Review of Quantitative Finance and Accounting, 13 (1999): 367±391
# 1999 Kluwer Academic Publishers, Boston. Manufactured in The Netherlands.
Microstructure of Firms' Disclosure
Department of Economics, Bar-Ilan University, Ramat-Gan 52900, Israel
VARDA (LEWINSTEIN) YAARI
Abstract. Because of imperfections in auditing technology, ®rms can successfully misrepresent ®nancial
reports. We offer a new mechanism, a ``sunshine rule,'' by which ®rms are required to publicize a management
draft prior to the audited reports. If the ®nal reports are materially different from the management's draft, the
market penalizes both the ®rm and the manager. The proposal's effectiveness in eliminating ``earnings
management,'' increasing the quality of the ®nancial reports, and reducing the cost of the manager's incentives is
illustrated in signaling games with perfect and imperfect information and a principal-agent model with perfect
Key words: disclosure, principal-agent, mechanism design, signaling
Financial reports prepared by ®rms' managements are a major source of information for
traders in the ®nancial market. Unfortunately, the information contained in these reports
may be misrepresented, because there exist reports that the management of a ®rm
considers ideal, regardless of the actual results.
For example, the lower a ®rm's
accounting earnings, the lower its tax expense which consumes costly resources. On the
other hand, the lower the accounting earnings, the lower the pro®t margin, and,
consequently, the less likely a bank will lend funds to the ®rm. Balancing these two forces
leads to optimal accounting earnings (i.e., the minimum report that allows the ®rm to
One of the parties harmed if ®rms misrepresent is the auditor. When the truth is ®nally
discovered, auditors are sued and pay dearly (see Minow (1984), and Zeff's (1995)
discussion of GAAP and the ``present fairly''). In 1993 alone, the costs associated with the
legal malpractice suits borne by auditors amounted to $1.1 billion. While the literature
offers remedies that improve the situation (e.g., Dye, 1995), the imperfection of auditing
technology is an inescapable fact. Yet, the problem of misrepresentation could to solved by
dealing with the source of the problem: Since managers have better information than
auditors, perhaps we should develop a way to elicit their private information.
Currently, the management's draft of the ®nancial report is con®dential information
between the ®rm's auditor and the management. We show that by making this draft public,
it is possible to deter management from misrepresenting the ®nancial reports. In essence,
our proposal is a ``sunshine rule''.