Joseph Han has $10 million that he wishes to invest. He has identified two candidate companies: Company A and Company B. Both companies are privately held and have never yet released external financial statements. Joseph Han has some familiarity with the use of financial statements, but his knowledge is not perfect and he can be fooled. However, he has the ability to recognize blatant financial statement manipulation. As Companies A and B prepare their financial statements, they must consider the following three scenarios:
• Scenario 1. Both prepare transparent financial statements that faithfully reflect their underlying business performance. Joseph Han is impressed with both companies and invests $5 million in each.
• Scenario 2. One of the companies prepares deceptive financial statements. These financial statements look so good compared to the transparent financial statements prepared by the other company that Joseph Han instantly decides to invest $8 million in the deceptive company and nothing in the truthful company. To avoid putting all of his eggs in one basket, Joseph Han holds back $2 million and puts it in a bank savings account.
• Scenario 3. Both companies prepare deceptive financial statements. In carefully comparing these two glowing sets of financial statements, Joseph Han realizes that both sets of financial statements have been manipulated. He decides to invest $1 million in each company, as a speculation, and to put the remaining $8 million in a bank savings account. Given these three scenarios, what is the best strategy for Companies A and B—to lie or to tell the truth? Will your answer change if Joseph Han announces his intention to make this same $10 million investment decision with respect to these two companies each year for the next 30 years?