Management's reporting strategy and imperfection of the capital market

Since the decision on the reported outcome is delegated to the management of the firm, it is commonly held that when the capital market is imperfect the manager achieves consumption smoothing by smoothing the reports relative to the actual outcome. Modeling the firm as a principal-agent contract shows the contrary. When the capital market is imperfect the firm's reporting strategy is conservative, as the manager never reports more than the actual outcome because of fear of an unfavorable future outcome. When the capital market is perfect the firm either smooths the report-reports more than the actual outcome when the actual outcome is low and reports less than the actual outcome when the outcome is high-or reports more than the actual outcome in order to take advantage of the sharing rule being an increasing function of the report.