Economics Seminar - Financial Reporting and Moral Sentiments

Adam Smith posits in Theory of Moral Sentiments that we self-regulate our conduct in anticipation of others’ moral judgments. The mechanism is an “Impartial Spectator,” a fictitious individual constructed in the mind who helps us predict whether our actions will earn others’ approval or disapproval. We hypothesize that financial reporting activates this mechanism and leads managers to make investment and resource sharing decisions 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 the manager’s reinvestment and self-compensation to the investor. 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 equalizing the relative power of the two individuals by giving the investor the right to terminate the game 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 judgments in addition to its traditional contracting or valuation functions.