The Effect of a Cautionary Notice on Investorss Reactions to More and Less Readable Disclosures

Abstract

Managers appear to use discretion over disclosure language strategically, in order to reduce the effect of bad news and/or amplify the effect of good news. We test how a cautionary notice highlighting management’s discretion over disclosure language affects investors’ reactions to more and less readable disclosures. We find that a cautionary notice causes investors to reduce their valuation and investment desirability judgments when readability is consistent with management’s incentives — that is, when bad news disclosures are less readable and when good news disclosures are more readable — but not when readability is inconsistent with a strategic motivation. Further, tests of an original process model indicate that investors who receive a cautionary notice evaluate all disclosures more skeptically, regardless of readability, but only decrease reliance on disclosures when language choices are consistent with management incentives to promote good news or obfuscate bad news. Our results should be informative to regulators, given their interest in both promoting more readable disclosures and protecting investors.