Asymmetric Reporting

We generalize the CAPM to a setting where a regulator requires firms to report earnings before their shares are publicly traded but does not specify the reporting system that maps economic income into reported earnings. We show that under fairly mild conditions, a riskaverse entrepreneur (as representative of the initial owners of the firm) will endogenously choose a reporting system where reported earnings reflect economic income to a greater extent in bad states than in good states. The intuition for this result is that by virtue of being risk averse, the entrepreneur’s utility is concave; as such, he derives greater marginal benefit from reducing uncertainty in bad states. Thus, the entrepreneur will be more willing to undertake costly verification in bad states, and this differential level of verification results in reported earnings that reflect economic income to a greater extent in bad states. Additionally, we show that the choice of reporting system endogenously affects firms’systematic risk. Firms where reported earnings reflect economic income to a greater extent in bad states have higher (lower) covariance with the market portfolio in good (bad) states. Strikingly, these results obtain even in the most basic of circumstances, where earnings serve only a valuation role and there are no agency problems or contracting considerations.