Topic and Objectives
In their annual reports, corporate managers often make forward-looking disclosures, i.e. statements about the future economic performance (e.g. future profits) of their firms. The informativeness of these statements for outside investors is ambiguous because, in contrast to financial statements, they are not verifiable by third parties (like auditors). Consequently, managers have a short-term incentive to mislead outside investors by making overly optimistic disclosures about their firms’ future performance. However, forward-looking disclosures might incur costs for managers’ firms, such as costs from the ensuing legal risks. Furthermore, in a setting of repeated interaction with external investors, the credibility of managers’ future disclosures depends on the accuracy of their current disclosures. Provided that they care about their credibility among investors, managers’ forward-looking disclosures are therefore affected by reputation concerns. Our paper explores the disclosure policies of corporate managers in the presence of disclosure-related costs and reputation concerns. To this end, we consider a game-theoretic model with reputation effects in which an informed manager raises funds from uninformed investors to finance an investment project. In order to signal the quality of the project, the manager can make a (possibly costly) forward-looking disclosure about the project’s success potential.
- If disclosures are associated with costs, the manager does not release forward-looking statements that are uninformative for external investors. The intuition for this result is that, if forward-looking disclosures are costly and offer no benefit to the firm, the manager always prefers to make no disclosures.
- If disclosure-related costs are high, the managers of firms that are transparent for investors release no forward-looking statements. The reason is that for the managers of these firms, forward-looking disclosures have only little benefit, such that they prefer to refrain from them if they are costly.
- However, if disclosure-related costs are low, the managers of opaque and profitable firms will release accurate forward-looking statements to the public. The intuition is that the managers of such firms find it valuable to retain their credibility among investors, and that they don’t want to jeopardize this credibility by misleading disclosures.
- To test our findings empirically, we employ computer-intensive techniques and construct an index that captures the quantity of forward-looking disclosures in public firms’ 10-K reports. Consistent with our results, we find that among opaque firms, our index is positively correlated with a firm’s profitability and financing needs, while for transparent firms, there is only a weak relation between the index and firm fundamentals.
- Furthermore, we find that the overall level of forward-looking disclosures strongly declined between 2001 and 2009, possibly as a result of the 2002 Sarbanes-Oxley Act.