Clarity Begins at Home: Internal Information Asymmetry and External Communication Quality

• In Event: Information Networks and Aggregation

Abstract

This paper investigates the effect of internal information asymmetry (hereafter IIA) in conglomerates on the quality of their disclosures, including management forecasts and financial statements. Using a novel measure to capture IIA between divisional managers and top corporate managers, computed as the difference in their respective trading profits on their own company’s stock (DIFRET), we show that firms with higher DIFRET issue management forecasts that are less accurate and more pessimistically biased. In addition, DIFRET is associated with both lower specificity and lower frequency of management earnings guidance. Moreover, we find that the likelihood of having error-driven accounting restatements increases with DIFRET. Further analysis suggests that weaknesses in governance and internal control systems are particularly detrimental for external communication quality when DIFRET is higher. Additional tests reveal that DIFRET is also associated with lower readability of financial statements and higher residual accruals volatility. Our results are robust to the 2SLS estimation and cannot be attributed to restrictions on top managers’ insider trading.

Author

• Xiumin Martin, Washington Univ in Saint Louis