Optimal reporting when additional information might arrive

Abstract

We study how the potential for discretionary disclosure affects the way a firm designs its reporting system. In our model, the firm's primary but nonexclusive concern is to induce beliefs that exceed a threshold. Such thresholds arise in numerous contexts, including investing decisions, liquidation/continuation choices, covenants, audits, impairments, listing requirements, index inclusion, credit ratings, analyst recommendations, and stress tests. The optimal reporting system is characterized by informative good reports when the threshold is high and, potentially, uninformative reports when the threshold is low. Under an optimal impairment-type reporting system, the likelihood of reported impairments and the information content of non-impairment reports both increase in the probability of the firm observing private information. We provide a novel motivation for the quiet period around an IPO and empirical predictions relating the probability of discretionary disclosure to the properties of financial reports. In extensions, we consider disclosure mandates, report manipulation, endogenous thresholds, and alternative payoff functions.