Deceiving Two Masters: The Effects of Labor Market Incentives on Reporting Bias and Market Efficiency

ABSTRACT

We study a model in which financial reports are used in labor markets to learn about managerial talent. A manager manipulates reports to influence the labor market assessment of his talent. If investors are uncertain about the manager’s incentives, manipulation introduces noise into the report and reduces its usefulness for the capital market. We consider price informativeness and expected reporting bias as measures of capital market efficiency and develop novel empirical predictions. We show that higher uncertainty about the manager’s contribution to firm value can decrease price informativeness and earnings response coefficients. Intuitively, supplemental disclosures about managerial talent can mitigate the detrimental consequences of uncertain labor market incentives. Perhaps surprisingly, we show that the usefulness of such supplemental disclosures may increase in their susceptibility to manipulation.