(28) The Narrative Premium Eventually Becomes a Reality Discount

The model changed. The risk did not.

In April 2022, Silicon Valley Bank changed a modelling assumption about the duration of its deposits. The change reduced the interest-rate risk shown by its model, even though no risk had left the balance sheet. The Federal Reserve later found that the assumption was poorly supported, that the bank had limited sensitivity testing and back-testing, and that its second line did not provide adequate challenge. Management also removed hedges while focusing on short-term profit. Less than a year later, depositors withdrew more than $40 billion in one day and the bank failed.

This is an unusually clean example of a common corporate pattern. A number becomes uncomfortable. The organisation changes the frame through which the number is interpreted. The reported position improves before the underlying position does. Each step can be explained in isolation, yet the combined effect is to protect a story from reality.

Corporate life runs on narratives because raw facts do not organise themselves. A strategy, budget or investor presentation selects evidence, assigns causality and describes a future. It tells employees what deserves effort, a board what deserves capital and investors what deserves confidence. Some narratives are true. Most mix observation, assumption and aspiration in proportions that are difficult to separate at the time.

The danger is therefore larger than lying. It begins when a useful interpretation acquires institutional protection. People are rewarded for extending it, seniority becomes associated with it, and contradictory evidence must clear a higher bar than confirming evidence. Stakeholders continue to price the coherence of the story while the business quietly incurs the cost of preserving it. The narrative premium then becomes a reality discount.

Narratives are part of the operating system

A company without a shared story would struggle to act. Research on organisational narratives describes them as a way to translate ideas across specialist groups, legitimate unfamiliar proposals and retain lessons in a form people can reuse. Research on strategic change reaches a similar conclusion: leaders make sense of ambiguity and then give sense to others so a dispersed organisation can move in roughly the same direction.

This coordination has economic value. Employees cannot reopen every strategic question before making a local decision. Directors cannot independently reconstruct every forecast. Investors use management's account of the business to connect reported numbers with competitive position and future cash flows. A credible narrative lowers the cost of interpretation.

Disclosure research shows why the premium can be deserved. Firms with more informative disclosure tend to attract more analyst coverage, more accurate forecasts and less dispersion among forecasts. Greater annual-report disclosure has also been associated with a lower cost of equity in some settings. Detailed explanations accompanying management forecasts can make good news more credible because outsiders receive claims they can later check.

The relationship is conditional. Annual-report disclosure, timely disclosure and investor-relations activity do not have identical effects. Readability measures capture only part of reporting quality. A vivid story can help people understand the company, while more words can obscure the few facts that would change a decision. Narrative is best understood as compressed analysis: valuable when its omissions are immaterial, dangerous when the compression removes the evidence that could disprove it.

Coherence earns a premium and creates a temptation

Stakeholders reward a company that can explain itself. Predictable earnings reduce uncertainty. A stable strategic identity helps employees and suppliers commit. A clear account of growth allows investors to value distant cash flows. Once those benefits appear, however, management gains an incentive to preserve coherence after the evidence has weakened.

Mark Lang and Russell Lundholm documented both sides around seasoned equity offerings. Companies with a consistent disclosure policy experienced behaviour consistent with lower information asymmetry. Companies that sharply increased discretionary disclosure before raising equity also enjoyed a price increase, followed by larger negative returns around the offering announcement and further underperformance. The same communication channel could inform the market or condition it.

The distinction is difficult to observe prospectively because weak narratives rarely arrive labelled as such. Optimism often uses true facts: a growing customer count, a promising contract, a product milestone or an adjusted risk measure. Distortion enters through selection and weight. A lagging indicator is called temporary, an inconvenient cohort is excluded, or an assumption that once looked reasonable is retained after conditions change.

Language studies find traces of this behaviour. Poorer environmental performers have used more optimistic and less certain wording in environmental disclosures. Linguistic models applied to conference calls have identified patterns associated with later financial misreporting, although their accuracy is far from sufficient to judge any individual executive. The useful lesson is narrower. Tone, detail and confidence are evidence about how management presents reality; they are not substitutes for evidence about the business itself.

Truth is filtered before it is denied

Most narrative failures do not require a conspiracy. Hierarchy and incentives can remove contradictory evidence one ordinary decision at a time. Employees decide that raising a problem is unsafe or futile. Managers translate a sharp warning into a manageable variance. Executives ask for more proof because the claim threatens a public commitment. The board receives a summary whose confidence reflects the number of filters it survived.

Research on employee silence shows that people withhold information about problems when they expect personal cost or little organisational benefit. In a study covering 3,149 employees and 223 managers, managerial openness was associated with more upward voice through greater psychological safety, especially among high performers. Amy Edmondson's study of 51 work teams similarly connected psychological safety with learning behaviour. These findings matter financially because information that cannot travel upward cannot influence a forecast, risk limit or capital request.

Cognitive bias strengthens the hierarchy. Motivated reasoning changes which memories, rules and evidence people retrieve while preserving a feeling of reasonableness. Confirmation bias favours information consistent with an existing belief. Experiments on escalation of commitment show that personal responsibility for a disappointing decision can increase subsequent commitment to it. Nobody needs to order the suppression of bad news; the organisation can produce suppression from career incentives, ownership and the human preference for a defensible explanation.

This is why boards often overweight strategy and underweight execution risk. The strategic story is concise and narratable. Delivery risk is dispersed across operating data, local qualifications and weak signals. It is also why strategy fails when the operating system contradicts it: employees learn from budgets, promotions and exceptions which account of reality carries consequences.

The story starts spending real money

Narrative distortion becomes financially important when the story moves from language into decisions. A classic field study surveyed 401 financial executives and interviewed another 20. Seventy-eight percent of respondents said they would give up economic value to achieve smooth earnings, while 55 percent would avoid starting a very positive net-present-value project if it caused the current quarter to miss the consensus estimate. The figures describe stated choices rather than observed transactions, but they expose the mechanism: once predictability has a market value, operations can be altered to manufacture it.

Accounting research has since documented forms of real-activity management such as price discounts to accelerate sales, overproduction to lower reported unit costs and cuts to discretionary spending. Other work finds that firms manipulating earnings can overinvest during the misreporting period and that post-offering performance deterioration is more severe when earnings are managed through real activity. A protected narrative can therefore change cash flow before anyone changes an accounting entry.

Wells Fargo turned its cross-sell story into an operating target. The company described the metric as evidence that its customer-focused strategy was working, while the SEC later found that it included large numbers of unused, unneeded or unauthorised accounts and that executive compensation was affected by cross-sell growth. The narrative, metric and incentive reinforced one another. Employees produced the number that validated the strategy, and the number sustained investor reliance on the strategy.

Boeing illustrates the cost of protecting a public assurance after contrary evidence arrives. The SEC found that the company and its former chief executive made materially misleading statements about the 737 MAX after internal information had identified an ongoing safety issue. The engineering problem already existed; the statements widened the distance between what the company knew and what stakeholders were told.

Carillion showed a related pattern in long-term contracts. A UK parliamentary inquiry found that management maintained optimistic contract margins, recognised revenue that might never be collected and sometimes overrode contrary internal assessments. Cash weakness was obscured by aggressive revenue judgements and delayed supplier payments. Complexity made the story harder to falsify, a recurring feature of the governance cost of diversification: the more assumptions a portfolio contains, the easier it becomes to move disappointment between them.

The discount arrives through cash flow and trust

Reality does not impose a single penalty. First comes the correction to the overstated earnings, asset value or growth expectation. Then come financing, legal, customer and contracting costs. A company that has taught stakeholders to rely on its interpretation must also absorb the loss of that interpretive credibility.

One study of 403 financial restatement announcements from 1995 to 1999 found an average two-day abnormal return of about minus 9 percent. That figure should not be treated as a generic price for narrative failure. Restatements include errors as well as deliberate irregularities, and later research found a much sharper average reaction for irregularities than errors, minus 14 percent against minus 2 percent in its samples. The market responds to revised cash-flow information and to what the revision implies about management integrity and internal control.

The second component can be larger. Jonathan Karpoff, D. Scott Lee and Gerald Martin examined 585 firms subject to SEC enforcement actions for financial misrepresentation between 1978 and 2002. For every dollar of market value a firm had gained through misrepresentation, it lost that dollar when the misconduct emerged plus an estimated $3.08. The authors attributed $2.71 of the additional loss to damaged reputation and 36 cents to legal penalties. The estimate depends on how the researchers separate those effects, yet its direction is compelling: stakeholders change the terms on which they provide capital, labour, supply and trust.

Delayed correction also concentrates risk. A small gap can be repaired quietly; a public reversal after years of assurance threatens the authority of the people and controls that certified the old account. The same repricing dynamic explains why boards can underprice succession risk: a stable surface encourages stakeholders to discount vulnerabilities until a discrete event forces several assumptions to change together.

Governance should make important claims easier to kill

The strongest objection to this thesis is that suspicion can become its own distortion. Organisations need commitment. Constantly reopening settled decisions can paralyse execution, and dissent is not automatically insightful. A reappraisal of groupthink research found that evidence for the classic model was weaker than its popularity implied. A meta-analysis found devil's advocacy helpful against an expert-only approach in some settings, but no universal superiority for a single conflict method. Research on real-activity management has even found cases where meeting an earnings benchmark predicted better subsequent performance, consistent with managers signalling future strength rather than destroying value.

Good governance must therefore distinguish disciplined challenge from permanent indecision. It should govern a major narrative as a testable model. The board should know which observations support it, which assumptions connect those observations to the forecast, what evidence would invalidate it and when the claim expires. Evidence owners should be independent enough to report an unwelcome result. Forecast changes should preserve the old assumption, the new assumption and the economic exposure that changed between them.

This approach extends existing control principles. The UK Corporate Governance Code now asks boards to monitor material controls and declare their effectiveness, including controls over narrative reporting. Audit standards treat management override as a core risk and emphasise evidence rather than assurance by status. Those disciplines should reach beyond financial statements into the claims that determine hiring, investment, product and funding decisions.

The practical test is simple. When performance departs from plan, does the organisation alter the business, alter the forecast, or alter the definition of success? Each can be legitimate. The governance failure is allowing the owner of the narrative to choose among them without an independent record of what changed and why.

Truth in corporate life is hard because it is distributed, provisional and often costly to the person who discovers it. Intention matters. A company gets closer to truth by designing institutions that give contradictory evidence somewhere to go before confidence, capital and compensation make the prevailing story too expensive to question.

Sources

Organisational Narratives and Decision-Making

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2. Dennis A. Gioia and Kumar Chittipeddi, "Sensemaking and Sensegiving in Strategic Change Initiation" https://sms.onlinelibrary.wiley.com/doi/10.1002/smj.4250120604

3. Scott Sonenshein, "We're Changing—Or Are We? Untangling the Role of Progressive, Regressive, and Stability Narratives During Strategic Change Implementation" https://journals.aom.org/doi/10.5465/amj.2010.51467638

4. Robert J. Shiller, "Narrative Economics" https://pubs.aeaweb.org/doi/10.1257/aer.107.4.967

5. Martha S. Feldman and James G. March, "Information in Organizations as Signal and Symbol" https://www.jstor.org/stable/2392467

6. Elizabeth W. Morrison and Frances J. Milliken, "Organizational Silence: A Barrier to Change and Development in a Pluralistic World" https://journals.aom.org/doi/abs/10.5465/amr.2000.3707697

7. Elizabeth W. Morrison, "Employee Voice and Silence" https://www.annualreviews.org/content/journals/10.1146/annurev-orgpsych-031413-091328

8. Amy C. Edmondson, "Psychological Safety and Learning Behavior in Work Teams" https://doi.org/10.2307/2666999

9. James R. Detert and Ethan R. Burris, "Leadership Behavior and Employee Voice: Is the Door Really Open?" https://journals.aom.org/doi/abs/10.5465/amj.2007.26279183

10. Ziva Kunda, "The Case for Motivated Reasoning" https://bear.warrington.ufl.edu/brenner/mar7588/Papers/kunda-psybull1990.pdf

11. Raymond S. Nickerson, "Confirmation Bias: A Ubiquitous Phenomenon in Many Guises" https://doi.org/10.1037/1089-2680.2.2.175

12. Barry M. Staw, "Knee-Deep in the Big Muddy: A Study of Escalating Commitment to a Chosen Course of Action" https://doi.org/10.1016/0030-5073(76)90005-2

13. Ramon J. Aldag and Sally Riggs Fuller, "Beyond Fiasco: A Reappraisal of the Groupthink Phenomenon and a New Model of Group Decision Processes" https://doi.org/10.1037/0033-2909.113.3.533

14. Charles R. Schwenk, "Effects of Devil's Advocacy and Dialectical Inquiry on Decision Making: A Meta-Analysis" https://www.sciencedirect.com/science/article/pii/074959789090051A

Disclosure and Market Credibility

15. Doris M. Merkl-Davies and Niamh M. Brennan, "Discretionary Disclosure Strategies in Corporate Narratives: Incremental Information or Impression Management?" https://researchrepository.ucd.ie/entities/publication/2449dfb8-b722-4db7-b693-af7ea4bfc8cf

16. Charles H. Cho, Robin W. Roberts and Dennis M. Patten, "The language of US corporate environmental disclosure" https://ideas.repec.org/a/eee/aosoci/v35y2010i4p431-443.html

17. Feng Li, "Annual Report Readability, Current Earnings, and Earnings Persistence" https://care-mendoza.nd.edu/assets/152198/li_jae_2008.pdf

18. David F. Larcker and Anastasia A. Zakolyukina, "Detecting Deceptive Discussions in Conference Calls" https://onlinelibrary.wiley.com/doi/10.1111/j.1475-679X.2012.00450.x

19. Ilia D. Dichev, John R. Graham, Campbell R. Harvey and Shiva Rajgopal, "Earnings Quality: Evidence from the Field" https://business.columbia.edu/faculty/research/earnings-quality-evidence-field

20. John R. Graham, Campbell R. Harvey and Shiva Rajgopal, "The Economic Implications of Corporate Financial Reporting" https://www.nber.org/papers/w10550

21. Paul M. Healy and Krishna G. Palepu, "Information Asymmetry, Corporate Disclosure, and the Capital Markets: A Review of the Empirical Disclosure Literature" https://ideas.repec.org/a/eee/jaecon/v31y2001i1-3p405-440.html

22. Christine A. Botosan, "Disclosure Level and the Cost of Equity Capital" https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2926

23. Christine A. Botosan and Marlene A. Plumlee, "A Re-Examination of Disclosure Level and the Expected Cost of Equity Capital" https://papers.ssrn.com/sol3/papers.cfm?abstract_id=208148

24. Mark H. Lang and Russell J. Lundholm, "Corporate Disclosure Policy and Analyst Behavior" https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2646

25. Mark H. Lang and Russell J. Lundholm, "Voluntary Disclosure and Equity Offerings: Reducing Information Asymmetry or Hyping the Stock?" https://doi.org/10.1506/9N45-F0JX-AXVW-LBWJ

26. Amy P. Hutton, Gregory S. Miller and Douglas J. Skinner, "The Role of Supplementary Statements with Management Earnings Forecasts" https://hub.hku.hk/bitstream/10722/236446/1/content.pdf?accept=1

27. Jonathan L. Rogers and Phillip C. Stocken, "Credibility of Management Forecasts" https://experts.colorado.edu/display/pubid_54733

28. Tim Loughran and Bill McDonald, "When Is a Liability Not a Liability? Textual Analysis, Dictionaries, and 10-Ks" https://doi.org/10.1111/j.1540-6261.2010.01625.x

Incentives, Reporting, and Financial Consequences

29. S. P. Kothari, Susan Shu and Peter D. Wysocki, "Do Managers Withhold Bad News?" https://ideas.repec.org/a/bla/joares/v47y2009i1p241-276.html

30. Amy P. Hutton, Alan J. Marcus and Hassan Tehranian, "Opaque Financial Reports, R2, and Crash Risk" https://doi.org/10.1016/j.jfineco.2008.10.003

31. Sudip Datta, Mai Iskandar-Datta and Vivek Singh, "Opaque Financial Reports and R2: Revisited" https://www.sciencedirect.com/science/article/pii/S1058330013000542

32. Michael C. Jensen, "Agency Costs of Overvalued Equity" https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1755-053X.2005.tb00090.x

33. Ulrike Malmendier and Geoffrey Tate, "CEO Overconfidence and Corporate Investment" https://onlinelibrary.wiley.com/doi/10.1111/j.1540-6261.2005.00813.x

34. Ulrike Malmendier and Geoffrey Tate, "Who Makes Acquisitions? CEO Overconfidence and the Market's Reaction" https://www.nber.org/papers/w10813

35. Daniel Bergstresser and Thomas Philippon, "CEO Incentives and Earnings Management" https://people.brandeis.edu/~dberg/papers/dbtp.pdf

36. Paul M. Healy and James M. Wahlen, "A Review of the Earnings Management Literature and Its Implications for Standard Setting" https://papers.ssrn.com/sol3/papers.cfm?abstract_id=156445

37. Sugata Roychowdhury, "Earnings Management through Real Activities Manipulation" https://eclass.aueb.gr/modules/document/file.php/LOXR612/Roychowdhury_Earnings%20management%20through%20real%20activities%20manipulation.pdf

38. Daniel A. Cohen, Aiyesha Dey and Thomas Z. Lys, "Real and Accrual-Based Earnings Management in the Pre- and Post-Sarbanes-Oxley Periods" https://doi.org/10.2308/accr.2008.83.3.757

39. Maureen F. McNichols and Stephen R. Stubben, "Does Earnings Management Affect Firms' Investment Decisions?" https://www.gsb.stanford.edu/faculty-research/publications/does-earnings-management-affect-firms-investment-decisions

40. Daniel A. Cohen and Paul Zarowin, "Accrual-Based and Real Earnings Management Activities around Seasoned Equity Offerings" https://www.sciencedirect.com/science/article/pii/S0165410110000054

41. Katherine A. Gunny, "The Relation Between Earnings Management Using Real Activities Manipulation and Future Performance: Evidence from Meeting Earnings Benchmarks" https://papers.ssrn.com/sol3/papers.cfm?abstract_id=816025

42. Zoe-Vonna Palmrose, Vernon J. Richardson and Susan Scholz, "Determinants of Market Reactions to Restatement Announcements" https://papers.ssrn.com/sol3/papers.cfm?abstract_id=474384

43. Karen M. Hennes, Andrew J. Leone and Brian P. Miller, "The Importance of Distinguishing Errors from Irregularities in Restatement Research: The Case of Restatements and CEO/CFO Turnover" https://papers.ssrn.com/sol3/papers.cfm?abstract_id=948929

44. Jonathan M. Karpoff, D. Scott Lee and Gerald S. Martin, "The Cost to Firms of Cooking the Books" https://www.cambridge.org/core/services/aop-cambridge-core/content/view/4BFFF52B30A4997F2ED5EA8BDA69CD1A/S0022109000004221a.pdf/the-cost-to-firms-of-cooking-the-books.pdf

Governance and Case Evidence

45. Financial Reporting Council, "UK Corporate Governance Code 2024" https://www.frc.org.uk/library/standards-codes-policy/corporate-governance/uk-corporate-governance-code/

46. OECD, "G20/OECD Principles of Corporate Governance 2023" https://www.oecd.org/en/publications/g20-oecd-principles-of-corporate-governance-2023_ed750b30-en/full-report/component-7.html

47. Public Company Accounting Oversight Board, "AS 2201: An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements" https://pcaobus.org/oversight/standards/auditing-standards/details/AS2201

48. Board of Governors of the Federal Reserve System, "Review of the Federal Reserve's Supervision and Regulation of Silicon Valley Bank" https://www.federalreserve.gov/publications/2023-April-SVB-Key-Takeaways.htm

49. U.S. Securities and Exchange Commission, "Wells Fargo to Pay $500 Million for Misleading Investors About the Success of Its Largest Business Unit" https://www.sec.gov/newsroom/press-releases/2020-38

50. U.S. Securities and Exchange Commission, "Boeing to Pay $200 Million to Settle SEC Charges that it Misled Investors about the 737 MAX" https://www.sec.gov/newsroom/press-releases/2022-170

51. House of Commons Business, Energy and Industrial Strategy and Work and Pensions Committees, "Carillion" https://publications.parliament.uk/pa/cm201719/cmselect/cmworpen/769/76905.htm