconsistent with proportional risk allocations.
7
4.1 FIRST PERIOD DIVIDENDS
In the basic setup of the model, the ﬁrst generation of investors does not
receive any dividends. They buy the ﬁrm’s shares from the initial owners
at date 0 and they sell them to the second generation at date 1. The ﬁrst
generation thus only bears the price risk
1
(˜ y
1
). This subsection analyzes
the (ir)relevance of this assumption.
Assume that the ﬁrm’s investment project also generates a cash ﬂow ˜ x
1
at
date 1 and that ˜ x
1
is paid as dividends to the ﬁrst generation of investors.
The dividend ˜ x
1
equals x with probability p and 0 with probability 1 − p
and is independent of ˜ x
2
, ˜ x
3
, . . . . Further, assume that the initial owners
disclose a report ˜ y
0
on ˜ x
1
before they sell the ﬁrm to the ﬁrst generation of
investors. Denote by
◦
t
(y
t
) the equilibrium price at date t =0, 1, 2, . . . . It
is straightforward to see that
◦
0
(y
0
) = π
y
0
+
r
r −1
π, and (12)
◦
t
(y
t
) =
t
(y
t
) = π
y
0
+
r
r −1
π, for t = 1, 2, . . . (13)
One can still decompose the share price
◦
t
(y
t
) into a transitory compo
nent, π
y
t
, and a permanent component,
r
r −1
π. The permanent component
7
To illustrate, consider an arbitrary AIS. Then the selling generation t bears the risk in
the date t price π
˜ y
t
and the buying generation t +1 bears the remaining risk, ˜ x
t +1
−π
˜ y
t
. Now,
suppose that π
˜ y
t
equals
1
2
˜ x
t +1
as should be the case under Pareto efﬁcient risk sharing (so
that ˜ x
t +1
−π
˜ y
t
=
1
2
˜ x
t +1
). Since the revenues of generation t and t +1 are perfectly correlated,
disclosure of the ﬁnancial report y
t
not only determines the revenue of generation t, it also
reveals the date t +1 revenue of generation t +1. This implies that for generation t +1, in
vesting in the ﬁrm’s stock at date t is risk free. Clearly, this contradicts the presumed Pareto
efﬁciency of the risk allocation.
1308 J. SUIJS
is the same as in Proposition 1 and the date 0 price
◦
0
(y
0
) now also in
cludes a transitory component, π
y
0
. However, for analyzing the effect of
AIS choice, the social perspective and the initial owner’s perspective are no
longer equivalent.
The results do not change when considering the social perspective be
cause it focuses onbetter risk sharing among future generations of investors.
Hence, the risk premiumρ included inthe permanent value
r
r −1
π still serves
as a proper proxy for risksharing efﬁciency. Furthermore, it is not affected
by whether dividends are paid on date 1. The results for the initial owner’s
perspective, however, do change. The reason is that the initial owners now
bear a price risk. The expected utility of the initial owners is now
E
U
0
(
◦
0
(˜ y
0
))
= E(
◦
0
(˜ y
0
)) −αVAR(
◦
0
(˜ y ))
= E(π
˜ y
0
) −αVAR(π
˜ y
0
) +
r
r −1
π
= E(π
˜ y
0
) −2αVAR(π
˜ y
0
) +αVAR(π
˜ y
0
) +
r
r −1
π
= r π +
1
2
rρ
S
+
r
r −1
π.
(14)
Inexpression(14), the term
r
r −1
π refers tolongtermrisksharing. The better
the risk sharing among future generations of investors, the higher π is. The
term r π +
1
2
rρ
s
refers to shortterm risk sharing between the initial owners
and the ﬁrst generation investors. The risksharing problem between the
initial owners and the ﬁrst generation investors differs from the risksharing
problem between generations t and t +1. Since the initial owners do not
buy the shares in a competitive market like future generations of investors
do, they price the risk in π
˜ y
0
at αVAR(π
˜ y
0
) =
1
2
ρ
S
. This is only half of the
cost, ρ
S
, at which generation t values its price risk π
˜ y
t
. The term
1
2
ρ
S
in
equation (14) thus reﬂects the lower riskbearing cost of the initial owners.
Consequently, the shortterm risksharing problem differs from the long
termrisksharing problemin that one would like more informative ﬁnancial
reporting so as to impose more price risk on the initial owners. In choosing
the ﬁrm’s AIS, the initial owners trade off the shorttermrisksharing beneﬁts
of more disclosure (i.e., higher ρ
S
) against the longterm risksharing costs
(i.e., lower π). Nevertheless, results remain similar to Proposition 2 and
Proposition 3. However, because of the shorttermbeneﬁts of more ﬁnancial
reporting, the AIS that maximizes the expected utility of the initial owners
is more informative than for the case with no date 1 dividends.
4.2 NORMALLY DISTRIBUTED CASH FLOWS
The purpose of this subsection is to show that asymmetric reporting also
affects ﬁrm value when the ﬁrm’s future cash ﬂows are approximately nor
mally distributed. I extend the model by assuming that the period t cash ﬂow
˜ x
t
is binomially distributed with n draws and success probability p. Notice
that a binomial distribution approximately follows a normal distribution
with expectation np and variance np(1 − p). It holds that ˜ x
t
=
¸
n
i =1
˜ x
i,t
with
ASYMMETRIC FINANCIAL REPORTING POLICIES 1309
˜ x
i,t
(i = 1, 2, . . . , n) independently and identically distributed with proba
bility distribution
˜ x
i,t
=
¸
1, with probability p
0, with probability 1 − p.
(15)
In terms of the original model, the ﬁrm thus consists of n different invest
ment projects with investment project i generating dividends ˜ x
i,t
at each
date t.
Next, assume that in each period t =1, 2, . . . , the AIS produces a ﬁ
nancial report ˜ y
t
on the cash ﬂow ˜ x
t +1
. This ﬁnancial report is such that
˜ y
t
= #{i  ˜ y
i,t
= G} with ˜ y
i,t
∈ {G, B} independent and identical probability
distributions satisfying P(˜ y
i,t
= G  ˜ x
i,t +1
= 1) = q
H
and P(˜ y
i,t
= G  ˜ x
i,t +1
=
0) = q
L
. Notice that the AIS is againcharacterized by the parameters q
H
and
q
L
. The AIS produces a binary signal, ˜ y
i,t
, of each dividend ˜ x
i,t +1
. The dis
closed ﬁnancial report ˜ y
t
is a sufﬁcient statistic for the signals ˜ y
1,t
, . . . , ˜ y
n,t
; it
equals the number of investment projects i =1, 2, . . . , n for which the ﬁrm
receives a good signal (i.e., ˜ y
i,t
= G).
For a giveninvestment project i, the inﬁnite streamof future dividends ˜ x
i,t
and signals ˜ y
i,t
, (t = 1, 2, . . .) ﬁts the original model with the high payoff
x set equal to 1. Hence, the price at which investment project i trades at
date t is given by Proposition 1. Since the investment projects are identically
and independently distributed, the price at which the ﬁrm trades on date t
equals
0
=
nr
r −1
π (16)
and
t
(y
t
) = y
t
π
G
+(n − y
t
)π
B
+
nr
r −1
π, t = 1, 2, . . . . (17)
Abstracting fromthe inﬂuence of discounting (i.e., r →1), applying Propo
sition 2 then yields that, compared to an uninformative AIS, risk sharing
improves if and only if ρ
G
>ρ
B
.
To see how the content of the ﬁnancial report relates to its precision, con
sider a realization y
t
of the ﬁnancial report. Given y
t
good signals (and
n−y
t
bad signals), investors rationally believe that y
t
out of n projects
generate dividend ˜ x
i,t +1
= 1 with probability p
G
and that the remaining
n−y
t
projects generate dividend ˜ x
i,t +1
= 1 with probability p
B
. Denot
ing by ˜z(y , p), a binomial distribution with parameters y and p, it follows
that ˜ x
t +1
 y
t
= ˜z(y
t
, p
G
) + ˜z(n − y
t
, p
B
). Hence, the posterior beliefs con
cerning future dividends approximately follow a normal distribution with
expectation
E(˜ x
t +1
 y
t
) = y
t
p
G
+(n − y
t
)p
B
= np
B
+ y
t
(p
G
− p
B
) (18)
1310 J. SUIJS
and variance
VAR(˜ x
t +1
 y
t
) = y
t
p
G
(1 − p
G
) +(n − y
t
)p
B
(1 − p
B
)
=
r
2α
(nρ
B
+ y
t
(ρ
G
−ρ
B
)) .
(19)
Consistent with y
t
being the number of good signals, the posterior expec
tation is increasing in y
t
. Furthermore, the residual uncertainty depends
on the content of the disclosed ﬁnancial report when ﬁnancial reporting is
asymmetric. The posterior variance increases in the report y
t
if and only if
ρ
G
>ρ
B
. In that case, the better a ﬁnancial report, the less informative it
becomes to investors (i.e., the higher the residual uncertainty). The reverse
holds true if ρ
G
< ρ
B
.
4.3 EXPONENTIAL UTILITY FUNCTIONS
In this subsection I present results similar to Proposition 2 for the case
that investors’ preferences are described by an exponential utility function.
Let U
t
(x) =−e
−αx
denote the utility function for each generation of in
vestors, withα >0representingthe degree of constant absolute riskaversion.
Proposition 1 still applies with prices ¯ π, π
G
, π
B
, and π replaced by
8
¯ π =
1
r
2
pxe
−αx
pe
−αx
+1 − p
, (20)
π
G
=
1
r
p
G
xe
−αx
p
G
e
−αx
+(1 − p
G
)
, (21)
π
B
=
1
r
p
B
xe
−αx
+(1 − p
B
)
p
B
e
−αx
H
+(1 − p
B
)
, (22)
π =
1
r
q π
G
e
−απ
G
+(1 −q )π
B
e
−απ
B
q e
−απ
G
+(1 −q )e
−απ
B
. (23)
To obtain a result similar to Proposition 2, a slightly different measure
for informativeness is necessary. Let V
t +1
(˜ x
t +1
 y
t
) denote the certainty
equivalent that generation t +1 assigns to the dividend ˜ x
t +1
 y
t
, that is,
V
t +1
(˜ x
t +1
 y
t
) = U
−1
t +1
(E(U
t +1
(˜ x
t +1
 y
t
))). Then the informativeness of the
report y =G, B is given by
y
= V
t +1
(˜ x
t +1
 y
t
) −π
y
. (24)
One caninterpret
y
as a kindof risk premiumas it represents the difference
between the maximum price that generation t +1 investors are willing to
8
Notice that the derivation of the equilibrium prices in Proposition 1 requires constant
absolute risk aversion and mutual independence of the cash ﬂows ˜ x
t
 ˜ y
t
. The linear mean
variance utility function and the exponential utility function both satisfy constant absolute risk
aversion. The only change that the transition to exponential utility functions brings about is the
explicit expression for the prices ¯ π, π
G
, π
B
, and π. The derivation of these prices is provided
in the appendix.
ASYMMETRIC FINANCIAL REPORTING POLICIES 1311
pay for the dividend ˜ x
t +1
 y
t
(i.e., the certainty equivalent) andthe price that
it actually pays. As more disclosure reduces the risk of generation t +1, a
more informative disclosure implies that
y
decreases. The following result
is similar to Proposition 2:
PROPOSITION 4. Let r →1. For the class of exponential utility functions it holds
that compared to an uninformative AIS, an AIS improves risk sharing if and only if
the bad ﬁnancial report is more informative than the good ﬁnancial report, that is,
ρ ≤ ¯ ρ if and only if
G
≥
B
.
A full characterization of the AIS that optimizes risk sharing is not avail
able. Numerical calculations suggest though, that similar to Proposition 3,
a bad news AIS (i.e., q
H
=1 and q
L
>0) induces the best risk allocation and
a good news AIS (i.e., q
H
<1 and q
L
=0) induces the worst risk allocation.
5. Conclusion
The informativeness of ﬁrms’ ﬁnancial reporting policies is partly gov
erned by the set of accounting principles and accounting standards that
ﬁrms need to comply with. The conventional wisdom is that accounting
standards do not affect the market value of the ﬁrm if there are no direct
(e.g., taxes due) or indirect (e.g., economic consequences) future cash ﬂow
effects. This study, however, shows that even without such cash ﬂow effects,
the market value of a ﬁrm can change. The additional value relevant factor
is asymmetric reporting of good and bad news. Such asymmetric treatment
of good and bad news is common practice in accounting and is known as
accounting conservatism. Traditionally, accounting conservatism is labeled
as “anticipate no gains, but anticipate all losses” (Bliss [1924]). Basu [1997]
and Watts [2003] take a more reﬁned stand and interpret conservatism as
the asymmetry in the veriﬁcation requirements for gains and losses; the
recognition of gains requires a higher degree of veriﬁcation than the recog
nition of losses. In terms of the model, this interpretation of conservative
(liberal) accounting is consistent with a more informative good (bad) ﬁ
nancial report. Since good news requires a higher degree of veriﬁcation, a
disclosure of good news is more informative than a disclosure of bad news.
Bad news is already disclosed if there is a remote possibility of anything
bad happening to the ﬁrm. This interpretation is to a large extent consis
tent with interpretations of conservatism in related models.
9
However, an
9
Binary settings with an information system similar to (q
H
, q
L
) are most common in ana
lyzing the role of accounting conservatism in various settings. The usual interpretation is that
the degree of conservatism is measured by the probability of underreporting (i.e., 1 −q
H
)
and that the degree of liberal accounting is measured by the probability of overreporting (i.e.,
q
L
). See, for example, Chen, Hemmer, and Zhang [2007] and Gigler and Hemmer [2001].
Bagnoli and Watts [2005] and Venugopalan [2004] impose the additional constraint q
L
=0
for conservative accounting (i.e., good news AISs) and q
H
=1 for liberal accounting (i.e., bad
news AISs).
1312 J. SUIJS
alternative interpretation of conservatism in the literature is that the prob
ability of correctly reporting the bad state of nature is higher than correctly
reporting the good state of nature (see, e.g., Kwon [2005], Stoughton and
Wong [2003], Antle and Lambert [1988]). In terms of the model, this in
terpretation corresponds to p
G
≤ 1 − p
B
and is thus consistent with a more
informative bad ﬁnancial report.
This paper also sheds a different light on the relation between disclosure
and a ﬁrm’s cost of capital. One can interpret the risk premium as the ﬁrm’s
cost of capital. Changes in the cost of capital then arise because disclosure
changes the volatility of future stock prices, which in turn affect risk sharing
across generations of investors. In particular, liberal accounting (i.e., a more
informative bad ﬁnancial report) decreases the cost of capital as it reduces
the dispersion in future stock prices. Lambert, Leuz, and Verrecchia [2007]
link disclosure to cost of capital in a model consistent with the CAPM. More
disclosure affects a ﬁrm’s cost of capital by changing investors’ perceptions
of the covariances across ﬁrms’ future cash ﬂows (i.e., the undiversiﬁable
risks). It differs fromthis paper in that it focuses on reducing estimation risk
instead of improving risk sharing. Studies like Easley and O’Hara [2004]
commonly link disclosure to the cost of capital by assuming information
asymmetry across investors. Disclosure then serves to reduce the risk of
trading with informed investors. One should remark though that any effect
on cost of capital is limited to systematic risk factors only (see, e.g., Hughes,
Liu, and Liu [2007], Lambert, Leuz, and Verrecchia [2007]).
Finally, this paper may provide an alternative explanation to empirical
evidence of shortterm underreaction of stock prices to news (e.g., post–
earnings announcement drift, Ball and Brown [1968], Foster, Olsen, and
Shevlin [1984], Bernard and Thomas [1989]). Explaining underreaction in
a capital market with rational, riskaverse investors requires a link between
the ﬁrm’s (systematic) risk and the content of the news: Good news should
increase ﬁrm risk whereas bad news should decrease ﬁrm risk. Notice that
asymmetric ﬁnancial reporting creates such a link. Shin [2006] presents an
alternative link based on uncertainty about the rate at which ﬁrm manage
ment receives information. In that case, better news also signals a higher
rate of information ﬂow to management. This, in turn, implies an increase
in ﬁrm risk as more disclosures are expected by ﬁrm management in the
near future.
APPENDIX A
LEMMA 1. It holds that
E(ρ
˜ y
) =
2αx
2
r
(p(1 − p
G
− p
B
) + p
B
p
G
) (25)
and
ρ
S
=
2αx
2
r
3
(p
G
− p)(p − p
B
) (1 −2αx(1 − p
B
− p
G
))
2
. (26)
ASYMMETRIC FINANCIAL REPORTING POLICIES 1313
Proof of Lemma 1. First, observe that one can show that
q
H
=
p
G
p
p − p
B
p
G
− p
B
(27)
and
q
L
=
1 − p
G
1 − p
p − p
B
p
G
− p
B
. (28)
Next, I prove expression (25). It holds that
E(ρ
˜ y
) = E
2α
r
VAR(˜ x  ˜ y )
=
2αx
2
r
(q p
G
(1 − p
G
) +(1 −q )p
B
(1 − p
B
))
=
2αx
2
r
p
B
(1 − p
B
) +q
p
G
− p
B
+ p
2
B
− p
2
G
=
2αx
2
r
(p
B
(1 − p
B
) +q (p
G
− p
B
)(1 − p
G
− p
B
)) .
Using that q = pq
H
+(1 − p)q
L
=
p−p
B
p
G
−p
B
this reduces to
E(ρ
˜ y
) =
2αx
2
r
(p
B
(1 − p
B
) +(p − p
B
)(1 − p
G
− p
B
))
=
2αx
2
r
(p(1 − p
G
− p
B
) + p
B
p
G
) .
Next, I prove expression(26). Recall that ρ
S
=
2α
r
VAR(π
˜ y
). By substituting
π
y
=
1
r
E(˜ x  y ) −ρ
y
it holds that
VAR(π
˜ y
) =
1
r
2
VAR(E(˜ x  ˜ y )) +VAR(ρ
˜ y
) −
2
r
COV(E(˜ x  ˜ y ), ρ
˜ y
). (29)
For calculating VAR(E(˜ x  ˜ y )), observe that E(E(˜ x  ˜ y )) = q p
G
x +(1 −
q )p
B
x so that
E(˜ x  y
G
) − E(E(˜ x  ˜ y ))=p
G
x−(q p
G
x +(1 −q )p
B
x)=(1 −q )(p
G
− p
B
)x
and
E(˜ x  y
B
) − E(E(˜ x  ˜ y )) = p
B
x −(q p
G
x +(1 −q )p
B
x) = −q (p
G
− p
B
)x.
Hence,
VAR(E(˜ x  ˜ y )) = q [E(˜ x  y
G
) − E(E(˜ x  ˜ y ))]
2
+(1 −q ) [E(˜ x  y
B
) − E(E(˜ x  ˜ y ))]
2
= q (1 −q )
2
(p
G
− p
B
)
2
x
2
+(1 −q )q
2
(p
G
− p
B
)
2
x
2
= q (1 −q )(p
G
− p
B
)
2
x
2
. (30)
Next, I calculate VAR(ρ
˜ y
). Using that ρ
˜ y
equals ρ
G
with probability q and
ρ
B
with probability 1 −q , one derives that
VAR(ρ
˜ y
) = q (1 −q )(ρ
G
−ρ
B
)
2
. (31)
1314 J. SUIJS
Finally, I calculate COV(E(˜ x  ˜ y ), ρ
˜ y
). Observe that
ρ
G
− E(ρ
˜ y
) = ρ
G
−(qρ
G
+(1 −q )ρ
B
) = (1 −q )(ρ
G
−ρ
B
)
and
ρ
B
− E(ρ
˜ y
) = ρ
B
−(qρ
G
+(1 −q )ρ
B
) = −q (ρ
G
−ρ
B
),
so that
COV(E(˜ x  ˜ y ), ρ
˜ y
) = q [E(˜ x  y
G
) − E(E(˜ x  ˜ y ))][ρ
G
− E(ρ
˜ y
)]
+(1 −q )[E(˜ x  y
B
) − E(E(˜ x  ˜ y ))][ρ
B
− E(ρ
˜ y
)]
= q [(1 −q )(p
G
− p
B
)x][(1 −q )(ρ
G
−ρ
B
)]
+(1 −q )[−q (p
G
− p
B
)x][−q (ρ
G
−ρ
B
)]
= q (1 −q )(p
G
− p
B
)x(ρ
G
−ρ
B
).
(32)
Combining expression (30), expression (31), and expression (32) with ex
pression (29) yields
VAR(π
˜ y
) = q (1 −q )
1
r
(p
G
− p
B
)x −(ρ
G
−ρ
B
)
2
. (33)
Since ρ
y
=
2αx
2
r
p
y
(1 − p
y
), it holds that
ρ
G
−ρ
B
=
2αx
2
r
(p
G
(1 − p
G
) − p
B
(1 − p
B
))
=
2αx
2
r
(p
G
− p
B
)(1 − p
B
− p
G
). (34)
Substituting this expression for ρ
G
−ρ
B
in expression (33) yields
VAR(π
˜ y
) = q (1 −q )
1
r
(p
G
− p
B
)x −
2αx
2
r
(p
G
− p
B
)(1 − p
B
− p
G
)
2
=
x
2
r
2
q (1 −q )(p
G
− p
B
)
2
(1 −2αx(1 − p
B
− p
G
))
2
. (35)
To complete the proof, recall that q =
p−p
B
p
G
−p
B
and 1 −q =
p
G
−p
p
G
−p
B
, so that
expression (35) reduces to
VAR(π
˜ y
) =
x
2
r
2
(p
G
− p)(p − p
B
) (1 −2αx(1 − p
B
− p
G
))
2
.
APPENDIX B
Proof of Proposition 2. Observe that for an uninformative AIS it holds
that ¯ ρ =
2α
r
VAR(˜ x) =
2αx
2
r
p(1 − p). Applying Lemma 1 inappendix Ayields
ASYMMETRIC FINANCIAL REPORTING POLICIES 1315
¯ ρ −ρ = ¯ ρ −
1
r
E(ρ
˜ y
) −ρ
S
=
2αx
2
r
2
p(1 − p) −
2αx
2
r
2
(p(1 − p
G
− p
B
) + p
B
p
G
)
−
2αx
2
r
3
(p
G
− p)(p − p
B
)(1 −2αx(1 − p
B
− p
G
))
2
= −
2αx
2
r
2
(p(p − p
G
− p
B
) + p
B
p
G
)
−
2αx
2
r
3
(p
G
− p)(p − p
B
)(1 −2αx(1 − p
B
− p
G
))
2
=
2αx
2
r
2
(p
G
− p)(p − p
B
)
−
2αx
2
r
3
(p
G
− p)(p − p
B
)(1 −2αx(1 − p
B
− p
G
))
2
=
2αx
2
r
3
(p
G
− p)(p − p
B
)(r −
1 −2αx(1 − p
B
− p
G
))
2
. (36)
Using that p
G
≥ p ≥ p
B
≥ 0, it follows that ¯ ρ −ρ ≥ 0 if and only if
(1 −2αx(1 − p
B
− p
G
))
2
≤ r. (37)
This inequality is equivalent to −
√
r ≤ 1 −2αx(1 − p
B
− p
G
) ≤
√
r . By as
sumption of 2αx < 1 (see, e.g., assumption (1)) it follows that 1 −2αx(1 −
p
B
− p
G
) ≥ 0 > −
√
r . Then the inequality 1 −2αx(1 − p
B
− p
G
) ≤
√
r
yields
1 − p
B
− p
G
≥ −
√
r −1
2αx
(38)
or, equivalently, 1 − p
B
≥ p
G
−
√
r −1
2αx
. Applying expression (34) to
expression (38) yields the alternative formulation ρ
G
> ρ
B
−
√
r −1
r
x(p
G
− p
B
).
Proof of Proposition 3. Observe that minimizing (maximizing) the risk pre
miumρ subject to 0 ≤q
L
≤q
H
≤1 is equivalent to maximizing (minimizing)
¯ ρ −ρ subject to 0 ≤ p
B
≤ p ≤ p
G
≤ 1 (see, e.g., expression (36)).
First, it is shown that an optimal solution (
ˆ
p
G
,
ˆ
p
B
) cannot be an interior
solution. For an interior solution it holds that
∂
∂p
G
(¯ ρ −ρ) = 0 and
∂
∂p
B
(¯ ρ −
ρ) = 0, or equivalently, that
∂
∂p
G
(¯ ρ −ρ) =
2αx
2
r
3
(p −
ˆ
p
B
)(r −
1 −2αx(1 −
ˆ
p
B
−
ˆ
p
G
))
2
−
8α
2
x
3
r
3
(
ˆ
p
G
− p)(p −
ˆ
p
B
)(1 −2αx(1 −
ˆ
p
B
−
ˆ
p
G
)) = 0
(39)
1316 J. SUIJS
and
∂
∂p
B
(¯ ρ −ρ) = −
2αx
2
r
3
(
ˆ
p
G
− p)(r −
1 −2αx(1 −
ˆ
p
B
−
ˆ
p
G
))
2
−
8α
2
x
3
r
3
(
ˆ
p
G
− p)(p −
ˆ
p
B
)(1 −2αx(1 −
ˆ
p
B
−
ˆ
p
G
)) = 0.
(40)
Combining both expression implies that
2αx
2
r
3
(p −
ˆ
p
B
)(r −
1 −2αx(1 −
ˆ
p
B
−
ˆ
p
G
))
2
= −
2αx
2
r
3
(
ˆ
p
G
− p)(r −
1 −2αx(1 −
ˆ
p
B
−
ˆ
p
G
))
2
.
Hence,
ˆ
p
B
=
ˆ
p
G
or r =
1 −2αx(1 −
ˆ
p
B
−
ˆ
p
G
)
2
. The former case cannot
be satisﬁed for an interior solution. The latter case implies ¯ ρ −ρ = 0 (see,
e.g., expression (36)). This cannot be a maximum because for p
B
→ 0 it
holds that 1 − p
B
> p
G
−
√
r −1
2αx
so that ¯ ρ −ρ > 0 (see, e.g., Proposition 2).
It cannot be a minimumbecause there exists (p
G
, p
B
) in a neighborhood of
the interior point (
ˆ
p
G
,
ˆ
p
B
) such that r < (1 −2αx(1 − p
B
− p
G
))
2
, which
implies ¯ ρ −ρ < 0.
Next, consider boundary solutions with p
G
= p. This implies that the AIS
is uninformative so that p
B
= p as well. Since this implies that ¯ ρ −ρ = 0, it
does not result in a maximum. It results in a minimum when ¯ ρ −ρ ≥ 0 for
all 0 ≤ p
B
≤ p ≤ p
G
≤1. From Proposition 2 it follows that ¯ ρ −ρ ≥ 0 if and
only if 1 − p
B
> p
G
−
√
r −1
2αx
, which is equivalent to
√
r −1
2αx
> p
G
+ p
B
−1. Be
cause sup{ p
G
+ p
B
 0 ≤ p
B
≤ p ≤ p
G
≤ 1} = 1 + p, this inequality reduces
to
√
r −1
2αx
≥ p, or equivalently, r ≥ (1 +2αxp)
2
. Hence,
ˆ
p
G
=
ˆ
p
B
= p mini
mizes ¯ ρ −ρ when r ≥ (1 +2αxp)
2
.
Consider boundary solutions with p
G
=1. Then expression (36) reduces
to
¯ ρ −ρ =
2αx
2
r
3
(1 − p)(p − p
B
)(r −
1 +2αxp
B
)
2
.
The optimal solution
ˆ
p
B
satisﬁes the ﬁrstorder condition
−
r −
1 +2αx
ˆ
p
B
2
−4αx(p −
ˆ
p
B
)
1 +2αx
ˆ
p
B
= 0.
One can derive that this is equivalent to
12
αx
ˆ
p
B
+
1
3
(1 −αxp)
2
−
1
3
(2αxp +1)
2
−r = 0,
which yields two solutions:
ˆ
p
−
B
=
1
3αx
αxp −1 −
1
2
(2αxp +1)
2
+3r
ˆ
p
+
B
=
1
3αx
αxp −1 +
1
2
(2αxp +1)
2
+3r
.
ASYMMETRIC FINANCIAL REPORTING POLICIES 1317
Observe that
ˆ
p
−
B
is not feasible as
ˆ
p
−
B
< 0 by assumption (1). Concerning
the feasibility of
ˆ
p
+
B
, observe that
ˆ
p
+
B
≥ 0 and that
ˆ
p
+
B
< p if and only if
r < (1 +αxp)
2
. Furthermore, it holds that the optimal solution (
ˆ
p
G
,
ˆ
p
B
) =
(1,
ˆ
p
+
B
) is a (local) minimum of ¯ ρ −ρ. To see this, observe that the second
order condition requires
4αx(r −(1 +2αx
ˆ
p
+
B
)) +4αx(1 +2αx
ˆ
p
+
B
) −8α
2
x
2
(p −
ˆ
p
+
B
) > 0,
which is equivalent to
4αx(r −2αxp +2αx
ˆ
p
+
B
) > 0.
This inequality holds because of assumption (1), r >1, and
ˆ
p
+
B
≥ 0.
Finally, consider boundary solutions with p
B
=0. Then expression (36)
reduces to
¯ ρ −ρ =
2αx
2
r
3
p(p
G
− p)(r −
1 −2αx(1 − p
G
))
2
.
The optimal solution
ˆ
p
G
satisﬁes the ﬁrst order condition
r −
1 −2αx(1 −
ˆ
p
G
)
2
−4αx(
ˆ
p
G
− p)
1 −2αx(1 −
ˆ
p
G
)
= 0.
One can derive that this equality is equivalent to
−12
αx
ˆ
p
G
−
1
3
(αx(2 + p) −1)
2
+
1
3
(1 −2αx(1 − p))
2
+r = 0.
The two solutions to this equation are
ˆ
p
−
G
=
1
3αx
αx(2 + p) −1 −
1
2
(1 −2αx(1 − p))
2
+3r
and
ˆ
p
+
G
=
1
3αx
αx(2 + p) −1 +
1
2
(1 −2αx(1 − p))
2
+3r
.
Observe that
ˆ
p
−
G
is not feasible as
ˆ
p
−
G
< p. This follows from
ˆ
p
−
G
− p =
1
3αx
2αx(1 − p) −1 −
1
2
(1 −2αx(1 − p))
2
+3r
< 0
because 2αx (1 − p) −1 ≤ 0 by assumption (1). Regarding the feasibility of
ˆ
p
+
G
, observe that
ˆ
p
+
G
≥ p and that
ˆ
p
+
G
< 1 if and only if r −1 < 4αx (1 − p).
Furthermore, it holds that the optimal solution (
ˆ
p
G
,
ˆ
p
B
) = (
ˆ
p
+
G
, 0) is a (lo
cal) maximumof ¯ ρ −ρ. To see this, observe that the secondorder condition
requires
4αx(1 −2αx(1 −
ˆ
p
+
G
)) −8α
2
x
2
(
ˆ
p
+
G
− p) −4αx(1 −2αx(1 −
ˆ
p
+
G
)) < 0,
which is equivalent to 8α
2
x
2
(
ˆ
p
+
G
− p) > 0. Observe that
ˆ
p
+
G
− p =
1
3αx
2αx(1 − p) −1 +
1
2
(1 −2αx(1 − p))
2
+3r
> 0
1318 J. SUIJS
is equivalent to
1
4
(1 −2αx(1 − p))
2
+
3
4
r > (1 −2αx(1 − p))
2
.
Rearranging terms yields r >(1 −2αx (1 − p))
2
, which holds because r >1
and 2αx (1 − p) < 1 by assumption (1).
Summarizing, the minimum solution for ¯ ρ −ρ equals (
ˆ
p
G
,
ˆ
p
B
) = (p, p)
when r ≥ (1 +2αxp)
2
and (
ˆ
p
G
,
ˆ
p
B
) = (1,
ˆ
p
+
B
) when r < (1 +2αxp)
2
. The
maximum solution for ¯ ρ −ρ equals (
ˆ
p
G
,
ˆ
p
B
) = (1, 0) when r −1 ≥ 4αx
(1 − p) and(
ˆ
p
G
,
ˆ
p
B
) = (
ˆ
p
+
G
, 0) whenr −1 <4αx (1 − p). Substituting q
H
=
p
G
p
p−p
B
p
G
−p
B
and q
L
=
1−p
G
1−p
p−p
B
p
G
−p
B
completes the proof.
Proof of Expression (21). Let z denote the demand of generation t +1 for
the asset ˜ x
t +1
 G at date t, that is, the date at whichgenerationt +1 is buying.
Let ζ denote the investment in the riskfree asset. Furthermore, denote by ω
the capital endowment of generationt +1. The optimal investment decision
of generation t +1 at date t is the solution to
max
z,ζ
−p
G
e
−α(zx+ζr )
−(1 − p
G
)e
−αζr
such that : zπ
G
+ζ
t
= ω
t
,
where π
G
is the price at which generation t buys the ﬁrm’s shares. Substi
tuting ζ =ω−z π
G
and differentiating with respect to z yields
pα(x −r π
G
)e
−αz(x−π
G
)
−(1 − p)αr π
G
e
αzπ
G
= 0.
Because generationt has tosell the ﬁrm’s shares by assumption, the supply of
shares is ﬁxed and equal to 1. Hence, the equilibriumdemand of generation
t +1 equals z =1. Substituting z =1 and rearranging terms yields
π
G
=
1
r
p
G
xe
−αx
p
G
e
−αx
+1 − p
G
.
In a similar way, one derives expression (20), expression (22), and expres
sion (23).
Proof of Proposition 4. Observe that ρ ≤ ¯ ρ if and only if π ≥ ¯ π. Using
expression (20) and expression (23), the inequality π ≥
1
r
¯ π equals
1
r
q π
G
e
−απ
G
+(1 −q )π
B
e
−απ
B
q e
−απ
G
+(1 −q )e
−απ
B
≥
1
r
2
pxe
−αx
pe
−αx
+1 − p
.
This is equivalent to
q pπ
G
e
−α(π
G
+x)
+ (1 −q )pπ
B
e
−α(π
B
+x)
+q (1 − p)π
G
e
−απ
G
+ (1 −q )(1 − p)π
B
e
−απ
B
≥
1
r
q pxe
−α(π
G
+x)
+(1 −q )pxe
−α(π
B
+x)
.
ASYMMETRIC FINANCIAL REPORTING POLICIES 1319
Rearranging terms gives
q pe
−α(π
G
+x)
π
G
−
1
r
x
+(1 −q )pe
−α(π
B
+x)
π
B
−
1
r
x
+q (1 − p)π
G
e
−απ
G
+(1 −q )(1 − p)π
B
e
−απ
B
≥ 0.
(41)
Using that
π
G
−
1
r
x =
1
r
p
G
xe
−αx
p
G
e
−αx
+1 − p
G
− x
= −
1
r
(1 − p
G
)x
p
G
e
−αx
+1 − p
G
and
π
G
=
1
r
p
G
xe
−αx
p
G
e
−αx
+1 − p
G
one obtains that
q pe
−α(π
G
+x)
π
G
−
1
r
x
+q (1 − p)π
G
e
−απ
G
= −
1
r
q p(1 − p
G
)xe
−α(π
G
+x)
p
G
e
−αx
+1 − p
G
+
1
r
q p
G
(1 − p)xe
−α(π
G
+x)
p
G
e
−αx
+1 − p
G
=
1
r
q (p
G
(1 − p) − p(1 − p
G
)) xe
−α(π
G
+x)
p
G
e
−αx
+1 − p
G
=
1
r
q (p
G
− p)xe
−α(π
G
+x)
p
G
e
−αx
+1 − p
G
.
(42)
Similarly,
π
B
−
1
r
x =
1
r
p
B
xe
−αx
p
B
e
−αx
+1 − p
B
− x
= −
1
r
(1 − p
B
)x
p
B
e
−αx
+1 − p
B
and
π
B
=
1
r
p
B
xe
−αx
p
B
e
−αx
+1 − p
B
yield
(1 −q )pe
−α(π
B
+x)
π
B
−
1
r
x
+(1 −q )(1 − p)π
B
e
−απ
B
= −
1
r
(1 −q )p(1 − p
B
)xe
−α(π
B
+x)
p
B
e
−αx
+1 − p
B
+
1
r
(1 −q )(1 − p)p
B
xe
−α(π
B
+x)
p
B
e
−αx
+1 − p
B
=
1
r
(1 −q ) (p
B
(1 − p) − p(1 − p
B
)) xe
−α(π
B
+x)
p
B
e
−αx
+1 − p
B
=
1
r
(1 −q )(p
B
− p)xe
−α(π
B
+x)
p
B
e
−αx
+1 − p
B
.
(43)
Substituting expression (42) and expression (43) into expression (41) gives
1
r
q (p
G
− p)xe
−α(π
G
+x)
p
G
e
−αx
+1 − p
G
+
1
r
(1 −q )(p
B
− p)xe
−α(π
B
+x)
p
B
e
−αx
+1 − p
B
≥ 0.
1320 J. SUIJS
Rearranging terms and using that p = P(˜ x = x) = q p
G
+(1 −q )p
B
implies
q (p
G
− p) =(1 −q )(p − p
B
), one obtains
e
−απ
G
p
G
e
−αx
+1 − p
G
≥
e
−απ
B
p
B
e
−αx
+1 − p
B
.
Taking the logarithm on both sides of the inequality gives
−
1
α
log(p
G
e
−αx
+1 − p
G
) −π
G
≥ −
1
α
log(p
B
e
−αx
+1 − p
B
) −π
B
. (44)
From
V
t +1
(˜ x
t +1
 y
t
= G) = −
1
α
log(p
G
e
−αx
+1 − p
G
)
and
V
t +1
(˜ x
t +1
 y
t
= B) = −
1
α
log(p
B
e
−αx
+1 − p
B
, )
it then follows that expression (44) is equivalent to
G
= V
t +1
(˜ x
t +1

y
t
= G) −π
G
≥ V
t +1
(˜ x
t +1
 y
t
= B) −π
B
=
B
.
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1298
J. SUIJS
determines the shareholders’ investment risk and not the volatility of the ﬁrm’s future cash ﬂows. What separates the two is the ﬂow of information in the capital market (see, e.g., Ross [1989]). As a result, the ﬁrm’s reporting policy is a primary determinant of investment risk and may thus affect the market value of the ﬁrm. The model I analyze has the following structure. A ﬁrm starts as an investment project that earns cash revenues in each period. Each generation of investors owns the ﬁrm’s shares for one period only and then sells the shares to the next generation of investors. At each date, just before trading takes place, the current generation investors receive the cash revenues generated in the prior period in the form of dividends and the ﬁrm’s accounting information system (AIS) generates a ﬁnancial report on the cash revenues of the next period (i.e., next period’s dividends). The role of the AIS is to allocate the risk of each period’s cash revenues among the buying and selling generations of investors. A more informative ﬁnancial report transfers risk from the buying generation to the selling generation. It imposes less risk on the buying generation as more uncertainty about the future dividends is resolved at the time they buy the shares. However, it imposes more risk on the selling generation as it increases the volatility of the stock price at which they can sell their shares. This paper analyzes how the ﬁrm’s stock price relates to the risksharing effects of its AIS. This overlapping generations model is related to the models in Dye [1990] and Dye and Verrecchia [1995]. Dye [1990] uses a twoperiod snapshot of an overlapping generations model. The main difference is that Dye’s [1990] model considers only symmetric ﬁnancial reporting, that is, good and bad news is equally informative. In Dye and Verrecchia [1995], current shareholders contract with a manager who discloses information about future expenses just before they sell their stock to a new generation of shareholders. The return on investment for the new generation is determined by an additional investment that they make based on the publicly disclosed information. The manager’s disclosure must comply with generally accepted accounting principles (GAAP) and the objective of their study is to analyze the effect of discretion among GAAP. The major difference with the study presented here is—apart from the agency problem—the investment horizon of the new generation of shareholders. Investors hold the ﬁrm’s stock until liquidation in Dye and Verrecchia [1995] so that their investment risk is solely determined by the volatility of the ﬁrm’s ﬁnal cash ﬂows. The main result of this paper is that when the discount rate is not too high, an AIS that reports bad news more precisely than good news results in a higher ﬁrm value, that is, more efﬁcient risk sharing among generations of shareholders, than an uninformative AIS while an AIS that reports good news more precisely than bad news results in a lower ﬁrm value, that is, less efﬁcient risk sharing. In fact, the value maximizing AIS perfectly reports bad news while the value minimizing AIS perfectly reports good news. These results thus imply that full disclosure, that is, a perfectly informative
taxes due) or indirect (e. The conventional wisdom is that accounting standards do not affect the market value of the ﬁrm if they do not have any direct (e. economic consequences) effects on the ﬁrm’s future cash ﬂows. Leuz. the stock price increase due to the good news is limited as it is partly offset by a relatively high risk premium. the dispersion in stock prices is high. and Verrecchia [2007] link disclosure to cost of capital in a capital asset pricing model (CAPM) model through a reduction in assessed covariances between ﬁrms’ future cash ﬂows. Hughes. see Verrecchia [2001]. the buying generation of shareholders bears a considerable amount of risk following the disclosure of good news. and Diamond and Verrecchia [1991].g. Reporting good news more precisely than bad news is consistent with accounting conservatism as formulated in Basu [1997]. Huddart. Disclosure reduces the cost of capital by improving risk sharing across generations of investors. Studies like Easley and O’Hara [2004] 1 focus on information asymmetry among investors. This study also presents an alternative link between a ﬁrm’s disclosure policy and its cost of capital. the higher veriﬁcation requirement for good news implies that good news disclosures are more informative than bad news disclosures. Verrecchia [1999]. investors require an additional risk premium for the adverse selection problem that arises when uninformed investors trade with informed investors. This study shows that such cash ﬂow effects are not a necessity. and Shibano [1999]. Lambert. Hence. The explanation for the value relevance of asymmetric ﬁnancial reporting is that disclosing bad news more precisely than good news damps the dispersion in future stock prices. Interpreting an AIS as a set of accounting standards has some interesting implications for the value relevance of accounting standards. results in suboptimal risk sharing and therefore lower ﬁrm value. In contrast. and Brunnermeier [1999]. Clinch. Asymmetric ﬁnancial reporting policies may also provide a rational explanation to empirical evidence of stock market underreaction to news (see also Shin [2006]). The stock price increase following the disclosure of good news is now offset by a small risk premium while the stock price decline following the disclosure of bad news is further reduced by a high risk premium..g. . When bad news is disclosed more precisely than good 1 For further examples..ASYMMETRIC FINANCIAL REPORTING POLICIES 1299 AIS. the value relevance of the asymmetric reporting of good and bad news is precisely what accounting conservatism aims at. Barth. the high information content of bad news imposes little residual uncertainty on the buying generation of shareholders. In addition. Public disclosure then mitigates this adverse selection problem and lowers the corresponding risk premium. In those models. The stock price decrease following the disclosure of bad news is also limited because the risk premium is relatively low. when good news is disclosed more precisely than bad news. When thereis low information content in good news. In contrast. Baiman and Verrecchia [1996].
2 At date t. Because the former risksharing effect is the primary focus of this paper. Investors of generation t buy the ﬁrm’s shares from generation t − 1 at date t − 1 and they sell the shares to generation t + 1 at date t. the ﬁrm starts ˜ an investment project that generates cash ﬂow xt at date t = 2. 3. The supply of the ﬁrm’s stock is normalized to one. . The paper proceeds as follows. . news. Failing to correct for this change in ﬁrm risk in empirical tests may produce positive abnormal returns for good news ﬁrms and negative abnormal returns for bad news ﬁrms.—Overview of the overlapping generations model. I exclude the latter risksharing effect by assuming no dividends at date 1. Section 5 presents a discussion of the results and concludes. Section 3 derives the equilibrium stock prices. . An Overlapping Generations Model Consider an overlapping generations model where investors of generation t live from date t − 1 until date t (ﬁg. . At date t = 0. The riskfree asset yields a return r > 1 and there are no constraints on borrowing in the riskfree asset. There is a single ﬁrm of which shares are traded among generations of investors. The ﬁrm’s stock is traded in a perfectly competitive market. 1. A ﬁrm’s AIS choice is then not only inﬂuenced by the AIS’s risksharing effects among future generations of shareholders but also by the AIS’s risksharing effects among the intitial owners of the ﬁrm and the ﬁrst generation of investors.1 discusses the situation with dividends at date 1.1300 J. Subsection 4. risk sharing. 2. All proofs are provided in appendices. Results are essentially the same. Section 2 describes the overlapping generations model and the ﬁnancial reporting policies. and ﬁrm value. The operations of the ﬁrm are as follows. Dividend payments at date 1 provide incentives to the initial owners to disclose a ﬁnancial report on next period’s dividends before they sell the ﬁrm to the ﬁrst generation of investors at date 0. Generation t = 0 represents the initial owners of the ﬁrm. before generation t sells the ﬁrm’s stock to generation t + 1. Section 4 analyzes the relation among AIS choice. the ﬁrm pays the realized cash ﬂow x t in the form of dividends to generation t. . The ﬁrm does not pay dividends at date 1. SUIJS FIG. the disclosure of good news leaves more residual uncertainty and thus imposes more risk on the shareholders of the ﬁrm than the disclosure of bad news. The 2 The cost of this investment project is irrelevant for the problem at hand and is therefore not speciﬁed. 1 presents an overview of the model).
before trading takes place. q H = P(˜t = G  xt+1 = x) y ˜ and q L = P(˜t = G  xt+1 = 0). In formal notation. conditional on xt = 0. observe that for q H = 1 and q L ∈ (0. q L ) = (1. the ﬁnancial reports are perfectly informative to investors if (q H . that is. Meanvariance utility functions. An AIS is characterized by the proba˜ bilities (q H . disclosure regulation. this equivalence does not hold for the model under consideration. trade is conditional on the disclosed ﬁnancial report y t .) are mutually independent and ˜ the distribution of xt is common knowledge. q H ∈ (0. Similarly.. are used for mathematical convenience.e. Conditional on xt+1 = x. At each date t = 1. The AIS does not change over time. The future dividends xt (t = 2. The ﬁnancial reports disclosed in previous periods are irrelevant as these reports concern past dividends. whereas they are completely uninformative if q H = q L . I restrict attention to AISs that satisfy q H ≥ q L . 1) and q L = 0). I refer to such AISs as bad news AISs. For instance. 4 Because investors are constant absolute risk averse. 1). . . E (˜t ) x .e. Further. Observe that the AIS determines the informativeness of the ﬁnancial reports. 3. without loss of generality I may assume that all capital endowments are zero. The preferences of generation t investors are described by a linear meanvariance utility function U t (˜) = E (˜) − αVAR(˜). y t . p = E (˜t )2 x VAR(˜t )+E (˜t )2 x x and x = VAR(˜t )+E (˜t )2 x x . For example. 4 While linear meanvariance utility functions are equivalent to exponential utility functions when payoffs are normally distributed. 3 The AIS can produce two types of ﬁnancial reports. . the AIS produces the good ﬁnancial report G with probability q H and the bad ﬁnancial report B with ˜ probability 1 − q H . . One drawback of meanvariance utility functions is that the implied preferences do not satisfy ﬁrstorder stochastic dominance. Good news AISs are deﬁned analogously (i. At each date t. any rational investor values the binary random payoff 3 Rock [2002] suggests that. the ﬁrm publicly ˜ discloses a ﬁnancial report. however. in this respect. unconstrained borrowing implies that the initial capital endowments of investors are irrelevant for their investment decisions.ASYMMETRIC FINANCIAL REPORTING POLICIES 1301 ˜ dividend xt equals x > 0 with probability p ∈ (0.. 1) and zero with probability ˜ 1 − p. 2. q L ). that reveals information on the date t + 1 ˜ dividend xt+1 . I assume that the ﬁrm’s AIS (i. like the 1934 Securities and Exchange Act. To be y consistent with the interpretation of the good ﬁnancial report G communicating favorable information about the date t + 1 dividend and the bad ﬁnancial report B communicating unfavorable information. . a good ﬁnancial report denoted by G or a bad ﬁnancial report denoted by B. Hence. The ﬁnancial report is generated by an AIS and the ﬁrm commits to publicly disclosing this report truthfully. ˜ Notice that the probability distribution of the future cash ﬂow xt is fully characterized by its mean and variance. serves as a credible commitment device for a ﬁrm’s future disclosures. the AIS produces the good ﬁnancial report G with probability q L and the bad ﬁnancial report ˜ B with probability (1 − q L ). . only the bad ﬁnancial report is perfectly informative. 0). the probabilities q H and q L ) is publicly observable. with α ≥ 0 representz z z ing the degree of risk aversion of generation t. .
Equilibrium Stock Prices Denote by t (y t ) the equilibrium stock price at date t = 1. B}. that is. Section 4. B}. Hence. namely. pq H +(1− p)q L x.2 shows how the main result may extend ˜ to normally distributed cash ﬂows xt . generation t + 1 faces two types of risk when they are buying the stock ˜ at date t. To rule out these cases. the dividend risk xt+1  y t and the price risk t+1 (˜t+1 ). 2. It is the x x r equilibrium price that is paid for next period’s dividend conditional on having received the report y t . results in an equilibrium price of E (˜t ) − 2αVAR(˜ ) = px − 2αp(1 − p)x 2 . SUIJS ˜ xt at at least zero.1302 J. the equilibrium price t (y t ) is additively separable in xt+1  y t and (˜t+1 ). Since investors’ posterior beliefs about the ˜ revenue xt+1 given a good ﬁnancial report equal ˜ xt+1  G = where p G = pq H . x x r . 0.3 shows how the results extend to exponential utility functions in order to show that the results do not critically depend on assumption (1) or the use of meanvariance utility functions. 3. Notice that xt+1  y t y is the dividend that generation t + 1 receives and that t+1 (˜t+1 ) is the equiy librium price at which generation t + 1 sells the stock to generation t + 2. they are ˜ ˜ investing in a risky asset that pays xt+1  y t + t+1 (˜t+1 ). . A meanvariance utility function. (1) This regularity condition implies that E (˜t ) − 2αVAR(˜t ) > 0 for any sucx x cess probability p ∈ (0. on the other hand. it follows that 1 2α pG x − p G (1 − p G )x 2 . r r (3) πG = 5 A standard result for linar meanvariance utility functions is that the equilibrium price for ˜ a risky payoff x equals 1 (E (˜ ) − 2αVAR(˜ )). I assume that 2αx < 1. . 5 y t+1 t (y t ) = 1 (E (˜t+1  y t ) − 2αVAR(˜t+1  y t )) x x r 1 y y + (E ( t+1 (˜t+1 )) − 2αVAR( t+1 (˜t+1 ))) . Section 4. with probability p G . When generation t + 1 buys the ﬁrm’s stock at date t. . with probability 1 − p G . which is less than or equal to zero x x whenever 2α (1 − p)x ≥ 1. for y t ∈ {G . r (2) Deﬁne π y t = 1 (E (˜t+1  y t ) − 2αVAR(˜t+1  y t )) for y t ∈ {G . which is the lowest possible outcome. 1). y ˜ y Since the dividend xt+1  y t and selling price t+1 (˜t+1 ) are stochastically independent and the utility function features constant absolute risk aver˜ sion.
they buy a risky asset that is sold at date t = 1 at r price 1 (˜1 ). Given an AIS (q H . observe that generation 1 investors do not receive any dividends. ˜ To determine 0 . r −1 After rearranging terms one obtains π= 1 q πG + (1 − q )π B − 2αq (1 − q )(πG − π B )2 . Substituting this into equation (2) y yields πB = t (y t ) = πyt + 1 r q πG + (1 − q )π B + π − 2αq (1 − q )(πG − π B )2 . 0. with probability 1 − p B . it follows that y y ˜ 0 = 1 (E ( 1 (˜1 )) − 2αVAR( (˜1 ))) y y r 1 1 = (E (π y 1 ) − 2αVAR(π y 1 )) + π ˜ ˜ r r −1 1 r =π+ π= π. q L ). To derive an explicit expression for t (y t ). It thus equals the equilibrium ˜ ˜ r price that a generation of investors pays today for the opportunity to sell the dividend to the next generation investors at price π y t+1 . B}.ASYMMETRIC FINANCIAL REPORTING POLICIES 1303 Similarly. a good ﬁnancial report is indeed a better indication of a high date t + 1 dividend than a bad ﬁnancial report. Since 1 (˜1 ) = π y 1 + r −1 π . r −1 r −1 Summarizing. r r −1 t (y t ) Combining this with the conjecture that πyt + r 1 π = πyt + r −1 r × q πG + (1 − q )π B + = πyt + r π r −1 gives r π − 2αq (1 − q )(πG − π B )2 . Hence. the posterior beliefs given the bad ﬁnancial report equal ˜ xt+1  B = where p B = x. r r Observe that q H ≥ q L implies p G ≥ p ≥ p B and π G ≥ π B . Hence. the probability of receiving the good report y t + 1 = G equals r y q = pq H + (1 − p)q L so that E ( (˜t+1 )) = q πG + (1 − q )π B + r −1 π and VAR( (˜t+1 )) = q (1 − q )(πG − π B )2 . p(1−q H )+(1− p)(1−q L ) 1 2α (4) pB x − p B (1 − p B )x 2 . I conjecture that t (y t ) = r π y t + r −1 π where π is a constant and y t ∈ {G . At date t = 0. . p(1−q H ) . with probability p B . r (5) Observe that π = 1 (E (π y ) − 2αVAR(π y )).
π y t . the future dividend xt+ j  y t+ j −1 trades at price ˜ ˜ ˜ π at date t + j − 2 when generation t + j − 2 sells xt+ j  y t+ j −1 to generation t + j − 1. It is the buyer’s expected risk pre˜ ˜ mium and arises from the uncertainty in the dividend xt+1  y t that genera˜ tion t + 1 faces when buying xt+1  y t from generation t at date t. Notice that when generation t is buying the ﬁrm’s stock at date t − 1. t (y t ) = π y t + r −1 (6) (7) Observe that t (y t ) = π y t + 0 . More generally. The remainder of the analysis focuses on the effect of AIS on the permanent value of the ﬁrm. . The second term ρ S refers to price risk. observe that changes in the price. Discounting then implies that at date t − 1.). SUIJS PROPOSITION 1. xt  y t−1 and xt+ j  y t+ j −1 ( j = ˜ 1. . A more informative report results in less residual uncertainty and thus in a lower risk premium.). they are buying xt+1  y t at date t at price π = 1 (E (π y ) − ˜ ˜ r ˜ ˜ 2αVAR(π y )). B. deﬁne ρ S = 1 E (π y ) − π = 2α VAR(π y ) and ρ y = ˜ ˜ r r 1 E (˜t  y ) − π y = 2α p y (1 − p y )x 2 for y = G . ρ y . 2. π. ˜ r 1 E (ρ y ) + ρ S ˜ r (8) The term E (ρ y ) refers to dividend risk. . It is the seller’s risk premium and arises from the ˜ ˜ uncertainty in the price. Generation t pays π y t for the dividend xt  y t−1 that they receive. the future dividend r ˜ ˜ xt+ j  y t+ j −1 trades at r j1 π. ˜ ˜ The price π that generation t pays at date t − 1 for the dividend xt+1  y t includes two different risk premiums: one for price risk and one for dividend risk. . depends on the informativeness of the ﬁnancial report y. at which generation t sells the dividend xt+1  y t ˜ to generation t + 1 at date t. generation t pays ∞ r1j π = r −1 π for −1 j =0 ˜ ˜ the future dividends xt+ j  y t+ j −1 ( j = 1. . Also.1304 J. . 2. Then x r r π= 1 1 (E (π y ) − 2αVAR(π y )) = E (π y ) − ρ S ˜ ˜ ˜ r r 1 1 1 − ρ S = 2 E (E (˜t  y )) − = x ˜ E E (˜t  y ) − ρ y x ˜ ˜ r r r = 1 E (˜t ) − x r2 1 E (ρ y ) + ρ S . arise only because the AIS affects the total risk premium ρ= 1 E (ρ y ) + ρ S ˜ r (9) . ˜ ˜ Furthermore. for t = 1. 2. since generation t sells the dividend xt+1  y t to generation ˜ ˜ t + 1 at price π y t . Hence. . 0 . To see this. ˜ ˜ ˜ they are effectively buying all future dividends. The equilibrium prices are given by r π 0 = r −1 and r π. Observe that the buyer’s risk premium. . . . so that one can interpret π y t as the ﬁrm’s transitory value and 0 as the ﬁrm’s fundamental or permanent value.
Indeed. that is. there is no price risk. A good ﬁnancial report induces a low price increase . ρ. that is. from a social perspective one can consider the risk premium as a proxy for risksharing efﬁciency. To illustrate the riskallocation effects of disclosure. a perfectly informative AIS imposes all of the ﬁrm’s risk on the selling generation t. The role of the AIS is to allocate price risk and dividend risk across consecutive generations of investors. ρ S . an informative AIS induces better risk sharing if and only if the bad ﬁnancial report is sufﬁciently more informative √ r −1 ¯ than the good ﬁnancial report. Conversely. observe that a noninformative AIS imposes all of the ﬁrm’s risk ˜ on the buying generation t + 1. Relative to the uninformative AIS. At date t.ASYMMETRIC FINANCIAL REPORTING POLICIES 1305 through the allocation of dividend risk and price risk. the date 0 selling price captures the permanent as opposed to the transitory component of ﬁrm value. that is. Accounting Information System Choice This section analyzes the effect of AIS choice on the risk premium ρ. π equals the discounted expected value of the dividend ˜ xt and does not depend on the information generated by the AIS and the corresponding allocation of risk. Second. PROPOSITION 2. The second is the time value of money. the selling generation t bears no price risk. they sell the ﬁrm’s stock to the next generation for the same price as they bought it at date t − 1. Since all uncertainty with respect ˜ ˜ to xt+1 is already resolved at date t. Observe that r ¯ (permanent) ﬁrm value 0 ≥ ¯ 0 if and only if ρ ≤ ρ. disclosure of information at date t increases the price risk to the selling generation t and decreases the dividend risk to the buying generation t + 1. Since all uncertainty with respect to xt+1 is revealed at date t + 1. a lower risk premium increases the date 0 selling price of the ﬁrm. Proposition 2 is driven by the natural damping effect of more precise bad news on price risk. 4. which is in the interest of the initial owners who can choose the ﬁrm’s AIS. π y t . The ﬁrst is asymmetric reporting of good and bad news. An uninformative AIS is characterized by q H = q L . There are two factors that determine the effect of the ﬁrm’s AIS on the risk premium ρ. This in turn r r r ¯ ¯˜ implies that ρ S = 2α VAR(π y ) = 0. investing in xt+1  y t is riskless for the buying generation t + 1 so that they bear no dividend risk. I denote the corresponding stock prices ¯ ¯ ¯ ¯ and risk premiums by means of an upper bar. In analyzing the effect of AIS choice on the allocation of risk. ¯ t . Since the ﬁnancial ˜ ˜ report communicates no information. A lower risk premium implies a better risk allocation among future generations of shareholders. ρG > ρ B − rr−1 x( p G − p B ). First. Generally. ρ S . if investors are risk neutral. Finally. I use the uninformative AIS as a benchmark. √ or equivalently. and ¯ ρ y . ρ < ρ if and only if 1 − p B > p G − 2αx . it holds that xt  y t−1 = xt so that 2 2 ¯ ¯ ¯ ¯ πG = π B = 1 px − 2αx p(1 − p) and ρG = ρ B = 2αx p(1 − p). Minimizing the risk premium is chosen as the objective for two reasons. π .
AIS choice is a tradeoff between dividend risk and price risk. the beneﬁt of timely reporting outweighs the beneﬁt of asymmetric reporting. Minimizing dividend risk (conditional on ρ G > ρ B ) thus results in optimal risk √ r −1 2αx 6 This follows from the alternative condition 1 − p B > p G − √ r −1 2αx and the observations that 1 − p B ≥ 0 and p G − < 0 for sufﬁciently large values of r . if r ≤ (1 + 2αxp)2 p αx(3− p)+1− 1 (2αxp+1)2 +3r ˇ qH = (11) 2 0. while a bad ﬁnancial report induces a low price decrease because the buyer’s risk premium is low. (b) The AIS (ˇ H .1306 J.e. q H = 1 and q L = 0) is optimal for sufﬁciently high discount rates r and asymmetric reporting is optimal when the discount rate is sufﬁciently low. 6 A complete characterization of riskmaximizing and riskminimizing AISs is provided in the following proposition: PROPOSITION 3. timely reporting dominates asymmetric reporting so that any informative AIS increases ﬁrm value. q L ) that maximizes the total risk premium ρ is unique and q ˇ ˇ satisﬁes q L = 0 and √ (2αxp+1)2 +3r 1 2αxp+1− 1 √ 2 . in addition to the bad news. if r > (1 + 2αxp)2 . a bad news AIS results in the best risk allocation and a good news AIS results in the worst risk allocation. A good ﬁnancial report induces a high price increase as the buyer’s risk premium is low. (a) The AIS (ˆ H . the stock price is even further reduced by a high buyer’s risk premium. whereas a bad ﬁnancial report induces a high price decrease as. q L ) that minimizes the total risk premium ρ is unique and q ˆ ˆ satisﬁes q H = 1 and √ p 1+αx(1− p)− 1 √(2αx(1− p)−1)2 +3r 2 . When the discount rate is sufﬁciently high. In contrast. that is. full disclosure (i. more precise good news increases the price risk ρ S . For a strictly positive discount rate r > 1. In particular. As the discount rate increases.. if r − 1 < 4αx(1 − p) ˆ q L = 1− p αx(2+ p)−1+ 1 (2αx(1− p)−1)2 +3r (10) 2 0. . ρ B − ρG < rr−1 x( p G − p B ). From Proposition 2 we know that dividend risk dominates price risk when bad news is disclosed more precisely than good news: A decrease in dividend risk results in a relatively low increase in price risk so that total risk decreases. there is a tradeoff between asymmetric reporting and timely reporting. if r − 1 ≥ 4αx(1 − p). ˆ ˆ Consistent with Proposition 2. SUIJS as the price increase is partly offset by a high buyer’s risk premium. More informative good news results in a higher ﬁrm value provided that the asym√ metry in informativeness is not too high. This is because every generation of shareholders beneﬁts from the decrease in dividend risk before they bear the price risk when selling the stock. ρ G .
.1 FIRST PERIOD DIVIDENDS In the basic setup of the model. and a permanent component. . price risk dominates dividend risk. ˜ The dividend x1 equals x with probability p and 0 with probability 1 − p ˜ ˜ and is independent of x2 . ˜ ˜ ˜ suppose that π y t equals 1 xt+1 as should be the case under Pareto efﬁcient risk sharing (so ˜ 2 ˜ ˜ that xt+1 − π y t = 1 xt+1 ). Conversely. . . (13) r −1 One can still decompose the share price ◦ (y t ) into a transitory compot r nent. However. . ˜ Assume that the ﬁrm’s investment project also generates a cash ﬂow x1 at ˜ date 1 and that x1 is paid as dividends to the ﬁrst generation of investors. p G = 1). 7 VAR(π y t ) = ˜ 4. the ﬁrst generation of investors does not receive any dividends. . 2. for t = 1. the minimum is obr tained for ρ B = 0. xt+1 − π y t . that is. Since the revenues of generation t and t + 1 are perfectly correlated. Since price risk equals 1 q (1 − q ) (( p G − p B )x − (ρG − ρ B ))2 .e. . Then the selling generation t bears the risk in ˜ the date t price π y t and the buying generation t + 1 bears the remaining risk. ˜ 2 disclosure of the ﬁnancial report y t not only determines the revenue of generation t. each generation receives 1 xt+1 (see. there exists no AIS that can replicate this Pareto optimal risk allocation (or any other proportional allocation of the risk). π y t . . r −1 π .ASYMMETRIC FINANCIAL REPORTING POLICIES 1307 sharing. 2. The permanent component ◦ t (y t ) = t (y t ) = πy0 + 7 To illustrate. This implies that for generation t + 1. . x3 . . the payoffs of generation t and t + 1 should be imperfectly correlated. It t is straightforward to see that r ◦ π. The ﬁrst generation thus only bears the price risk 1 (˜1 ). This subsection analyzes y the (ir)relevance of this assumption. and (12) 0 (y 0 ) = π y 0 + r −1 r π. Further. The optimal AIS does not induce Pareto efﬁcient risk sharing among the two different generations of investors. . Denote by ◦ (y t ) the equilibrium price at date t = 0. To enable risk sharing in this setting. r2 the maximum (conditional on ρ G < ρ B ) is obtained for ρ G = 0 (i. 1. consider an arbitrary AIS. .g. Now.. . A Pareto optimal risksharing ˜ arrangement allocates the risky cash ﬂow xt+1 equally to generation t and ˜ generation t + 1. investing in the ﬁrm’s stock at date t is risk free. The main reason for this is that generation t and generation t + 1 receive their payoffs at different points in time. They buy the ﬁrm’s shares from the initial owners at date 0 and they sell them to the second generation at date 1. Since dividend risk equals 1 (qρG + (1 − q )ρ B ). when good news is disclosed more precisely than bad news. Clearly. it also reveals the date t + 1 revenue of generation t + 1. assume that the initial owners ˜ ˜ disclose a report y 0 on x1 before they sell the ﬁrm to the ﬁrst generation of investors. Wilson 2 [1968]). e. this contradicts the presumed Pareto efﬁciency of the risk allocation. something that is inconsistent with proportional risk allocations.
The risksharing problem between the initial owners and the ﬁrst generation investors differs from the risksharing problem between generations t and t + 1. higher ρ S ) against the longterm risksharing costs (i. the initial owners trade off the shortterm risksharing beneﬁts of more disclosure (i. do change. the shortterm risksharing problem differs from the longterm risksharing problem in that one would like more informative ﬁnancial reporting so as to impose more price risk on the initial owners. = E (π y 0 ) − αVAR(π y 0 ) + ˜ ˜ E U0( ◦ y 0 (˜0 )) = E( ◦ y 0 (˜0 )) − αVAR( ◦ y 0 (˜ )) 4. Furthermore.2 NORMALLY DISTRIBUTED CASH FLOWS The purpose of this subsection is to show that asymmetric reporting also affects ﬁrm value when the ﬁrm’s future cash ﬂows are approximately normally distributed. r Hence. I extend the model by assuming that the period t cash ﬂow ˜ xt is binomially distributed with n draws and success probability p.t with .e. they price the risk in π y 0 at αVAR(π y 0 ) = 1 ρ S . Since the initial owners do not buy the shares in a competitive market like future generations of investors do. The results for the initial owner’s perspective. the risk premium ρ included in the permanent value r −1 π still serves as a proper proxy for risksharing efﬁciency. The results do not change when considering the social perspective because it focuses on better risk sharing among future generations of investors. lower π ). The expected utility of the initial owners is now r π r −1 r = E (π y 0 ) − 2αVAR(π y 0 ) + αVAR(π y 0 ) + π ˜ ˜ ˜ r −1 1 r (14) = r π + rρ S + π. The reason is that the initial owners now bear a price risk.. the social perspective and the initial owner’s perspective are no longer equivalent. because of the shortterm beneﬁts of more ﬁnancial reporting. However.. This is only half of the ˜ ˜ 2 cost. The term 1 ρ S in ˜ 2 equation (14) thus reﬂects the lower riskbearing cost of the initial owners. the term r −1 π refers to longterm risk sharing. ρ S . However. Notice that a binomial distribution approximately follows a normal distribution n ˜ ˜ with expectation np and variance np(1 − p). however. results remain similar to Proposition 2 and Proposition 3. The term r π + 1 rρs refers to shortterm risk sharing between the initial owners 2 and the ﬁrst generation investors. Nevertheless.1308 J. the AIS that maximizes the expected utility of the initial owners is more informative than for the case with no date 1 dividends. It holds that xt = i=1 xi. In choosing the ﬁrm’s AIS. 2 r −1 r In expression (14). The better the risk sharing among future generations of investors. at which generation t values its price risk π y t . the higher π is. π y 0 . SUIJS is the same as in Proposition 1 and the date 0 price ◦ (y 0 ) now also in0 cludes a transitory component. it is not affected by whether dividends are paid on date 1. Consequently.e. for analyzing the effect of AIS choice.
.t = G ). . Denoting by ˜(y . .t at each date t. . . 2.e. . a binomial distribution with parameters y and p. compared to an uninformative AIS. Given y t good signals (and n − y t bad signals). 2. .t+1 .t = G } with y i. .t+1 = 1 with probability p B . assume that in each period t = 1. (t = 1. the price at which the ﬁrm trades on date t equals 0 = nr π r −1 (16) and t (y t ) = y t πG + (n − y t )π B + nr π. p G ) + ˜(n − y t .t+1 = y y 0) = q L . . . Notice that the AIS is again characterized by the parameters q H and ˜ ˜ q L . the AIS produces a ﬁ˜ ˜ nancial report y t on the cash ﬂow xt+1 . . applying Proposition 2 then yields that. 0. . the price at which investment project i trades at date t is given by Proposition 1.t ˜i. To see how the content of the ﬁnancial report relates to its precision. . Hence.) ﬁts the original model with the high payoff and signals y x set equal to 1. Hence. . it follows z ˜ that xt+1  y t = ˜(y t .ASYMMETRIC FINANCIAL REPORTING POLICIES 1309 ˜ xi.t = 1.. r → 1).t = G  xi.t (i = 1.t ∈ {G. . p). Since the investment projects are identically and independently distributed.. the ﬁrm thus consists of n different invest˜ ment projects with investment project i generating dividends xi. (15) In terms of the original model. p B ). y n. Next. the inﬁnite stream of future dividends xi.t+1 = 1 with probability p G and that the remaining ˜ n − y t projects generate dividend xi. r −1 (17) Abstracting from the inﬂuence of discounting (i. .t . with probability p with probability 1 − p. .t = G  xi. it equals the number of investment projects i = 1. . of each dividend xi. the posterior beliefs conz z cerning future dividends approximately follow a normal distribution with expectation E (˜t+1  y t ) = y t p G + (n − y t ) p B = np B + y t ( p G − p B ) x (18) .t+1 = 1) = q H and P(˜i. This ﬁnancial report is such that ˜ ˜ ˜ y t = #{i  y i. . . 2.e. . consider a realization y t of the ﬁnancial report.t . y i. . 2. n for which the ﬁrm ˜ receives a good signal (i.t . y i. n) independently and identically distributed with probability distribution ˜ xi. The dis˜ ˜ ˜ closed ﬁnancial report y t is a sufﬁcient statistic for the signals y 1. The AIS produces a binary signal. t = 1. . investors rationally believe that y t out of n projects ˜ generate dividend xi. 2. ˜ For a given investment project i. B} independent and identical probability ˜ ˜ distributions satisfying P(˜i.t . risk sharing improves if and only if ρ G > ρ B .
r p G e −αx + (1 − p G ) 1 p B xe −αx + (1 − p B ) . The linear meanvariance utility function and the exponential utility function both satisfy constant absolute risk aversion. Let U t (x) = − e − αx denote the utility function for each generation of investors. π B . 4. In that case. with α > 0 representing the degree of constant absolute risk aversion. = 2α Consistent with y t being the number of good signals. πG . a slightly different measure for informativeness is necessary. the higher the residual uncertainty).3 EXPONENTIAL UTILITY FUNCTIONS In this subsection I present results similar to Proposition 2 for the case that investors’ preferences are described by an exponential utility function. the posterior expectation is increasing in y t . and π . πG .e. the less informative it becomes to investors (i. The only change that the transition to exponential utility functions brings about is the ¯ explicit expression for the prices π . Furthermore. SUIJS and variance VAR(˜t+1  y t ) = y t p G (1 − p G ) + (n − y t ) p B (1 − p B ) x r (19) (nρ B + y t (ρG − ρ B )) . The posterior variance increases in the report y t if and only if ρ G > ρ B . π B .. The derivation of these prices is provided in the appendix. (24) One can interpret y as a kind of risk premium as it represents the difference between the maximum price that generation t + 1 investors are willing to 8 Notice that the derivation of the equilibrium prices in Proposition 1 requires constant ˜ ˜ absolute risk aversion and mutual independence of the cash ﬂows xt  y t . Then the informativeness of the x x report y = G . Let Vt+1 (˜t+1  y t ) denote the certainty x ˜ equivalent that generation t + 1 assigns to the dividend xt+1  y t . r 2 pe −αx + 1 − p (20) πG = 1 p G xe −αx . ¯ Proposition 1 still applies with prices π. (23) r q e −απG + (1 − q )e −απ B To obtain a result similar to Proposition 2. The reverse holds true if ρ G < ρ B . that is. the residual uncertainty depends on the content of the disclosed ﬁnancial report when ﬁnancial reporting is asymmetric. and π replaced by 8 ¯ π= pxe −αx 1 . r p B e −αx H + (1 − p B ) (21) πB = (22) 1 q πG e −απG + (1 − q )π B e −απ B . the better a ﬁnancial report. .1310 J. −1 Vt+1 (˜t+1  y t ) = U t+1 (E (U t+1 (˜t+1  y t ))). B is given by π= y x = Vt+1 (˜t+1  y t ) − π y .
q L ). The usual interpretation is that the degree of conservatism is measured by the probability of underreporting (i. 5.. Conclusion The informativeness of ﬁrms’ ﬁnancial reporting policies is partly governed by the set of accounting principles and accounting standards that ﬁrms need to comply with.e. but anticipate all losses” (Bliss [1924]).ASYMMETRIC FINANCIAL REPORTING POLICIES 1311 ˜ pay for the dividend xt+1  y t (i.e. the market value of a ﬁrm can change. accounting conservatism is labeled as “anticipate no gains. As more disclosure reduces the risk of generation t + 1.g. Such asymmetric treatment of good and bad news is common practice in accounting and is known as accounting conservatism.. q H = 1 and q L > 0) induces the best risk allocation and a good news AIS (i. See. The following result is similar to Proposition 2: PROPOSITION 4. Since good news requires a higher degree of veriﬁcation. bad news AISs). the certainty equivalent) and the price that it actually pays.e. Chen.. q ) are most common in anaH L lyzing the role of accounting conservatism in various settings. and Zhang [2007] and Gigler and Hemmer [2001]. 1 − q H ) and that the degree of liberal accounting is measured by the probability of overreporting (i..g. Numerical calculations suggest though. 9 However. a more informative disclosure implies that y decreases. In terms of the model. . This interpretation is to a large extent consistent with interpretations of conservatism in related models.. For the class of exponential utility functions it holds that compared to an uninformative AIS. Basu [1997] and Watts [2003] take a more reﬁned stand and interpret conservatism as the asymmetry in the veriﬁcation requirements for gains and losses. The additional value relevant factor is asymmetric reporting of good and bad news. an AIS improves risk sharing if and only if the bad ﬁnancial report is more informative than the good ﬁnancial report. for example. Traditionally. an 9 Binary settings with an information system similar to (q .. the recognition of gains requires a higher degree of veriﬁcation than the recognition of losses.e. a disclosure of good news is more informative than a disclosure of bad news. A full characterization of the AIS that optimizes risk sharing is not available. ¯ ρ ≤ ρ if and only if G ≥ B . Bagnoli and Watts [2005] and Venugopalan [2004] impose the additional constraint q L = 0 for conservative accounting (i. taxes due) or indirect (e. economic consequences) future cash ﬂow effects.. q H < 1 and q L = 0) induces the worst risk allocation.e. This study. Hemmer.e.e. shows that even without such cash ﬂow effects. Let r → 1. Bad news is already disclosed if there is a remote possibility of anything bad happening to the ﬁrm.. good news AISs) and q H = 1 for liberal accounting (i. this interpretation of conservative (liberal) accounting is consistent with a more informative good (bad) ﬁnancial report. The conventional wisdom is that accounting standards do not affect the market value of the ﬁrm if there are no direct (e. that similar to Proposition 3. a bad news AIS (i.. that is. however.
e.. Leuz. Hughes. This paper also sheds a different light on the relation between disclosure and a ﬁrm’s cost of capital. APPENDIX A LEMMA 1.e. Kwon [2005]. More disclosure affects a ﬁrm’s cost of capital by changing investors’ perceptions of the covariances across ﬁrms’ future cash ﬂows (i. Lambert.g. the undiversiﬁable risks).. and Verrecchia [2007]). which in turn affect risk sharing across generations of investors.. a more informative bad ﬁnancial report) decreases the cost of capital as it reduces the dispersion in future stock prices. SUIJS alternative interpretation of conservatism in the literature is that the probability of correctly reporting the bad state of nature is higher than correctly reporting the good state of nature (see.g. It differs from this paper in that it focuses on reducing estimation risk instead of improving risk sharing. Shin [2006] presents an alternative link based on uncertainty about the rate at which ﬁrm management receives information. better news also signals a higher rate of information ﬂow to management... Bernard and Thomas [1989]). e. liberal accounting (i. This. Antle and Lambert [1988]). In that case. implies an increase in ﬁrm risk as more disclosures are expected by ﬁrm management in the near future. Liu.g. Foster. Studies like Easley and O’Hara [2004] commonly link disclosure to the cost of capital by assuming information asymmetry across investors.1312 J. Changes in the cost of capital then arise because disclosure changes the volatility of future stock prices. and Verrecchia [2007] link disclosure to cost of capital in a model consistent with the CAPM. and Liu [2007]. Leuz. In terms of the model. In particular. Explaining underreaction in a capital market with rational. Olsen. It holds that E (ρ y ) = ˜ and ρS = 2αx 2 ( p G − p)( p − p B ) (1 − 2αx(1 − p B − p G ))2 .e. this interpretation corresponds to p G ≤ 1 − p B and is thus consistent with a more informative bad ﬁnancial report. Ball and Brown [1968]. Finally. riskaverse investors requires a link between the ﬁrm’s (systematic) risk and the content of the news: Good news should increase ﬁrm risk whereas bad news should decrease ﬁrm risk. post– earnings announcement drift. r3 (26) 2αx 2 ( p(1 − p G − p B ) + p B p G ) r (25) . One should remark though that any effect on cost of capital is limited to systematic risk factors only (see. Stoughton and Wong [2003]. Notice that asymmetric ﬁnancial reporting creates such a link. in turn. this paper may provide an alternative explanation to empirical evidence of shortterm underreaction of stock prices to news (e. One can interpret the risk premium as the ﬁrm’s cost of capital. and Shevlin [1984]. Lambert. Disclosure then serves to reduce the risk of trading with informed investors.
(30) Next. = r Using that q = pq H + (1 − p)q L = E (ρ y ) = ˜ p− p B pG − p B this reduces to 2αx 2 ( p B (1 − p B ) + ( p − p B )(1 − p G − p B )) r 2αx 2 ( p(1 − p G − p B ) + p B p G ) . By substituting ˜ r Next. Using that ρ y equals ρ G with probability q and ˜ ˜ ρ B with probability 1 − q . observe that E (E (˜  y )) = q p G x + (1 − x ˜ x ˜ q ) p B x so that E (˜  y G ) − E (E (˜  y )) = p G x −(q p G x + (1 − q ) p B x) = (1 − q )( p G − p B )x x x ˜ and E (˜  y B ) − E (E (˜  y )) = p B x − (q p G x + (1 − q ) p B x) = −q ( p G − p B )x. 1 − p pG − p B (28) pG p − p B p pG − p B (27) Next. ρ y ).ASYMMETRIC FINANCIAL REPORTING POLICIES 1313 Proof of Lemma 1. I prove expression (25). I calculate VAR(ρ y ). = r 2α VAR(π y ). one derives that VAR(ρ y ) = q (1 − q )(ρG − ρ B )2 . I prove expression (26). observe that one can show that qH = and qL = 1 − pG p − p B . x x ˜ Hence. ˜ (31) . It holds that E (ρ y ) = E ˜ = 2α 2αx 2 (q p G (1 − p G ) + (1 − q ) p B (1 − p B )) VAR(˜  y ) = x ˜ r r 2αx 2 2 p B (1 − p B ) + q p G − p B + p 2 − p G B r 2αx 2 ( p B (1 − p B ) + q ( p G − p B )(1 − p G − p B )) . VAR(E (˜  y )) = q [E (˜  y G ) − E (E (˜  y ))]2 x ˜ x x ˜ + (1 − q ) [E (˜  y B ) − E (E (˜  y ))]2 x x ˜ = q (1 − q )2 ( p G − p B )2 x 2 + (1 − q )q 2 ( p G − p B )2 x 2 = q (1 − q )( p G − p B )2 x 2 . (29) x ˜ x ˜ ˜ ˜ 2 r r For calculating VAR(E (˜  y )). First. Recall that ρ S = π y = 1 E (˜  y ) − ρ y it holds that x r VAR(π y ) = ˜ 1 2 VAR(E (˜  y )) + VAR(ρ y ) − COV(E (˜  y ).
ρ y ). pG − p B x2 ( p G − p)( p − p B ) (1 − 2αx(1 − p B − p G ))2 . ρ y ) = q [E (˜  y G ) − E (E (˜  y ))][ρG − E (ρ y )] x ˜ x x ˜ ˜ ˜ + (1 − q )[E (˜  y B ) − E (E (˜  y ))][ρ B − E (ρ y )] x x ˜ ˜ = q [(1 − q )( p G − p B )x][(1 − q )(ρG − ρ B )] + (1 − q )[−q ( p G − p B )x][−q (ρG − ρ B )] = q (1 − q )( p G − p B )x(ρG − ρ B ). (33) p y (1 − p y ). Observe that for an uninformative AIS it holds 2 ¯ that ρ = 2α VAR(˜ ) = 2αx p(1 − p). r2 APPENDIX B Proof of Proposition 2. Applying Lemma 1 in appendix A yields x r r . recall that q = expression (35) reduces to VAR(π y ) = ˜ and 1 − q = pG − p . SUIJS Finally. Observe that x ˜ ˜ ρG − E (ρ y ) = ρG − (qρG + (1 − q )ρ B ) = (1 − q )(ρG − ρ B ) ˜ and ρ B − E (ρ y ) = ρ B − (qρG + (1 − q )ρ B ) = −q (ρG − ρ B ). I calculate COV(E (˜  y ). r2 p− p B pG − p B (35) so that To complete the proof. and expression (32) with expression (29) yields VAR(π y ) = q (1 − q ) ˜ Since ρ y = 2αx 2 r 1 ( p G − p B )x − (ρG − ρ B ) r 2 . expression (31). (32) Combining expression (30). r ρG − ρ B = (34) Substituting this expression for ρG − ρB in expression (33) yields VAR(π y ) = q (1 − q ) ˜ = 1 2αx 2 ( p G − p B )x − ( p G − p B )(1 − p B − p G ) r r 2 x2 q (1 − q )( p G − p B )2 (1 − 2αx(1 − p B − p G ))2 .1314 J. it holds that 2αx 2 ( p G (1 − p G ) − p B (1 − p B )) r 2αx 2 = ( p G − p B )(1 − p B − p G ). ˜ so that COV(E (˜  y ).
Then the inequality 1 − 2αx(1 − p B − p G ) ≤ r yields √ r −1 1 − p B − pG ≥ − 2αx √ (38) r −1 or. For an interior solution it holds that ∂ pG (ρ − ρ) = 0 and ∂ p B (ρ − ρ) = 0.g. p B ) cannot be an interior ∂ ∂ ¯ ¯ solution. (36) r3 ¯ Using that p G ≥ p ≥ p B ≥ 0. ˆ ˆ First. that ∂ 2αx 2 ˆ ˆ ˆ ¯ (ρ − ρ) = ( p − p B )(r − 1 − 2αx(1 − p B − p G ))2 ∂ pG r3 8α 2 x 3 ˆ ˆ ˆ ˆ − 3 ( p G − p)( p − p B )(1 − 2αx(1 − p B − p G )) = 0 r (39) .ASYMMETRIC FINANCIAL REPORTING POLICIES 1315 ¯ ¯ ρ−ρ = ρ− = 1 E (ρ y ) − ρ S ˜ r 2αx 2 2αx 2 p(1 − p) − 2 ( p(1 − p G − p B ) + p B p G ) 2 r r 2αx 2 − 3 ( p G − p)( p − p B )(1 − 2αx(1 − p B − p G ))2 r 2αx 2 = − 2 ( p( p − p G − p B ) + p B p G ) r 2αx 2 − 3 ( p G − p)( p − p B )(1 − 2αx(1 − p B − p G ))2 r 2αx 2 = ( p G − p)( p − p B ) r2 2αx 2 − 3 ( p G − p)( p − p B )(1 − 2αx(1 − p B − p G ))2 r 2αx 2 = ( p G − p)( p − p B )(r − 1 − 2αx(1 − p B − p G ))2 . assumption (1)) it follows that 1 − 2αx(1 − √ √ p B − p G ) ≥ 0 > − r . it follows that ρ − ρ ≥ 0 if and only if (1 − 2αx(1 − p B − p G ))2 ≤ r. Applying expression (34)√ to expression (38) yields the alternative formulation ρG > ρ B − rr−1 x( p G − p B ).g. By assumption of 2αx < 1 (see. e.. or equivalently. e.. Observe that minimizing (maximizing) the risk premium ρ subject to 0 ≤ q L ≤ q H ≤ 1 is equivalent to maximizing (minimizing) ¯ ρ − ρ subject to 0 ≤ p B ≤ p ≤ p G ≤ 1 (see. Proof of Proposition 3. 1 − p B ≥ p G − 2αx . equivalently. expression (36)). it is shown that an optimal solution ( p G . (37) √ √ This inequality is equivalent to − r ≤ 1 − 2αx(1 − p B − p G ) ≤ r .
. it ¯ does not result in a maximum. 3 . Since this implies that ρ − ρ = 0.g. expression (36)). e. or equivalently. Then expression (36) reduces to 2αx 2 (1 − p)( p − p B )(r − 1 + 2αxp B )2 .g. The former case cannot ¯ be satisﬁed for an interior solution. e.1316 and J. p B ) in a neighborhood of ˆ ˆ the interior point ( p G . p B = p G or r = 1 − 2αx(1 − p B − p G ) . SUIJS ∂ 2αx 2 ˆ ˆ ˆ ¯ (ρ − ρ) = − 3 ( p G − p)(r − 1 − 2αx(1 − p B − p G ))2 ∂ pB r 8α 2 x 3 ˆ ˆ ˆ ˆ − 3 ( p G − p)( p − p B )(1 − 2αx(1 − p B − p G )) = 0. p G = p B = p mini¯ mizes ρ − ρ when r ≥ (1 + 2αxp)2 . This cannot be a maximum because for p B → 0 it √ r −1 ¯ holds that 1 − p B > p G − 2αx so that ρ − ρ > 0 (see. this inequality reduces √ r −1 ˆ ˆ to 2αx ≥ p. The latter case implies ρ − ρ = 0 (see.. consider boundary solutions with p G = p. p B ) such that r < (1 − 2αx(1 − p B − p G ))2 . It cannot be a minimum because there exists ( p G . r3 ˆ The optimal solution p B satisﬁes the ﬁrstorder condition ¯ ρ−ρ = ˆ − r − 1 + 2αx p B 2 ˆ ˆ − 4αx( p − p B ) 1 + 2αx p B = 0. Because sup{ p G + p B  0 ≤ p B ≤ p ≤ p G ≤ 1} = 1 + p. which ¯ implies ρ − ρ < 0. αxp − 1 + 2 αxp − 1 − 2 − 1 (2αxp + 1)2 − r = 0. This implies that the AIS ¯ is uninformative so that p B = p as well. √ r −1 r −1 only if 1 − p B > p G − 2αx . Hence. r ˆ ˆ ˆ ˆ 2 Hence. r ≥ (1 + 2αxp)2 . Next. Consider boundary solutions with p G = 1. One can derive that this is equivalent to 1 ˆ 12 αx p B + (1 − αxp) 3 which yields two solutions: 1 3αx 1 ˆB p+ = 3αx ˆB p− = 1 (2αxp + 1)2 + 3r 2 1 (2αxp + 1)2 + 3r . Proposition 2). which is equivalent to 2αx > p G + p B − 1. r (40) Combining both expression implies that 2αx 2 ˆ ˆ ˆ ( p − p B )(r − 1 − 2αx(1 − p B − p G ))2 r3 2αx 2 ˆ ˆ ˆ = − 3 ( p G − p)(r − 1 − 2αx(1 − p B − p G ))2 . It results in a minimum when ρ − ρ ≥ 0 for ¯ all 0 ≤ p B ≤ p ≤ p G ≤ √ From Proposition 2 it follows that ρ − ρ ≥ 0 if and 1.
This follows from ˆG p− − p = 1 3αx 2αx(1 − p) − 1 − 1 (1 − 2αx(1 − p))2 + 3r 2 <0 because 2αx (1 − p) − 1 ≤ 0 by assumption (1). consider boundary solutions with p B = 0. To see this. 2 αx(2 + p) − 1 − 1 (1 − 2αx(1 − p))2 + 3r 2 ˆG ˆG Observe that p − is not feasible as p − < p. observe that the secondorder condition requires ˆB ˆB ˆB 4αx(r − (1 + 2αx p + )) + 4αx(1 + 2αx p + ) − 8α 2 x 2 ( p − p + ) > 0. 0) is a (lo¯ cal) maximum of ρ − ρ. Concerning ˆB ˆB ˆB the feasibility of p + .ASYMMETRIC FINANCIAL REPORTING POLICIES 1317 ˆB ˆB Observe that p − is not feasible as p − < 0 by assumption (1). 2 One can derive that this equality is equivalent to 1 ˆ −12 αx p G − (αx(2 + p) − 1) 3 1 3αx 1 3αx + 1 (1 − 2αx(1 − p))2 + r = 0. observe that p + ≥ p and that p + < 1 if and only if r − 1 < 4αx (1 − p). which is equivalent to ˆB 4αx(r − 2αxp + 2αx p + ) > 0. Observe that ˆG p+ − p = 1 3αx 2αx(1 − p) − 1 + 1 (1 − 2αx(1 − p))2 + 3r 2 >0 . observe that the secondorder condition requires ˆG ˆG ˆG 4αx(1 − 2αx(1 − p + )) − 8α 2 x 2 ( p + − p) − 4αx(1 − 2αx(1 − p + )) < 0. it holds that the optimal solution ( p G . r3 ˆ The optimal solution p G satisﬁes the ﬁrst order condition ¯ ρ−ρ = ˆ r − 1 − 2αx(1 − p G ) 2 ˆ ˆ − 4αx( p G − p) 1 − 2αx(1 − p G ) = 0. ˆG ˆ ˆ Furthermore. Then expression (36) reduces to 2αx 2 p( p G − p)(r − 1 − 2αx(1 − p G ))2 . and p + ≥ 0. p + ) is a (local) minimum of ρ − ρ. ˆG which is equivalent to 8α 2 x 2 ( p + − p) > 0. ˆB This inequality holds because of assumption (1). p B ) = ( p + . Regarding the feasibility of ˆG ˆG ˆG p + . 3 The two solutions to this equation are ˆG p− = and ˆG p+ = αx(2 + p) − 1 + 1 (1 − 2αx(1 − p))2 + 3r . r > 1. Finally. it holds that the optimal solution ( p G . observe that p + ≥ 0 and that p + < p if and only if ˆ ˆ r < (1 + αxp)2 . To see this. p B ) = ˆB ¯ (1. Furthermore.
p B ) = (1. Because generation t has to sell the ﬁrm’s shares by assumption. the minimum solution for ρ − ρ equals ( p G . p B ) = (1. p + ) when r < (1 + 2αxp)2 . The ˆ ˆB when r ≥ (1 + 2αxp) and ( p ˆ ˆ ¯ maximum solution for ρ − ρ equals ( p G . denote by ω the capital endowment of generation t + 1. which holds because r > 1 and 2αx (1 − p) < 1 by assumption (1). r p G e −αx + 1 − p G In a similar way. p B ) = ( p + . The optimal investment decision of generation t + 1 at date t is the solution to max z. p B ) = ( p.ζ − p G e −α(z x+ζ r ) − (1 − p G )e −αζ r such that : zπG + ζt = ωt . the supply of shares is ﬁxed and equal to 1. ˆ ˆ ¯ Summarizing. one derives expression (20). and expression (23). that is. where π G is the price at which generation t buys the ﬁrm’s shares. Hence. 0) when r − 1 ≥ 4αx ˆG . r q e −απG + (1 − q )e −απ B r pe +1− p This is equivalent to q pπG e −α(πG +x) + (1 − q ) pπ B e −α(π B +x) + q (1 − p)πG e −απG + (1 − q )(1 − p)π B e −απ B 1 ≥ q pxe −α(πG +x) + (1 − q ) pxe −α(π B +x) . Substituting ζ = ω − z π G and differentiating with respect to z yields pα(x − r πG )e −αz(x−πG ) − (1 − p)αr πG e αzπG = 0. the inequality π ≥ 1 π equals r 1 q πG e −απG + (1 − q )π B e −απ B pxe −αx 1 ≥ 2 −αx . Observe that ρ ≤ ρ if and only if π ≥ π . Using ¯ expression (20) and expression (23). Substituting q H = ˆ ˆG (1 − p) and ( p p G p− p B and q L = 1− ppG pp− ppBB completes the proof. 4 4 Rearranging terms yields r > (1 − 2αx (1 − p))2 . Let z denote the demand of generation t + 1 for ˜ the asset xt+1  G at date t. the equilibrium demand of generation t + 1 equals z = 1. Furthermore. expression (22). p) 2 ˆG . 0) when r − 1 < 4αx (1 − p). Let ζ denote the investment in the riskfree asset. the date at which generation t + 1 is buying. r . Substituting z = 1 and rearranging terms yields πG = 1 p G xe −αx .1318 J. ¯ ¯ Proof of Proposition 4. SUIJS is equivalent to 1 3 (1 − 2αx(1 − p))2 + r > (1 − 2αx(1 − p))2 . p pG − p B 1− G− Proof of Expression (21).
πB − and 1 p B xe −αx r p B e −αx + 1 − p B =− yield (1 − q ) pe −α(π B +x) π B − = − = = 1 x + (1 − q )(1 − p)π B e −απ B r 1 (1 − q ) p(1 − p B )xe −α(π B +x) 1 (1 − q )(1 − p) p B xe −α(π B +x) + r p B e −αx + 1 − p B r p B e −αx + 1 − p B 1 (1 − q ) ( p B (1 − p) − p(1 − p B )) xe −α(π B +x) r p B e −αx + 1 − p B 1 (1 − q )( p B − p)xe −α(π B +x) . r p G e −αx + 1 − p G r p B e −αx + 1 − p B (43) Substituting expression (42) and expression (43) into expression (41) gives . p G xe −αx −αx + 1 − e πG = one obtains that q pe −α(πG +x) πG − = − = 1 x + q (1 − p)πG e −απG r 1 (1 − p G )x r p G e −αx + 1 − p G (41) Using that πG − and 1 p G xe −αx −αx + 1 − p r pG e G 1 1 x= r r pG pG −x =− 1 q p(1 − p G )xe −α(πG +x) 1 q p G (1 − p)xe −α(πG +x) + r p G e −αx + 1 − p G r p G e −αx + 1 − p G 1 q ( p G (1 − p) − p(1 − p G )) xe −α(πG +x) 1 q ( p G − p)xe −α(πG +x) = . r p B e −αx + 1 − p B 1 q ( p G − p)xe −α(πG +x) 1 (1 − q )( p B − p)xe −α(π B +x) + ≥ 0. −αx + 1 − p r pG e r p G e −αx + 1 − p G G (42) 1 1 x= r r p B xe −αx −x p B e −αx + 1 − p B πB = 1 (1 − p B )x r p B e −αx + 1 − p B Similarly.ASYMMETRIC FINANCIAL REPORTING POLICIES 1319 Rearranging terms gives q pe −α(πG +x) πG − 1 1 x + (1 − q ) pe −α(π B +x) π B − x r r −απG −απ B + q (1 − p)πG e + (1 − q )(1 − p)π B e ≥ 0.
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