Deceiving two masters: the effects of financial incentives and reputational concerns on reporting bias

Abstract

We study managers’ decisions to bias financial reports if these reports are used by capital and labor markets to learn about firm value and managerial talent. If managers have private information on their financial and reputational incentives, we identify interactions in the capital and labor markets’ use of reports: The reception of reports in one market motivates reporting bias, which reduces value relevance and price efficiency in the other market. This interaction changes established results and has implications for financial reporting standard setters: We characterize environments where capital market efficiency can be improved by eliminating information on managerial talent from financial reports – even if this information is relevant for investors. This is particularly the case if there is high uncertainty about managers’ reputational concerns and if talent uncertainty represents a small part of the overall fundamental uncertainty.