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.