“Reputation, reputation, reputation! O! I have lost my reputation,” lamented Cassio in Shakespeare’s tragedy Othello. “I have lost the immortal part of myself, and what remains is bestial.”

Modern managers responsible for releasing information about their companies’ finances may put it less dramatically. But many fear the disgrace that results from a blow to one’s reputation. “Anyone even vaguely familiar with U.S. capital markets knows that managers display a considerable concern for protecting and enhancing their reputations for honesty and forthrightness while they are communicating with or transacting in these markets,” says Ronald Dye, professor of accounting information and management at Kellogg School of Management.

Dye and Anne Beyer, who received her PhD from Kellogg in 2006 and is now an associate professor of accounting at Stanford University’s Graduate School of Business, recently examined how economic incentives influence managers in developing and maintaining a reputation for being forthcoming. They created an economic model that, Dye says, aims for “a better understanding of how reputational considerations affect the propensity of managers to issue earnings forecasts and other information that is not required to be disclosed in their firms’ financial statements.”

As investors observe the manager making—or not making—voluntary disclosures over time, they will revise their assessments of the manager’s openness, thus determining how his or her reputation evolves.

More Flexibility than Expected
The model reveals that management reputations can sometimes be a double-edged sword, as far as disclosure and other market transactions are concerned. Managers who have developed strong reputations for being forthcoming are not beyond exploiting those reputations by avoiding, or delaying, the disclosure of information that might put their companies in a bad light.

Bernie Madoff’s long record of success on Wall Street as a wealth manager and investment adviser represents an extreme example of how a manager’s reputation can be exploited.  “Before his notorious fraud became public, Bernie had a sterling reputation among investors,” Dye recalls. “That sterling reputation is one of the reasons it was so easy for him to perpetuate the fraud, and also what allowed the fraud to get so big.”

On the flip side, the model predicts that managers with a reputation for withholding potentially harmful information will work hard to improve investors’ perceptions of their reputation.  The model establishes that one way managers can improve their reputations with investors is to disclose unfavorable earnings forecasts that have the potential to reduce their firms’ current market value in the short term. “[W]hen observing an unfavorable forecast, investors revise upwards their perceptions of the probability the manager is forthcoming,” Beyer and Dye report.

“Forthcoming” and “Strategic” Managers
The pair started the project by developing a simple model that distinguishes between “forthcoming” and “strategic” managers. “[A] forthcoming manager discloses his earnings forecast whenever he receives it,” they write in their paper, “and a strategic manager discloses his earnings forecast only if it is in his self-interest to do so.” Investors are never really certain which profile individual managers fit:  there is always the possibility that a manager can surprise investors—managers with flawless reputations can behave badly, or the converse.  To account for such surprises, a manager’s reputation is defined in terms of investors’ perceptions of the probability that the manager’s disclosure is forthcoming or strategic. As investors observe the manager making—or not making—voluntary disclosures over time, they will revise their assessments of the manager’s openness, thus determining how his or her reputation evolves.

The initial model assumed specific behavior on the part of strategic managers concerned about their reputations. “We expected strategic managers to try to imitate the behavior of forthcoming managers and disclose unfavorable information about their firms when they receive it, to convince investors that they are really forthcoming managers,” Dye explains. “But, of course, we did not expect strategic managers to always disclose all bad information they receive.”

Beyer and Dye anticipated that strategic managers would adopt a “cutoff” strategy: they would disclose all information they receive that is sufficiently good (in other words, above the cutoff), but they would withhold any information worse than that. “In this sort of setting, a strategic manager would manifest a reputation for being forthcoming by adopting a lower cutoff—that is, by disclosing a greater array of his unfavorable information—than would a strategic manager not concerned about his reputation,” Dye says.

Facing Reality
Reality turned out to be more complicated. “The problem arose from our originally viewing managers too simplistically, as either forthcoming all the time or strategic all the time,” Dye says.  “When we tried to make predictions with the original model, we found out that it sometimes generated inconsistent behavior by managers. What we discovered,” Dye recalls, “was that strategic managers would sometimes have an incentive to defy investors’ expectations and deviate from what investors expected them to do.” In particular, the strategic managers would sometimes disclose information just below the cutoff that the model predicted they would withhold.

That insight forced the pair to expand their view of the behavioral differences between forthcoming and strategic managers. “Rather than [considering it] a permanent and enduring feature of a manager’s behavior, we started thinking about managers being more complex beings—strategic in some periods and forthcoming in others,” Dye says. “Not only does this more complex behavior fit with our intuition about managers’ actual disclosure behavior, but once we started taking this more expanded view of the differences between strategic and forthcoming managers, we found it easy to make the model internally consistent. Also it allowed us to generate a variety of predictions about how concerns for reputation formation affect managers’ disclosure behavior over time.”

Principal Predictions
The expanded model produces five principal predictions:

  1. Concern for a reputation may be so strong that a manger may voluntarily disclose adverse information that he or she would not otherwise reveal.
  2. When there is uncertainty about managers’ reputations, there are always some managers who try to alter their reputations by changing their disclosure behavior.
  3. When there is uncertainty about managers’ reputations, there are also always other managers who make their disclosure decisions without any concern for the effect of their disclosures on their reputations.
  4. The importance a manager attaches to developing a reputation for being forthcoming varies depending on how persistent his firm’s earnings are over time.
  5. The more investors are uncertain about managers’ reputations, the less likely it is that strategic managers will try to imitate forthcoming managers.

In addition to improving our understanding of managers’ handling of their reputations, the model produces practical advice. “Most of these conclusions were developed as a guide to formulate hypotheses about managers’ disclosure behavior that is subject to empirical testing,” Dye says. “But some of these results can also be the basis of guiding managers’ disclosure choices. For example, managers running firms with earnings that are very persistent over time who want to develop a reputation for being forthcoming will want to disclose the information they receive more aggressively than managers of firms whose earnings are less persistent.”