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

Abstract

This paper investigates the effect of internal information asymmetry (hereafter IIA) within conglomerate firms on the quality of management forecasts and financial statements. We develop 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). Firms with higher DIFRET issue less accurate management forecasts that also exhibit greater pessimistic bias and lower specificity. Management forecasts are also less frequent among firms with higher DIFRET. Furthermore, the likelihood of error-driven accounting restatements increases with DIFRET, and weaknesses in internal control systems are particularly detrimental for the quality of both management forecasts and financial statements when DIFRET is higher. Our results are robust to controlling for endogeneity and cannot be attributed to restrictions on top managers’ insider trading.