The financial reporting environment: Review of the recent literature

https://doi.org/10.1016/j.jacceco.2010.10.003Get rights and content

Abstract

The corporate information environment develops endogenously as a consequence of information asymmetries and agency problems between investors, entrepreneurs, and managers. We review current research on the three main decisions that shape the corporate information environment in capital market settings: (1) managers’ voluntary disclosure decisions, (2) disclosures mandated by regulators, and (3) reporting decisions by analysts. We conclude that, in the last ten years, research has generated several useful insights. Despite this progress, we call for researchers to consider interdependencies between the various decisions that shape the corporate information environment and suggest new and interesting issues for researchers to address.

Introduction

Accounting information plays two important roles in market-based economies. First, it allows capital providers (shareholders and creditors) to evaluate the return potential of investment opportunities (the ex-ante or valuation role of accounting information). Second, accounting information allows capital providers to monitor the use of their capital once committed (the ex-post or stewardship role of accounting information).

Thus, the demand for accounting information by outsiders arises for two reasons. First, ex-ante, firms’ managers typically have more information about the expected profitability of firms’ current and future investments than outsiders. This information asymmetry makes it difficult for outside capital providers to assess the profitability of the firm’s investment opportunities. This problem is exacerbated because insiders (both managers and owner-managers) have incentives to exaggerate their firms’ projected profitability. In turn, if capital providers cannot assess firms’ profitability, they will under-price firms with high profitability and over-price firms with low profitability, potentially leading to market failure. This “lemons problem” (Akerlof, 1970) and the resulting incentives to disclose additional information have long been recognized in the literature.

Second, the ex-post demand for accounting information arises from a separation of ownership and control (a characteristic of modern economies), which results in capital providers not having full decision-making rights. To solve the ensuing agency problems, both implicit and explicit contracts often use accounting information such as the use of resources, decisions taken, and generated return on investments. Investors value such information ex-post and require a lower rate of return ex-ante when they can rely on such information. However, as we will discuss, the ex-ante and ex-post demands for accounting information may not always result in the information being voluntarily supplied.

The characteristics of the corporate information environment will therefore be shaped by the relative magnitude of the stewardship and valuation problems. This tension has long been recognized in the literature (e.g., Gjesdal, 1981), and can best be illustrated with a simple example. Suppose the firm’s value (net of the manager’s compensation) depends on two factors: management effort and luck (i.e., things that affect firm value but are beyond the manager’s control). In such a setting, resolving the stewardship problem and valuing the firm require different information. The latter requires that the firm’s accounting system provides information about firm value, i.e., the combined effect of management effort and luck. By contrast, the former requires that investors either observe the manager’s actions directly (which is usually not the case) or that the firm’s accounting system provides information that allows investors to make inferences about the manager’s actions.1

We focus on these two reasons for information environments to develop endogenously: the information asymmetry between capital providers and entrepreneurs with investment opportunities (the valuation problem) and the agency problems that result from the separation of ownership and control (the stewardship problem). If the corporate information environment arises endogenously to resolve valuation and stewardship problems, then why is disclosure regulation needed in capital markets? In Section 3.1, we discuss the conditions under which insiders (e.g., managers) do not voluntarily disclose all their private information (i.e., when the “unraveling result” by Grossman and Hart, 1980, Grossman, 1981, Milgrom, 1981, Milgrom and Roberts, 1986 does not hold).

Our discussion implies that the corporate information environment will be shaped by (i) the extent to which each of the conditions of the unraveling result do not hold (see Section 3.1), (ii) the availability and cost-effectiveness of alternative mechanisms or information from sources other than the firm itself that help address valuation and stewardship problems (see Section 5), and (iii) the magnitude of the stewardship problem compared to the magnitude of the valuation problem.

When managers do not voluntarily disclose all their private information, there is room for disclosure regulation in capital markets. As discussed in Section 4, the literature provides two main reasons for disclosure regulation. First, misalignment of insiders’ (entrepreneurs’ or management’s) and investors’ incentives can make it difficult for managers to credibly convey information. From this perspective, disclosure requirements, accounting standards, auditors, and SEC enforcement actions are mechanisms that allow firms to commit to certain disclosure levels and improve the credibility of disclosed information. We discuss these issues in Section 4.2.

Second, the public goods aspect of disclosures results in free-rider problems, creating circumstances in which managers’ incentives to voluntarily disclose information are insufficient even though additional information would improve social welfare. In such cases, regulation mandating the disclosure of certain information can be desirable.2 Hence, disclosure regulation will, in part, depend on the kind of information that a firm voluntarily discloses or that can (efficiently) be produced by other market participants.

In addition to voluntary and mandatory disclosures, third parties (e.g., information intermediaries) play a key role in shaping the information environment. Consistent with the extant literature, we focus our discussion of information intermediaries on sell-side security analysts. In Section 5, we structure our discussion of the information environment around the key decisions an analyst makes: (i) whether to follow a firm and how many firms to follow; (ii) how much information to acquire/produce; (iii) whether and when to issue or revise a report; (iv) what kind of report to issue; and (v) whether and to what extent to issue a report that diverges from or is less precise than the analyst’s private signal or beliefs.

Throughout the survey, we emphasize the endogenous nature of the corporate information environment, the role of disclosure regulation, and the interdependencies between the various parts of the disclosure environment. Considering this endogeneity is likely to affect the inferences drawn. For example, when analyzing the effects of a mandatory change in disclosure requirements, most empirical studies do not incorporate how other aspects of the corporate information environment, such as third-party production of information or the incentive to disclose information voluntarily, respond to this change. Another example is the interrelation between earnings management, management’s propensity to issue voluntary forecasts, and the informativeness of managements’ forecasts. It is likely that a standard that reduces the ability to manage earnings also reduces managers’ willingness to issue voluntary forecasts, but simultaneously increases the informativeness of any forecasts issued. As a consequence, it is necessary to consider multiple aspects of the corporate information environment in order to conclude whether it becomes more or less informative in response to an exogenous change.

While it would be desirable to consider all interdependencies of the decisions related to the information environment, this is hardly feasible for two reasons. First, as a result of the numerous interdependencies, one would not expect simple causal relationships to hold (such as voluntary disclosure strategies determine analyst following or vice versa). Rather, “equilibrium” concepts for the market for information defy a simplified view of cause and effect. Second, our understanding of the interdependencies and interactions of the elements of the information system is still limited. For instance, to date, not much is known about the effect of regulation (e.g., Regulation Fair Disclosure), the incentives to produce and disseminate information, the resulting information asymmetry between insiders and outsiders, the role of regulatory enforcement actions on the incentives to produce information, the (political) process by which disclosure regulation evolves over time, or the role and relative effectiveness of alternative accounting standards (e.g., U.S. GAAP versus IFRS).

Due to the inherent complexity of the corporate information environment, we do not provide a formal general framework that captures all those interdependencies. Rather, following a somewhat more limited approach, we focus on the decision makers’ incentives for selected decisions that shape the corporate information environment (such as management’s decision to voluntarily provide earnings forecasts or an analyst’s decision to cover a company). We discuss possible links to other decisions and interactions with other parties in the corporate information environment.3 To provide some guidance on which information sources are likely to be the most relevant, we start with an empirical analysis of the relative importance of earnings announcements, voluntary management forecasts, analyst forecasts, and regulatory filings in explaining abnormal stock returns (see Section 2).

As stated, the purpose of a survey reviewing the corporate information environment might be too broad to result in a systematic and careful examination of all the research in this area. For that reason, we have chosen to limit our review in four ways. First, we systematically exclude certain topics that, while part of the corporate information environment, are either covered by other surveys (e.g., management’s decision to manipulate earnings, stock market anomalies and capital market inefficiencies, and features of corporate governance that affect firms’ disclosure strategies) or are not part of the focus of accounting research in general or the Journal of Accounting and Economics in particular. The latter category includes the information processing of individual decision makers including their behavioral biases to the extent that they are not specific to the context studied here.4 Second (and related), we concentrate almost exclusively on research using analytical and empirical archival methods. By its very nature, an analytical approach assumes away a lot of the complexity inherent in the environment. As such, these models are only able to address narrow parts of the puzzle. By contrast, empirical archival data reflect the complexity of the real world. However, inference problems result because it is impossible to control for all of these complex factors in empirical analyses. Thus, combining the results from both approaches increases the reliability of the conclusions drawn. Third, we primarily focus our survey on papers published or written during the 2000–2010 period to highlight the current state of the literature and to also minimize overlap with the surveys published in the Journal of Accounting and Economics in 2001 (see Healy and Palepu, 2001, Core, 2001, Fields et al., 2001). (We make exceptions to this restriction as we see fit for papers that serve as a foundation for the recent literature.)5 Fourth, we focus on the role of accounting information in the corporate information environment and largely ignore other sources of information (e.g., signaling through dividends or other specific corporate transactions).

We hope that our survey will impact future research in three ways. First, the description of the corporate information environment highlights aspects of the environment that are still not well understood. Providing answers to questions that lead to a more complete description of the corporate information environment is an important first step to develop a better understanding of the elements of the corporate information environment. We conclude that the fundamental questions that still remain unanswered include: (1) the costs and benefits of voluntary disclosure, (2) the reasons why disclosure regulation so prevalent in advanced and developed economies such as the U.S., and (3) the relation between firms’ voluntary disclosure policies, mandatory disclosure requirements, and the information produced by security analysts (including which firms they follow and what items they include in their reports).

Second, the interrelations among the decisions that shape the corporate information environment highlight the interdependencies that have so far been ignored in the literature or not considered in a joint fashion. For example, incentive systems are designed not only to influence management’s disclosure decisions but also investment decisions, competitive behavior, and capital structure choices. Incorporating some (if not all) of these other (real) decisions in any analysis of disclosure decisions would allow us to obtain a better understanding of the effect of firms’ disclosure policies. Moreover, the influence of the firm’s existing information environment (including firm disclosures and disclosures from other information intermediaries) in an analyst’s decision to follow a firm is unclear. For example, there is conflicting evidence from theoretical and empirical studies on whether firms are able to attract analyst following through additional voluntary disclosures.

Finally (and possibly most importantly), the link between theory and empirical tests is still weak and rather “loose.” Commonly, empirical work selectively focuses on aspects of related analytical research in motivating and interpreting the results. Empirical researchers should acknowledge competing theoretical predictions underlying their research questions, and attempt to distinguish among these predictions. A tighter link between theory and empirical work would enhance our understanding of the corporate information environment significantly.

The survey proceeds as follows: in Section 2, we describe our empirical analysis of the importance of earnings announcements, voluntary management forecasts, analyst forecasts, and regulatory filings in explaining abnormal stock returns. In Section 3, we discuss the literature on voluntary disclosures, followed by a review of the research on mandatory disclosures in Section 4. Section 5 discusses the decisions facing sell-side security analysts and the research on each. Finally, our conclusions and suggested directions for future research are in Section 6.

Section snippets

Sources of corporate financial information

We motivate our review by documenting the sources of information obtained by investors. To this end, we conduct a simple decomposition of the quarterly stock return variance. The main purpose of this analysis is to determine the relative contribution of management forecasts (voluntary disclosures), analyst forecasts (information provided by information intermediaries), SEC filings (mandatory disclosures), issuance of earnings guidances (voluntary disclosures), and actual earnings disclosures

Models of corporate voluntary disclosure

The unraveling result (Grossman and Hart, 1980, Grossman, 1981, Milgrom, 1981, Milgrom and Roberts, 1986) identifies conditions under which firms voluntarily disclose all their private information. These conditions include (1) disclosures are costless; (2) investors know that firms have, in fact, private information; (3) all investors interpret the firms’ disclosure in the same way and firms know how investors will interpret that disclosure; (4) managers want to maximize their firms’ share

Models of disclosure regulation

Most developed capital markets mandate corporate disclosures, but why is such regulation necessary? If the unraveling result (Grossman and Hart, 1980, Grossman, 1981, Milgrom, 1981, Milgrom and Roberts, 1986) holds, firms will voluntarily disclose all information, making mandatory disclosure requirements unnecessary. The unraveling result, however, has not been successful in explaining observed disclosure practices. Section 3.1 discusses the reasons full disclosure may not occur. But even if

Analyst reports

Both buy- and sell-side analysts forecast firms’ earnings, cash flows, and/or revenues, and provide price targets and make stock recommendations. Reflecting the empirical research, our review primarily focuses on sell-side analysts (i.e., analysts employed by brokerage houses, independent research institutes, or investment-banking firms). We structure our discussion of the research around the decisions an analyst makes:

  • whether to follow a firm (coverage); how many firms to follow;

  • how much

Conclusions and directions for future research

We have focused on three aspects of the corporate information environment – voluntary firm disclosures, mandatory firm disclosures, and analysts’ reports – to better understand how each contributes to the information available for valuation and stewardship purposes. Our empirical analysis in Section 2 indicates that of the sources of information we consider, voluntary management earnings forecasts (while not very frequent) explain the largest fraction of the variation in quarterly stock

References (421)

  • E. Bartov et al.

    The rewards to meeting or beating earnings expectations

    Journal of Accounting and Economics

    (2002)
  • S. Basu

    The conservatism principle and the asymmetric timeliness of earnings

    Journal of Accounting and Economics

    (1997)
  • A. Beyer

    Financial analysts’ forecast revisions and managers’ reporting behavior

    Journal of Accounting and Economics

    (2008)
  • N. Bhattacharya et al.

    Assessing the relative informativeness and performance of pro forma earnings and GAAP operating earnings

    Journal of Accounting and Economics

    (2003)
  • R. Bhushan

    Firm characteristics and analyst following

    Journal of Accounting and Economics

    (1989)
  • M. Bradshaw

    A discussion of ‘Assessing the relative informativeness and permanence of pro forma earnings and GAAP operating earnings’

    Journal of Accounting and Economics

    (2003)
  • L. Brown et al.

    Security analyst superiority relative to univariate time-series models in forecasting quarterly earnings

    Journal of Accounting and Economics

    (1987)
  • S. Brown et al.

    Conference calls and information asymmetry

    Journal of Accounting and Economics

    (2004)
  • D. Burgstahler et al.

    Earnings management to avoid earnings decreases and losses

    Journal of Accounting and Economics

    (1997)
  • B. Bushee et al.

    Open versus closed conference calls: the determinants and effects of broadening access to disclosure

    Journal of Accounting and Economics

    (2003)
  • J. Campbell et al.

    No news is good news: an asymmetric model of changing volatility in stock returns

    Journal of Financial Economics

    (1992)
  • P. Chen et al.

    How do accounting variables explain stock price movements? Theory and evidence

    Journal of Accounting and Economics

    (2007)
  • S. Chen et al.

    Voluntary disclosure of balance sheet information in quarterly earnings announcements

    Journal of Accounting and Economics

    (2002)
  • J. Abarbanell et al.

    Tests of analysts’ overreaction/underreaction to earnings information as an explanation for anomalous stock price behavior

    The Journal of Finance

    (1992)
  • J. Abarbanell et al.

    Letting the “tail wag the dog”: the debate over GAAP versus street earnings revisited

    Contemporary Accounting Research

    (2007)
  • D. Aboody et al.

    Earnings quality, insider trading, and cost of capital

    Journal of Accounting Research

    (2005)
  • Acharya, V.V., DeMarzo, P., Kremer, I., 2008. Endogenous information flows and the clustering of announcements. Working...
  • A.R. Admati et al.

    A monopolistic market for information

    Journal of Economic Theory

    (1986)
  • A.R. Admati et al.

    Forcing firms to talk: financial disclosure regulation and externalities

    The Review of Financial Studies

    (2000)
  • J. Affleck-Graves et al.

    Forecasts of earnings per share: possible sources of analyst superiority and bias

    Contemporary Accounting Research

    (1990)
  • A. Agrawal et al.

    Do analyst conflicts matter? Evidence from stock recommendations

    Journal of Law and Economics

    (2008)
  • B.B. Ajinkya et al.

    The association between outside directors, institutional investors and the properties of management earnings forecasts

    Journal of Accounting Research

    (2005)
  • G.A. Akerlof

    The market for ‘lemons’: quality uncertainty and the market mechanism

    The Quarterly Journal of Economics

    (1970)
  • A. Alford et al.

    A simultaneous equations analysis of forecast accuracy, analyst following, and trading volume

    Journal of Accounting, Auditing and Finance

    (1999)
  • A. Ali et al.

    The limitations of industry concentration measures constructed with Compustat data: implications for finance research

    Review of Financial Studies

    (2009)
  • F. Allen et al.

    Beauty contest and iterated expectations in asset markets

    The Review of Financial Studies

    (2006)
  • Y. Amihud et al.

    The effects of beta, bid-ask spread, residual risk and size on stock returns

    The Journal of Finance

    (1986)
  • Armstrong, C., Guay, W., Weber, J., 2010. Role of information and financial reporting in corporate governance and debt...
  • Arya, A., Frimor, H., Mittendorf, B., 2009. Discretionary disclosure of proprietary information in a multi-segment...
  • K. Bae et al.

    International GAAP differences: the impact on foreign analysts

    The Accounting Review

    (2008)
  • S.P. Baginski et al.

    The effect of legal environment on voluntary disclosure: evidence from management earnings forecasts issued in U.S. and Canadian markets

    The Accounting Review

    (2002)
  • S.P. Baginski et al.

    Why do managers explain their earnings forecasts?

    Journal of Accounting Research

    (2004)
  • M. Bagnoli et al.

    The information in management’s expected report date: a day late, a penny short

    Journal of Accounting Research

    (2002)
  • R. Ball et al.

    How much new information is there in earnings?

    Journal of Accounting Research

    (2008)
  • L.S. Bamber et al.

    Discretionary management earnings forecast disclosures: antecedents and outcomes associated with forecast venue and forecast specificity choices

    Journal of Accounting Research

    (1998)
  • R. Barniv et al.

    Do analysts practice what they preach and should investors listen? Effects of recent regulations

    The Accounting Review

    (2009)
  • C. Barry et al.

    Differential information and security market equilibrium

    Journal of Financial and Quantitative Analysis

    (1985)
  • M. Barth et al.

    Accruals and the prediction of future cash flows

    The Accounting Review

    (2001)
  • M. Barth et al.

    Analyst earnings forecast revisions and the pricing of accruals

    Review of Accounting Studies

    (2004)
  • M. Barth et al.

    Analyst coverage and intangible assets

    Journal of Accounting Research

    (2001)
  • Cited by (1567)

    • Industry-sensitive language modeling for business

      2024, European Journal of Operational Research
    • Risk factors disclosure and corporate philanthropy

      2024, International Review of Financial Analysis
    • Liquid stock as an acquisition currency

      2024, Journal of Corporate Finance
    • Worldwide board reforms and financial reporting quality

      2024, Research in International Business and Finance
    • Textual disclosure complexity and analysts’ weighting of information

      2024, Journal of Contemporary Accounting and Economics
    View all citing articles on Scopus

    We thank Philip Berger (discussant), Ronald Dye, Ilan Guttman, Margaret Neale, Ulf Schiller, Ron Shalev, Ross Watts (editor), Jerold Zimmerman (editor), and participants at the 2009 Journal of Accounting and Economics conference for helpful comments and discussions. We appreciate the financial support from Stanford University, New York University, and the Kellogg School of Management at Northwestern University.

    View full text