"Earnings increases as costly signals: Theory and Evidence"

Davide Cianciaruso (HEC Paris)


We model a noisy signaling game and empirically test the relation between the costs and benefits of a signal and its informativeness. A manager whose firm experiences a sales decline has private information about future cash flows, which he signals by reporting an increase in earnings despite decreasing sales. Earnings increase can be achieved through value-increasing corrective actions (e.g., cutting costs, changing product mix) or artificial earnings management. We predict and find that a higher cost of corrective actions increases the informativeness of the signal. Second, whereas extant theory predicts that earnings are more informative when the costs of misreporting are higher, we derive and empirically validate the opposite prediction. Finally, signal informativeness is lower when the firm’s management is more myopic. To our knowledge, our results represent some of the earliest empirical evidence on the relation between the costs and benefits of an earnings signal and its informativeness.