Financial Reporting and Moral Sentiments

Dating back at least to Adam Smith (1790), philosophers and researchers expect that people will behave differently when they know their actions are observable to others. We hypothesize that financial reporting reveals managers’ actions and leads them to take different actions that are better aligned with investor interests. We posit that the reason why is the activation of our internal mental self-evaluation that Smith refers to as an “Impartial Spectator.†We test this hypothesis with an experiment in which we manipulate the availability of a financial report that makes managerial actions transparent. Our evidence shows that financial reporting leads a manager to choose reinvestment and resource sharing actions that are better aligned with investor interests, even in a sparse experimental setting where the investor can impose no cost or confer no reward on the manager. This same effect holds in a setting where the investor can shut down the firm at any point and take a sizable portion of the assets. Our evidence is important because it suggests that part of financial reporting’s economic value comes from its enabling moral evaluation by the manager in addition to its traditional contracting function