Nonprofessional Investors Use of Biased Disclosures in Decision Making

Abstract

We report the results of an experiment where management discloses in the audited financial statements a firm-specific capital structure that is susceptible to manipulation (i.e., subjective). This disclosure is allowed under current IAS 1 rules. In our study, if used by nonprofessional investor participants, the firm-specific capital structure disclosure will lead to higher firm values than would capital structures commonly determined from the firm’s balance sheet. Our results show that when participants received the disclosure it was used to determine firm value; this was despite the participants recognizing the bias in the disclosure. We also found that when the participants who received the disclosure were cautioned of management’s ability to manipulate the disclosure, the warning had no effect. This finding differs from prior research. Explanatory analysis reveals that the disclosure itself activated participant skepticism removing a mechanism by which cautionary guidance can help protect nonprofessional investors from misleading management disclosures. A mediation analysis reveals that a misleading disclosure impacts investor stock purchasing decisions through investment attractiveness. Our study adds to the disclosure literature and has important implications for investors, standard setters, and auditors.