7 Conclusion
We study the implication of managerial manipulation for stock market participation in a rational expectations model. We show that the existence of managerial manipulation can endogenously give rise to limited market participation when investors have heterogeneous perceptions of its practice. When the dispersion among investor beliefs about manipulation is sufficiently large, investors who are pessimistic about the credibility of financial reporting will consider the market price unjustified by firm value and optimally choose not to invest in stocks in equilibrium.
We also show that tightening accounting standards can have an effect of improving market participation. Increasing the cost of manipulating earnings by tightening accounting standards reduces the degree of managerial manipulation, which lowers the demand heterogeneity across investors with differential beliefs; the equilibrium stock price must adjust in this case to induce a larger proportion of investors to hold stocks and absorb the market, raising the market participation rate. In addition, although revelations of managerial manipulation through regulatory detections provide additional public information (directly about reporting practices) and level the playing field for investors with differential information, they can also cause a loss of trust in the reporting system and hence lower stock ownership.
