A Cognitive Theory of Corporate Disclosures

Abstract

I analyze how disclosure policies and managerial attributes interact to influence stock prices, firm values, and the liquidity of financial markets. I adopt the reasonable premises that high cognitive ability assists in value-creation within private corporations, and psychic costs in the sense of Becker (1976) limit (but do not eliminate) the extent of misrepresentation in disclosures. Managerial cognitive ability, the attribute which facilitates the successful functioning of firms, also enhances the odds of success of strategies which mislead large numbers of agents who observe the firm's disclosure statements. Further, agents with greater cognitive ability have higher reservation wages which increases their incentives to overstate firm value. These features cause the equilibrium degree of misrepresentation in disclosures to increase with managerial cognitive capacity (or intellect). Equilibrium efforts at improving true expected values of firms are limited by expected gains from misrepresentation. In a setting where stock prices influence real investment, I show that such confounding disclosures may actually improve ex post firm values. I then argue that agents may have inadequate incentives to acquire information in firms run by managers who are effective at misrepresenting their firms in disclosure statements. This indicates that contrary to findings in the extant theoretical literature, there may be a positive relation between liquidity and the degree of information asymmetry between management and outside investors. Keywords: Disclosure, liquidity, information asymmetry

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