Inducing Reliable Reporting

SEC Chairman Arthur Levitt recently called on investors to discourage firms' earnings management by expecting reliable reporting and punishing deceptive reporters (Levitt 1998a, 1999). This paper presents a game-theoretic model in which such punishments can induce managers to develop reputations for reliable reporting. Our first experiment confirms that investors can induce managers to report reliably when one investor visibly commits to a strategy of expecting reliable reporting and punishing reporters who fail to meet that expectation. However, our second experiment shows that reliable reporting is much more difficult to sustain without such a visibly committed investor. These results suggest that managers and investors may have difficulty avoiding the pareto-dominated equilibrium in which managers exploit all of the discretion permitted by GAAP