Processing Fluency and Investors’ Reactions to Disclosure Readability

The SEC's emphasis on the use of plain English is designed to make disclosures more readable and more informative. Using an experiment, I find that more readable disclosures lead to stronger reactions from small investors, so that changes in valuation judgments are more positive when news is good and more negative when news is bad. Drawing on research in psychology to explain this result, I predict and find that processing fluency from a more readable disclosure acts as a subconscious heuristic cue and increases investors’ beliefs that they can rely on the disclosure. Although I do not find that more readable disclosures directly increase perceptions of management credibility, I do find evidence of an indirect effect operating through feelings of processing fluency. In supplemental analyses, I find that investors who receive more readable disclosures revise their valuation judgments to be less extreme when they are explicitly made aware of the potential for variation in readability. I discuss potential explanations for these revised valuation judgments.     

Chief Human Resource Officers and accounting disclosures: Illuminating the firm’s most important asset or window dressing?

Social activism, including movements towards equal pay, gender rights, and racial equality, has heightened public scrutiny, exerting pressure on firms to reassess and reform their human resource practices to ensure they align with current social and ethical norms. Chief Human Resource Officers (CHROs) have a potentially important role in defining and promoting appropriate human resource practices through human resource disclosures in corporate annual reports. We empirically examine the effect of CHROs on expanded human capital resource (HCR) disclosures, recently mandated by the SEC. We find that CHROs have a greater effect on the quality of HCR disclosures when they belong to the top management team, and less so when they belong to groups that are more poorly represented in top management, such as women, racial or ethnic minorities, or non-US nationals, and CHROs holding a liberal arts degree. Jointly considering the characteristics of CHROs, CEOs, and CFOs, we additionally find that pro-democratic political ideology is related to higher quality HCR disclosures. This study contributes to the literature by introducing a generalizable measure of HCR disclosure quality, uncovering significant heterogeneity in HCR disclosure quality across large US firms, and highlighting the role of CHROs in this process. In doing so, this study documents evidence that individual top executives in addition to the CEO and CFO can have a measurable effect on voluntary financial disclosures.     

Strategic Subsidiary Disclosure

Although subsidiary disclosures in firms’ filings with the Securities and Exchanges Commission (SEC; Exhibit 21) represent the most granular required public disclosure of a firm's geographic footprint, little is understood about the quality of the disclosure, and anecdotal evidence suggests firms may not fully comply with the disclosure requirements. We use data provided by multinational firms to the Internal Revenue Service regarding their foreign subsidiary locations to explore the accuracy of public subsidiary disclosures on Exhibit 21 of Form 10-K per SEC rules. The overall incidence of nondisclosure is low, suggesting that most firms comply with Exhibit 21 disclosure rules, and that for most applications, Exhibit 21 disclosures provide a reasonable proxy for locations of significant subsidiaries. Nevertheless, there is some evidence of nondisclosure, particularly when subsidiaries are in tax havens, when the firm is more highly scrutinized in the media, or when the firm has other characteristics consistent with low-quality disclosures such as SEC comment letters.     

Shareholder activism and voluntary disclosure

We examine the relation between shareholder activism and voluntary disclosure. An important consequence of voluntary disclosure is less adverse selection in the capital markets. One class of traders that finds less adverse selection unprofitable is activist investors who target mispriced firms whose valuations they can improve. Consistent with this idea, we find that managers issue earnings and sales forecasts more frequently when their firm is more at risk of attack by activist investors, and that these additional disclosures reduce the likelihood of becoming an activist’s target. These additional disclosures also prompt a positive price reaction, contain more precise guidance, and exceed prevailing market expectations. These findings imply that managers use voluntary disclosure to preempt activism at their firm, and that activists prefer to target relatively opaque firms.     

Do managers withhold bad news from credit rating agencies?

Research documents that managers, on average, withhold bad news and emphasize good news in their public disclosures. We ask whether the same is true in their private communications with credit rating agencies. We study how rating agencies anticipate and react to public information events as a function of their access to rated firms’ private information. We show that, in terms of ratings downgrades, rating agencies exhibit relatively more anticipation and less reaction to negative (compared to positive) public information events when they have more access to private information. Our results are strongest when firms are most optimistic in their public disclosures and are not due to rating agencies focusing their efforts on downside risk. Overall, we find consistent evidence that rated firms provide less optimistic information to rating agencies in their private communications and that this information is reflected in credit ratings.

     

The role of creative strategy,ad disclosure and regulatory focus in investors’ decision making: An experimental investigation

This study examines the effects of creative strategy and ad disclosure in financial services advertising (FSA) and individual differences in regulatory focus on retail investors’ attitudes and behavioral intentions. Results from a between-subject experiment indicate that investors’ regulatory focus (promotion focus versus prevention focus) moderates the effects of FSA related to creative strategy and ad disclosure. Specifically, prevention-focused investors (promotion-focused investors) had more favorable attitudes towards and showed greater purchase intentions of a financial product when exposed to informational ads and ads with disclosures (transformational ads and ads without disclosures). The authors offer theoretical, managerial and public policy implications.     

Do Risk Disclosures Matter When It Counts? Evidence from the Swiss Franc Shock

We examine the relation between disclosure quality and information asymmetry among market participants following an exogenous shock to macroeconomic risk. In 2015, the Swiss National Bank abruptly announced that it would abandon the longstanding minimum euro‐Swiss franc exchange rate. We find evidence suggesting that firms with more transparent disclosures regarding their foreign exchange risk exposure ex ante exhibit significantly lower information asymmetry ex post. The information gap in bid‐ask spreads appears within 30 minutes of the announcement and persists for two weeks, during which new information gradually substitutes for past disclosures. We validate the information dynamics of past risk disclosures with three field surveys: (1) Sell‐side analysts emphasize the importance of existing (risk) disclosures in evaluating the translational and transactional effects of the currency shock. (2) Lending banks’ credit officers rely on past disclosures as the primary information source available for smaller (unlisted) firms in the immediate aftermath of the shock. (3) Investor‐relations managers use existing financial filings as a key resource when communicating with external stakeholders. The results suggest that historical disclosures help investors attenuate information asymmetry in light of unexpected news.     

Key audit matters and stock price synchronicity: Evidence from a quasi-natural experiment in China

The recent requirement to disclose key audit matters (KAMs) in audit reports aims to improve audit quality and provide extra information to external users. Using a quasi-natural experiment in China and the difference-in-differences approach, we document causal evidence that KAM disclosures provide incremental firm-specific information and reduce stock price synchronicity. The effect of KAM disclosures is more pronounced in firms with controlling shareholders and fewer institutional shareholders. Overall, the findings suggest that KAM disclosures reduce information acquisition costs and facilitate firm-specific information impounded in price, especially when such information is less accessible to outside shareholders.     

Intertemporal Dynamics of Corporate Voluntary Disclosures

While empirical evidence alludes to the intertemporal nature of corporate voluntary disclosures, most of the existing theory analyzes firms' voluntary disclosure decisions within single‐period settings. Introducing a repeated, multiperiod, disclosure setting, we study the extent to which firms' strategic disclosure behavior in the past affects their prosperity to provide voluntary disclosures in the future. Our analysis demonstrates that by voluntarily disclosing private information firms make an implicit commitment to provide similar disclosures in the future, and therefore are less willing to voluntarily disclose information in the first place. This effect is expected to be of larger magnitude for firms (1) with a long history of absence of voluntary disclosures and an impressive past operating performance, or (2) that operate in a relatively stable and predictable business and information environment, or (3) whose managers have a long time horizon and a high degree of risk aversion.     

Evidence of assurance enhancing the quality of voluntary environmental disclosures: an empirical analysis

In response to investor and public concerns about harm to the environment, companies are increasingly disclosing environmental information. To enhance the quality of corporate environmental disclosures in a largely voluntary context, various stakeholders are also demanding independent assurance. This study uses a stakeholder‐agency theoretical perspective to examine whether the quality of voluntary environmental disclosures is enhanced when assured. This study also examines the difference in the quality of voluntary environmental disclosures when assurance is provided by either professional accountant assurers or private consultants. Our sample comprises listed companies voluntarily disclosing environmental information in stand‐alone reports, annual reports, and websites. We use an index based upon the Global Reporting Initiative (GRI) to measure the quality of company environmental reporting. Results of this matched pairs study show that the quality of voluntary environmental disclosures scores significantly higher for assured companies than unassured companies. For assured companies, the quality is no different when assured by accountants or consultants. Additional analysis provides preliminary evidence that experience improves the quality of environmental disclosures.     

Threat to regulate and coordination failures: Experimental evidence

Coordination games can represent a wide range of issues in real estate. In this paper, we present the results of an experiment designed to investigate the impact of regulatory threats in a coordination game. The experiment consisted of two sessions. The first session included a simple coordination game. We found significant coordination failures among the players in this session. We then conducted a second session in which we introduced a new player who had the choice to either intervene and regulate the payoffs of the other players or not to intervene and let the other players' actions determine the outcome. Our objective was to test whether the introduction of such a regulatory authority would induce more cooperative play by the players and move the market to the Pareto superior outcome. We found this not to be the case. There was no statistically significant difference between the choices of subjects in the two sessions.     

Mandatory and Voluntary Disclosures: Dynamic Interactions

Firms sometimes obtain soft private information about growth prospects along with hard information about current or past performance. In this environment, we find that optimizing disclosures over multiple periods yields nonlinear stock price reactions following both voluntary and mandatory disclosures. Further, we derive several predictions about distinct short‐run and long‐run effects of disclosures and nondisclosures on security prices. Under specified conditions, when the volatility of the firm's earnings increases, the average contemporaneous and prospective post‐mandatory‐disclosure market premia (for voluntary disclosures over nondisclosures) rise, while farther‐in‐future market discounts (for such voluntary disclosures) also become larger. Our analysis moreover predicts that both the disclosure probability and the information content of nondisclosures can increase in the persistence of earnings.     

Externalities of public firm presence: Evidence from private firms' investment decisions

Public firms provide a large amount of information through their disclosures. In addition, information intermediaries publicly analyze, discuss, and disseminate these disclosures. Thus, greater public firm presence in an industry should reduce uncertainty in that industry. Following the theoretical prediction of investment under uncertainty, we hypothesize and find that private firms are more responsive to their investment opportunities when they operate in industries with greater public firm presence. Further, we find that the effect of public firm presence is greater in industries with better information quality and in industries characterized by a greater degree of investment irreversibility. Our results suggest that public firms generate positive externalities by reducing industry uncertainty and facilitating more efficient private firm investment.     

Private communication among competitors and public disclosure

I study how private communication among competitors affects their public disclosures. Theory suggests that competing firms can use public disclosure to coordinate, and predicts less public disclosure when there is more private communication. Using data on strategic alliances, I predict and find that firms that enter strategic alliances with competitors reduce their public disclosure, and that the reduction is more pronounced for alliances that allow for more private communication.     

Meeting user information needs: The impact of major changes in FASB and GASB standards on financial reporting by colleges and universities

This longitudinal study reports the impact of changes in generally accepted accounting principles on financial statement disclosures for 100 public and private institutions of higher education. Disclosures from the period when all colleges and universities followed the same accounting standards are compared with disclosures in periods after major changes in accounting and reporting standards were made by the Financial Accounting Standards Board (FASB) for private institutions and by the Governmental Accounting Standards Board (GASB) for public institutions. We find that an importance-weighted disclosure index shows that user needs are better met using the new reporting standards for public but not private institutions. An expanded unweighted index, however, shows improvement for both public and private colleges and universities. Using this disclosure index, the improvement for universities reporting under GASB standards exceeded the improvement for those reporting under FASB standards.     

On the Value of Transparency in Agencies with Renegotiation

In this paper we study when it is advantageous to improve corporate transparency by allowing shareholders direct access to corporate information and when it is preferable to rely on a reporting system in which shareholders only gain access to information that management chooses to disclose. We show that in an agency model that allows for contract renegotiation, the desirability of a fully transparent reporting regime hinges on the stewardship properties of the information in question. Specifically, information that is mainly useful for predicting future events and of little use for evaluating past actions should only be made available to the public through management's self‐interested disclosures. Only if the information is useful for making inference about managerial actions can it be optimal to have full corporate transparency, so that outsiders have independent access to the same information as management.     

Forcing firms to talk: financial disclosure regulation and externalities

We analyze a model of voluntary disclosure by firms and thedesirability of disclosure regulation. In our model disclosureis costly, it has private and social value, and its precisionis endogenous. We show that (i) a convexity in the value ofdisclosure can lead to a discontinuity in the disclosure policy;(ii) the Nash equilibrium of a voluntary disclosure game isoften socially inefficient; (iii) regulation that requires aminimal precision level sometimes but not always improves welfare;(iii) the same is true for subsidies that change the perceivedcost of disclosures; and (iv) neither regulation method dominatesthe other.     

The effect of information disclosure on demand for high‐load insurance

Economists, regulators, and consumer protection agencies have highlighted the welfare losses for consumers who purchase high‐load insurance against modest stakes risks. Mandatory information disclosure is a potentially attractive public policy tool that might improve consumers' choices, but has not been widely tested in insurance settings. We conduct an incentive‐compatible insurance demand experiment, in which we manipulate the information disclosed to subjects. We test whether any of the three most commonly suggested disclosures affect insurance demand, disclosing either (1) the true probability of loss, (2) the contract's expected loss, or (3) the insurer's profit on the transaction. Similar to consumers in naturally occurring insurance markets, subjects in the laboratory demonstrate significant demand for high‐load insurance against modest stakes. However, we find no effect of any of the three disclosure treatments on subjects' insurance choices. We discuss the implications of our results for possible public policy initiatives in insurance markets.     

When the Use of Positive Language Backfires: The Joint Effect of Tone,Readability, and Investor Sophistication on Earnings Judgments

Recent studies document that market participants react positively to the positive language sentiment or tone embedded in financial disclosures, and that investors’ reactions to negative news are more muted with poor disclosure readability. However, while language sentiment and readability co‐occur in practice, their joint effects remain largely unexplored. In an experiment with MBA students as participants, we investigate how the effect of language sentiment varies with readability and investor sophistication level. We find that language sentiment influences investors’ judgments when readability is low, but not when readability is high. Specifically, when readability is low, disclosures couched in positive language lead to higher earnings judgments for less sophisticated investors, but lower earnings judgments for more sophisticated investors. These findings show that the main effects of readability and language sentiment documented in prior studies have boundary effects, and may reverse when both variables are jointly considered along with investor sophistication.