Knowledge that Transforms

We construct a new, parsimonious, measure of disclosure quality—disaggregation quality (DQ)—and offer validation tests. DQ captures the level of disaggregation of accounting data through a count of nonmissing Compustat line items, and reflects the extent of details in firms’ annual reports. Conceptually, DQ differs from existing disclosure measures in that it captures the “fineness” of data and is based on a comprehensive set of accounting line items in annual reports. Unlike existing measures, which are usually applicable for a subset of firms or are based on a subset of information items, DQ can be generated for the universe of Compustat industrial firms. We conduct three sets of validation tests by examining DQ's association with variables predicted by prior literature to be associated with information quality. DQ is negatively (positively) associated with analyst forecast dispersion (accuracy) and negatively associated with bid‐ask spreads and cost of equity. These associations continue to hold after we control for firm fundamentals. Taken together, results from this battery of validation tests are consistent with our measure capturing disclosure quality.

We examine how corporate social media affects the capital market consequences of firms’ disclosure in the context of consumer product recalls. Product recalls constitute a “product crisis” exposing the firm to reputational damage, loss of future sales, and legal liability. During such a crisis it is crucial for the firm to quickly and directly communicate its intended message to a wide network of stakeholders, which, in turn, renders corporate social media a potentially useful channel of disclosure. While we document that corporate social media, on average, attenuates the negative price reaction to recall announcements, the attenuation benefits of corporate social media vary with the level of control the firm has over its social media content. In particular, with the arrival of Facebook and Twitter, firms relinquished complete control over their social media content, and the attenuation benefits of corporate social media, while still significant, lessened. Detailed Twitter analysis confirms that the moderating effect of social media varies with the level of firm involvement and with the amount of control exerted by other users: the negative price reaction to a recall is attenuated by the frequency of tweets by the firm, while exacerbated by the frequency of tweets by other users.

This paper investigates the extent to which delayed expected loan loss recognition ( DELR ) is associated with greater vulnerability of banks to three distinct dimensions of risk: (1) stock market liquidity risk, (2) downside tail risk of individual banks, and (3) codependence of downside tail risk among banks. We hypothesize that DELR increases vulnerability to downside risk by creating expected loss overhangs that threaten future capital adequacy and by degrading bank transparency, which increases financing frictions and opportunities for risk‐shifting. We find that DELR is associated with higher correlations between bank‐level illiquidity and both aggregate banking sector illiquidity and market returns (i.e., higher liquidity risks) during recessions, suggesting that high DELR banks as a group may simultaneously face elevated financing frictions and enhanced opportunities for risk‐shifting behavior in crisis periods. With respect to downside risk, we find that during recessions DELR is associated with significantly higher risk of individual banks suffering severe drops in their equity values, where this association is magnified for banks with low capital levels. Consistent with increased systemic risk, we find that DELR is associated with significantly higher codependence between downside risk of individual banks and downside risk of the banking sector. We theorize that downside risk vulnerability at the individual bank level can translate into systemic risk by virtue of DELR creating a common source of risk vulnerability across high DELR banks simultaneously, which leads to risk codependence among banks and systemic effects from banks acting as part of a herd.

We offer evidence that the use of relative performance evaluation (RPE) in CEOs’ incentive contracts influences the effect of risk‐taking incentives on both the magnitude and composition of firm risk. We find that, when the incentive design lacks RPE features, the incentive portfolio vega motivates CEOs to increase total risk through the systematic component because it can be hedged. In contrast, when the incentive design includes RPE features, CEOs prefer idiosyncratic risk because RPE filters out the systematic component of firm performance. We also document that the use of RPE reinforces the incentive portfolio vega's effect on the total risk.

Using a new measure of financial constraints based on firms’ qualitative disclosures, we find that financially constrained firms—firms that use more negative words in their annual reports—pursue more aggressive tax planning strategies as evidenced by: (1) higher current and future unrecognized tax benefits, (2) lower short‐ and long‐run current and future effective tax rates, (3) increase in tax haven usage for their material operations, and (4) higher proposed audit adjustments from the Internal Revenue Service. We exploit the unexpected closures of local banks as exogenous liquidity shocks to show that firms’ external financial constraints affect their tax avoidance strategies. Overall, the linguistic cues in firms’ qualitative disclosures provide incremental information beyond traditional accounting variables or commonly used effective tax rates to reveal and predict tax aggressiveness, both contemporaneously and in the future.

The audit market's unique combination of features—its role in capital market transparency, mandated demand, and concentrated supply—means it receives considerable attention from policy makers. We explore the effects of two market scenarios that have been the focus of policy discussions: mandatory audit firm rotation and further supply concentration due to the exit of a “Big 4” audit firm. To do so, we first estimate publicly traded firms' demand for auditing services, allowing the services provided by each of the Big 4 to be differentiated products. We then use those estimates to calculate how each scenario would affect client firms' consumer surplus. We estimate that, for U.S. publicly trade firms, mandatory audit firm rotation would induce consumer surplus losses of approximately $2.7 billion if rotation were required after 10 years and $4.7–5.0 billion if after only four years. We find similarly that exit by one of the Big 4 would reduce client firms' surplus by $1.4–1.8 billion. These estimates reflect only the value of firms' lost options to hire the exiting audit firm; they do not include likely fee increases resulting from less competition among audit firms. The latter could result in audit fee increases between $0.75–1.3 billion per year for mandatory rotation and $0.47–0.58 billion per year for the disappearance of a Big 4 audit firm. Such losses are substantial; by comparison, total audit fees for public firms were $11 billion in 2010.

How should a firm measure a productive asset used as collateral? To answer this question, we develop a model in which firms borrow funds subject to collateral constraints. We characterize the qualities of optimal asset measurements and analyze their interactions with financing needs, collateral constraints, and interest rates. Because of real effects, complete transparency would reduce contracting efficiency and, hence, the measurement must be suitably adapted to credit conditions. The optimal measurement is asymmetric and reports precise information about high collateral values if credit frictions are low, but the reverse if credit frictions are high. Tighter credit market conditions may lead to more opaque measurements and increased investment, in the form of inefficient continuations.

Recent changes in technology and the media are causing significant changes in how capital markets assimilate and respond to information. We identify important themes in the disclosure literature and use this as a framework to discuss the conference papers that appear in this volume. These papers examine how managers’ disclosure practices are being affected by changes in technology, the media, and capital markets. While this work makes important progress, we discuss how continuing technological change and the emergence of new forms of media offer further opportunities for research on the role of disclosure in capital markets.

We outline several properties of IFRS that potentially affect the contractibility or the transparency of financial statement information, and hence the use of that information in debt contracts. Those properties include the increased choice among accounting rules IFRS gives to managers, enhanced rule‐making uncertainty, and increased emphasis on fair value accounting. Consistent with reduced contractibility of IFRS financial statement information, we find a significant reduction in accounting‐based debt covenants following mandatory IFRS adoption. The reduction in accounting covenant use is associated with measures of the difference between prior domestic standards and IFRS. Because IFRS adoption changed financial reporting in many ways simultaneously, it is difficult to trace the decline in accounting covenant use to individual IFRS properties, though we report larger declines in accounting covenant use in banks, which have a higher proportion of assets and liabilities that are fair‐valued. Our findings are better explained by reduced contractibility than by increased transparency, which would predict reduced nonaccounting covenant use as well, whereas we observe increases. Overall, we conclude that IFRS rules sacrifice debt contracting usefulness to achieve other objectives, such as provision of accounting information relevant to valuation.

Principals make decisions on various issues, ranging from contract design to control system implementation. Few studies examine the principal's active role in these decisions. We experimentally investigate this role by studying how a principal's choice of an incentive contract that may discourage misrepresentation, compared to a fixed‐salary contract, affects the honesty of his or her agents’ cost reporting. Results show that, besides an incentive effect and a principal trust effect, the active choice for incentives produces a negative “information leakage” effect. When principals use incentives, their choices not only incentivize truthful reporting and signal distrust, but they also leak important information about the social norm, namely, that other agents are likely to report dishonestly. Agents conform to this social norm by misrepresenting cost information more. Our results have important practical implications. Managers must recognize that their decisions can leak information to their agents, which may produce unanticipated consequences for the social norms of the organization.