1. Introduction

The best plan is… to profit by the folly of others. Taken from Pliny the Elder, by John Bartlett,

Familiar Quotations, 10th ed. 1909.

Recent corporate scandals across the globe have drawn attention to the field of corporate governance. Users of financial information such as investors, governments and regulators are increasingly concerned about how earnings numbers are derived [1]. This is due in large part to the countless examples of managers who have used their discretionary decision-making power to misreport their firms' profits. Petrobras in Brazil, which overpriced contracts for private benefits, or Disco in Argentina, which was found to have inappropriately recorded the financial results from several joint ventures, are just two examples of high profile firms that have inflated their earnings, to the detriment of investors and in direct contradiction to the provisions of governments and regulators.

This chapter studies the impact of financial reporting quality on firms' market performance in a sample of LATAM corporations, using these data to examine the perception processes of investors as a mediating variable between reporting quality and market performance. Specifically, we address whether the perceived performance of an organization is in reality based upon actual organizational performance, or is instead more a function of the results overtly exhibited in the organization's financial reporting structures, which may have been discretionally manipulated. We propose that, especially in contexts of high asymmetry of information, investors are not able to effectively discern the quality of information provided to them for decision-making purposes and can therefore be easily 'fooled' by managerial opportunism.

Empirically, we base this upon data collected in six Latin American countries by applying the Generalized Method of Moments (GMM) model [2], thereby hypothesizing that a positive relationship will be observed between the opportunistic manipulation of earnings and the firm's market performance. We then examine these results using a lens that combines agency theory with a social cognitive approach, to analyse the manipulated perception process that occurs as a result of that relationship.

There are a number of principal contributions from this chapter. We begin by viewing the process of manipulation with a holistic approach that integrates both a cognitive and agency perspective and allows us to better understand the relationship between earnings management, financial reporting quality and market performance as a whole, thereby providing a more comprehensive vision of the entire process. This contribution is even more valuable because we have situated our study in the under-researched context of Latin America. We also believe that we are the first to apply the GMM methodology in this context, empirically showing how financial manipulation occurs and then impacts upon investor decisions, thus influencing the organization's market valuation. By doing so we have created an algorithm and adapted an overall model that can be more generally used to rank the quality of any earnings reports, thereby contributing to a more transparent market information system. Finally, we hope that our research will go on to inform and serve decision-makers who analyse firms' financial statements, as well as act as a catalyst to governments, institutions and policy-makers in deriving policy and promoting market efficiency.

Our most important findings can be summarized to be the following. Our results show: (1) Financial data are identifiably and consistently manipulated through discretionary accruals in these countries. (2) As manipulation increases, markets do tend to appear more attractive to investors. (3) The elasticity of the market reaction to this manipulation is higher in what we term 'opaque' countries.

The steps we take in this chapter begin with our theoretical framework, where we review the relevant literature, illustrate this with a comprehensive model of the overall process and then state our hypothesis. As a second step, we then proceed with the empirical analysis through the operationalization of our baseline model and the construction of our variables. In our third step, we present and discuss our results. We do this by displaying and analysing both the univariate and multivariate analysis and by segmenting the sample into clusters based on the country-level governance system, calling them 'opaque' (lower level of governance) or 'transparent' (higher level of governance) countries. Our conclusions and final remarks are presented at the end of the chapter, where we also address policy recommendations.
