Fear of Reporting Bad News: Why Risk and Loss Aversion Can Tempt Top Executives to Create Information Asymmetry
Abstract
Top executives sometimes attempt to create information asymmetry through
corporate reporting manipulation. In the United States, one method was not to report
financials in certain quarters (this was a legal option before 1970), and a second method
is to report inaccurate financials (which has been a major concern in the 1990s-2000s).
This study argues that when cognitive bias of loss aversion is high, a firm?s risk can
induce such attempts to create information asymmetry. This argument is based on
prospect theory's loss aversion axiom, which states that people psychologically weigh
losses more strongly than equivalent gains.
In this study, a firm's risk is theoretically operationalized using independent
variables of firm-specific risk (firm's unsystematic risk as assessed by stock market) and
default risk (difficulty the firm faces in meeting its debt market obligations).
Correspondingly, loss aversion is theoretically operationalized using moderator variables
of institutional ownership concentration (as an indicator of shareholder resistance to loss
aversion) and top executive in-the-money stock options to salary ratio (as an indicator of personal wealth that is exposed to loss if a firm approaches bankruptcy). Hypotheses are
tested using data collected for a 6 year period from 1964 to 1969 and for a 9 year period
from 1997 to 2006.
Findings suggest that when cognitive bias of loss aversion is high, firm-specific
risk in stock market and default risk in debt market may cause top executives to be
fearful of reporting bad news, tempting them to create information asymmetry as a
result. An implication is that the encouragement of risk (as recommended by agency
theory) without factoring in the role of loss aversion (as highlighted by prospect theory's
loss aversion axiom) can be counterproductive.
Subject
CompensationQuarterly reporting
Annual reporting
Inaccurate reporting
Sarbanes Oxley
Scandals
Fraudulent reporting
Fraud
Manipulation
CEO turnover
succession
Economic crisis
Financial crisis
Credit crisis
Event study
OLS regression
Tobin regression
Tobit regression
Logistic regression
Matched sampling
Interaction
Disordinal
Crossover
Strategy
Strategic management
Management
Competitive advantage
Corporate governance
Leadership
Ethics
Reporting
Restatements
Agency theory
Prospect theory
Institutional theory
Information Asymmetry
Moral hazard
Adverse selection
Loss aversion
Risk
Firm specific risk
Unsystematic risk
Default risk
Bankruptcy risk
Credit
Creditors
Debt
Debtors
Top Management
Top executive
CEO
Ownership
Institutional ownership
Institutional ownership concentration
Institutional regulations
Public policy
Stock options
In the money
Citation
Chakrabarty, Subrata 1979- (2009). Fear of Reporting Bad News: Why Risk and Loss Aversion Can Tempt Top Executives to Create Information Asymmetry. Doctoral dissertation, Texas A & M University. Available electronically from https : / /hdl .handle .net /1969 .1 /155365.
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