Financial Reporting and Moral Sentiments

Smith and Wilson (2019) posit that we self-regulate our actions to conform with what we believe is socially appropriate. The mechanism is Adam Smith's “Impartial Spectator,” a fictitious individual constructed in the mind who helps us predict whether our actions and motivations will earn others' approval or disapproval. We hypothesize that financial reporting activates this mechanism and leads managers to take actions that are better aligned with investor interests. We test this hypothesis with an experiment where we manipulate the availability of a financial report that reveals earnings and assets, and thus the actions of the manager. Our evidence shows that financial reporting better aligns a manager's reinvestment and resource sharing actions with investor interests even though the investor can impose no cost or confer no reward on the manager. This effect is robust to giving the investor a right to dissolve the firm at any point and take a sizable portion of the assets. Our evidence is important because it suggests that at least part of financial reporting's economic value derives from implicating human moral thinking and feelings in addition to its traditional contracting function