Forward-looking Information Research Articles

Sarbanes-Oxley, Corporate Corruption, and the Complicity of Courts and Legislatures

The main thrust of this article is that courts and legislatures, particularly Congress and the federal courts, are biased in favor of management, and that their failure to hold management to account has emboldened management to engage in corrupt behavior, and has led to passivity and supineness by gatekeepers, such as accountants and directors. Part I explores the notion of bias and asserts that we are bombarded with much information that bias, among others, serves to filter. But bias is most dangerous when it is not recognized by the holder. Part II addresses the notion of complicity and causation/correlation, and then addresses state law developments, such as the development of special litigation committees and statutes exculpating directors from liability, that have insulated management from accountability. Part II concludes by looking at the trilogy of insider trading decisions by the U.S. Supreme Court in the early 1980s Part III moves into the 1990s and the disastrous policy reflected in the 1994 Central Bank decision and the 1995 Private Litigation Securities Reform Act (PLSRA). The Central Bank decision was judicial activism at its worst; PLSRA, by requiring specificity in pleading without the benefit of discovery, and by providing that a cautionary warning on forward-looking information absolved management of any responsibility, even though management knew there was no basis for the statements, also led to a what, me worry? mentality. Part IV examines the criticism of Sarbanes-Oxley by business, and concludes that the accounting profession grossly overreacted to section 404. But this is a problem with the accounting profession, not with the statute itself. The new SEC releases, providing risk-based guidance and defining material weakness, should put to rest some of the criticism. The article also rebuts complaints about overregulation and excessive litigation. The article concludes with the question why not tell the truth? If management were honest and candid, there would be much less litigation and greater market efficiency from truthful disclosure. But for this to come to pass, courts need to be more concerned about truthfulness than they are in protecting management.

Determinants of voluntary disclosures in Kenyan companies annual reports

In recent years, the Kenyan Government has initiated reforms at the Nairobi Stock Exchange aimed at transforming the exchange into a vehicle for mobilising domestic savings and attracting foreign capital investments. Consequently, the corporate financial reporting, and in particular, the level of voluntary disclosure is a vital part of the process for building investor confidence (local and foreign) and trust. Drawing on prior corporate disclosure research, this study examines factors associated with voluntary disclosure of four types of information: general and strategic, financial, forward-looking, and social and board information in the annual reports of Kenyan companies. This study provides longitudinal examination of voluntary disclosure practices in the annual reports of listed companies in Kenya from 1992 to 2001. The study investigates the extent to which corporate governance attributes, ownership structure and company characteristics influence voluntary disclosure of various types of information. Due to the panel nature of our data, to estimate the determinants of voluntary disclosure of various types of information, we use pooled Ordinary Least Square (OLS) with Panel-Corrected Standard Errors (PCSEs). Our results indicate that, disclosures of all types of information are influenced by corporate governance attributes, ownership structure and corporate characteristics. In particular, the results also suggest that size and companies in the agricultural sector are significantly associated with the voluntary disclosure of all four types of information disclosures. Keywords: Voluntary disclosures, companies’ annual reports, Kenya

Information Asymmetries and IPO Underpricing: The Role of Voluntary Disclosure of Forward-Looking Information in the Prospectus

When a firm files to go public it faces the risk of underpricing. Within the agency theory framework, models of underpricing are based on adverse selection and rely on the ways in which the different parties, involved in the IPO process, are asymmetrically informed as managers and internal subjects posses private information about the firm's future prospects which may be not completely known to external investors. The underpricing phenomenon, measured by the difference between the closing price and the opening price on the first day of trading, represents the cost paid by the issuer for the ex-ante uncertainty perceived by external investors. Thus, underpricing is often used as a proxy of the ex-ante uncertainty. Theoretical and empirical studies have evidenced that an issuing firm can reduce ex-ante uncertainty both by signalling the quality of the IPO through various mechanisms (e.g. a larger retention of ownership by the insiders, an appointment of high quality auditors, and highly reputable investment bankers as underwriters) and by disclosing information before the IPO deadline in the hope of decreasing the money left on the table. There are different ways and prospects through which a firm can disclose information before the IPO date. Among them, the most comprehensive document is the IPO prospectus. The EEC Directive n. 2003/71 regulates the contents of the prospectus by defining information that must be disclosed and information that can be voluntary disclosed: an issuer exercises considerable subjectivity in disclosing voluntary information such as projected financial statements, indication on future and planned investments, information on strategies - projected and implemented, EPS estimates, etc. to external investors. In this paper we contend that a higher level of voluntary disclosure leads to a lower level of underpricing, after having controlled for the mechanisms used for signalling the quality of the IPO. As the evaluation of IPOs is strictly linked with the value that external investors attribute to the perspective of new listed firms, and there is no information about past share price, risk and forward-looking information (FLI) in IPO prospectus play a crucial role in supporting financial analysts in their earnings forecasts. We analyse 85 IPOs issued between 1999 and 2005 on the Italian Stock Exchange by applying content analysis to the IPO prospectuses. The Italian set is very distinctive because, although in presence of low litigation costs, only few firms disclose earnings forecasts and prospective financial information even if law allows their inclusion in the IPO prospectus. We focus on the role played by narrative FLI contained in the IPO prospectus and by its attributes in relation with underpricing. Following previous literature, we study also the relation between underpricing and the extent of risk factors included in the prospectuses. We find a negative association between the level of underpricing and the extent of FLI in the IPO prospectus and a positive association between the level of underpricing and the number of risk factors disclosed.

Regime Shifts in the Stock–Bond Relation in Australia

Previous evidence suggests that the implied volatility from equity index options, as a measure of stock market uncertainty, can provide "forward-looking information" about the stock–bond return correlation. This paper uses an alternative regime-switching autoregressive model to characterize state-dependent stock–bond return comovement and to evaluate the contribution of implied volatility in understanding transition dynamics. We confirm that implied volatility provides information about transition dynamics which is not inherent in the stock and bond returns, notwithstanding several different features of our data set and methodological approach.

Instrument Rules in Monetary Policy under Heterogeneity in Currency Trade

We embed different instrument rules into a New Keynesian model for a small open economy that is augmented with technical trading in currency trade to examine the prerequisites for monetary policy. Specifically, this paper focuses on conditions for a determinate, least-squares learnable rational expectations equilibrium (REE). Under an interest rate rule with only contemporaneous macroeconomic data, the intensity of technical trading or trend-seeking in currency trade does not affect these conditions, except in the case of an extensive use of trend-seeking. On the other hand, if the central bank uses only forwardlooking information in its interest rate rule, a determinate and learnable REE is a less likely outcome when trend-seeking in currency trade becomes more popular. The interest rate rule followed by the central bank in the model incorporates interest rate smoothing.

Does the financial analysts' usage of non-financial information influence the analysts' forecast accuracy? Some evidence from the Belgian sell-side financial analyst

This paper examines whether the use of non-financial information by sell-side financial analysts influences the accuracy of analysts’ forecasts. The research findings, based on a survey of Belgian financial analysts, suggest that financial analysts who use more forward-looking information and more internal-structure information offer more accurate forecasts. Furthermore, the listed Belgian firms examined in this study have improved their non-financial information reporting over time. However, neither the frequency nor the quantity of non-financial information mentioned by financial analysts in their reports appears to have increased over time.

Forward-Looking Disclosure in Italy: An Analysis of Company Announcements

There is a consensus that the disclosure of information with a forward- looking perspective is essential in order to help stakeholders - and especially investors - in forming opinions on corporate performance. Perspectives and forecasts are disclosed through several documents and financial statements, such as IPO prospectuses, annual reports, interim reports and strategic plans.In recent years, Italian researchers have focused their efforts on forward- looking information provided in annual reports and strategic plans. This paper shifts the focus on company announcements, that represent a consolidated research topic in international literature but have been looked at by little research in Italy. They are a very important source of forward-looking information because of their timeliness and because companies have to disclose every kind of price sensitive information through them.The primary purpose of this study is to investigate what kinds of forecast information are disclosed in company announcements. To achieve this objective, announcements issued by a sample of Italian listed companies are analyzed with regard to categories based on the standard format required by the Italian Stock Exchange. A first analysis concerns the kind of announcement which forward- looking information are provided in (e.g. approval of an interim report). Then, forward-looking information provided in announcements are examined with reference to their estimate degree (forecast/objective), the covered topics, the disclosure of quantitative data and of underlying hypotheses.This study represents a preliminary attempt to advance our understanding of forward-looking disclosure with reference to the role of company announcements in corporate communication strategy. It also provides a basis for further research regarding the accuracy and the determinants of forward-looking information.

The output gap and the real interest rate gap in the euro area, 1960–2003

In this paper we aim at identifying the natural real rate of interest, defined here as the (unobservable) component of the real interest rate which has no contemporaneous and lagged correlation with the output gap. We first discuss the theoretical underpinnings and the possible empirical advantages of this measure. Based on this definition and taking a measure of the output gap as given, we then derive an estimate of the natural interest rate for the euro area over a sample period from 1960 to 2003. The corresponding estimate of the natural interest rate measure is found to fluctuate significantly, a finding which appears to be well explained by economic and institutional developments in the euro area over the past 4 decades. Moreover, the resulting estimate of the real rate gap is found to have some forward-looking information content on inflationary pressure in the euro area.

The Effect of Macro Information Environment Change on the Quality of Management Earnings Forecasts

The 1990s were characterized by substantial increases in the performance of and investor reliance on financial analysts. Because managers possess superior private information and issue forecasts to align investors' expectations with their own, we predict that managers increased the quality of their earnings forecasts during the 1990s in order to keep pace with the improved forward-looking information provided by financial analysts, upon which investors increasingly relied. Using a sample of 2,437 management earnings forecasts, we document an increase in management earnings forecast precision, management earnings forecast accuracy, and managers' tendency to explain earnings forecasts in 1993-1996 relative to 1983-1986. Given that these forecast characteristics are linked to greater informativeness and credibility, we also document that the information content of management earnings forecasts, as measured by the strength of share price responses to forecast news, increased in 1993-1996 relative to 1983-1986. As expected, the increased information content of management forecasts primarily occurred for firms covered by financial analysts.

Corporate Web Site Reports

We investigate whether corporations are following the “best disclosure practices” when presenting business reports on their Web sites. As a benchmark, we use the recommendations made by the Jenkins Committee (1994) to improve corporate reporting practices, to evaluate reports presented on corporate Web sites for their value, relevance, and quality of information. We compute a disclosure score using 26 items recommended by the Jenkins Committee and Meek et al. (Meek, Roberts, & Gray, 1995) as indicators of best reporting practices. Our findings reveal that most corporations do not follow “best disclosure practices” when reporting information on their Web sites. Only about half of the 26 disclosure items recommended by the Jenkins Committee are reported, and less than 50% of the sample firms in our study make such disclosure. Some of the items that the Jenkins Committee recommends as essential for improving quality and relevance of reporting such as forward-looking information (e.g., plans, opportunities and risks, forecasts, critical success factors), nonfinancial items (e.g., changes in operating performance, research and development activities), or off-balance sheet financing, are least often reported. The findings suggest that corporations must improve their Web site disclosures for investors to find them valuable, relevant, and useful.

Information Content and Earnings Management Implication of Changes in the Valuation Allowance for Deferred Tax Assets

The valuation allowance for deferred tax assets is an estimate of the portion of deferred tax assets that is not realizable because of insufficient future taxable income. A change in the valuation allowance might contain the manager's private forward-looking information that helps users of financial statements assess the firm's future income. The inclusion of changes in the valuation allowance in income from continuing operations, however, creates opportunities for earnings management because the valuation allowance amount is based primarily on the manager's unverifiable judgment. This study provides evidence of both benefits (incremental information content) and costs (earnings management implication) of disclosing the valuation allowance for deferred tax assets. Changes in the valuation allowance contain incremental information content, in addition to publicly available information, in predicting one- and two-year-ahead income. However, changes in the valuation allowance for firms that likely manage earnings through their valuation allowance accounts are less associated with future income than for non-earnings management firms, implying that managers manipulate the valuation allowance to manage earnings.

Forward-looking information in VAR models and the price puzzle

With a view to addressing the major disadvantage of the VAR model, namely the inadequate description of the central bank reaction function, we propose a VAR specification that proves successful in solving the price puzzle featuring in monetary VARs for the US. This specification consists in augmenting a standard VAR with two forward-looking variables: the federal funds futures rate (or alternatively a money market forward rate) reflecting monetary policy expectations and a composite leading indicator of economic activity. These two variables appear to effectively control for the information set that the Federal Reserve may use in monetary policy decision-making. With this modification, theory-consistent responses to monetary policy shocks are obtained.

The Market Equity Risk Premium

The New Zealand Superannuation Act 2001 requires the Treasury to state each year the required capital contribution of the New Zealand Government to the New Zealand Superannuation Fund. This paper examines a key assumption made in that calculation - the level of expected long-term premium of return on equity market investments over return on long-term government bonds. Over the past seventy-five years, US capital markets have provided an equity risk premium over long-term bonds in the region of 7%. The traditional view has been that these historical results provide an unbiased estimate of the expected future long-term equity risk premium. This view has given way over the past few years to a consensus that the future expected risk premium is actually somewhat lower. This consensus rests on a range of recent empirical evidence and theoretical analysis. It draws on both the historical records of market returns, dividends and reported earnings, and on forward-looking information through surveys of market experts and from the expectations implicit in analysts' earnings forecasts. On the basis of this analysis, we believe that the long-term annual (arithmetic) expected equity risk premium sits in the range of 3% to 5%. For the purpose of calculating the required capital contribution to the New Zealand Superannuation Fund, the Treasury is adopting the assumption of a long-term expected future equity risk premium of 4%.

Decomposing Credit Spreads

This paper investigates the information contained in the yields of corporate debt securities using a structural credit risk model. As previous studies have found, credit risk is not the only factor that affects corporate yield spreads. The aim is to decompose credit spreads, using a structural model of credit risk, into credit and non-credit risk components. The contribution relative to the existing literature is the use of contemporaneous forward-looking information on equity risk premia and equity value uncertainty in a structural model. In particular, implied equity risk premia from a three-stage dividend discount model that incorporates analysts' long-term earnings forecasts are used, together with implied measures of equity value uncertainty from option prices. The paper examines the evolution of the different components of spreads across time as well as the effect of particular events. It also analyses the relationship between the derived components and other financial variables, such as swap spreads and the equity risk premium.

Forward-looking Information and Stock Price Around Earnings Announcement

We create two quantitative measures of forward-looking information disclosed by firms around earnings announcement. The two variables are extracted from revisions in analyst forecasts of future earnings and are orthogonal to earnings surprise. The adjusted R-square of the announcement-period abnormal return regression doubles after including the two variables in addition to earnings surprise. We find that market knows less of bad news about future earnings than good news in days before earnings announcement, and subsequently reacts more strongly to bad news than good news upon the announcement. Furthermore, stock price adjustment to forward-looking information exhibits significant cross-sectional difference among firms.

Information management with specific investments and cost-based transfer prices

We analyse information flows in a profit-centre organisation with internal trade between two risk-neutral divisions. Prior to production, the divisions make unverifiable investments in intrafirm synergies. After investments are made, the selling division announces a cost-based transfer price which includes a mark-up on variable costs. The buying division then decides what quantity to purchase at that unit cost. From the head office's perspective, the key issues are to influence both, divisional investments and the seller's manipulation of the mark-up. To do so, the head office can fund a pre-decision information system before divisional investments are made. The system produces forward-looking information that can be used to improve the divisions' investment decisions, but which cannot be used in evaluating their performance. Our analytical framework allows us to identify cost and revenue structures for which pre-decision information either supports or destroys intrafirm synergies by motivating or discouraging divisional investments, thereby resulting in an increase in, decrease in or in no impact whatsoever on, firm profit. Among our most interesting findings is the counterintuitive result that pre-decision information can undermine the incentives of risk-neutral agents to invest specifically. Our results add to earlier agency models that found different, albeit equally dysfunctional effects of pre-decision information. Contrary to these studies, our findings are not driven by either risk aversion or rent extraction.

Disclosure Regimes and Corporate Decisions around Initial Public Offerings

This paper analyzes the impact of different disclosure regimes on corporate decision-making during initial public offering. Specifically, it examines how disclosure rules affect firms' incentives to acquire forward-looking information, their disclosure practices and investment strategies. The disclosure regimes examined are Non-Disclosure, Voluntary, and Mandatory Disclosure Regimes. The analysis yields a number of insights. It shows that a Non-Disclosure Regime for management forecasts, as what's found in the US, can impair firms' ability to reduce information asymmetry through disclosure. By depriving firms of the opportunity to convey private information to investors, such a policy results in undervaluation of firms with profitable prospects and overvaluation of firms with poor growth potentials. Misvaluation also alters the conditions under which firms make their investment decisions. In particular, investors' overvaluation can give firms incentives to invest in negative NPV projects. Furthermore, a non-disclosure rule reduces equity-issuing firms' incentives to acquire valuable productive information. However, the other two disclosure regimes also have their own distortions. Both overinvestment and underinvestment can occur under the Voluntary Disclosure Regime. In addition, with the discretion to disclose, firms tend to excessively acquire information so that they can strategically use it in the later offerings. The Mandatory Disclosure Regime has the highest price efficiency, but it also imposes burden on firms to produce information to meet the disclosure requirement. Finally, a welfare analysis shows that each of the three disclosure regimes can emerge as the socially optimal regime under some conditions.

The Securities Litigation Reform and its Impact on Analyst Research

We examine the effect of the Private Securities Litigation Reform Act of 1995 and the Securities Litigation Uniform Standards Act of 1998 on analyst recommendations. We refer to these acts as the Reform, which addresses the safe harbor provision for forward-looking information. After controlling for other variables, we find higher short-term market reaction following recommendation revisions after the Reform, suggesting that analysts play an increasingly important role. We also find that following upgrades (downgrades), the long-term drifts increase (decrease) in magnitude, and price reversions are less (more) likely.

The Role of Analysts? Forecasts in Accounting-Based Valuation: A Critical Evaluation

This paper critically evaluates the use of analysts’ forecasts in accounting-based valuation. Specifically, I assess the usefulness and the limitation of analysts’ forecasts in predicting future earnings and in explaining the market-to-book ratio, in light of a comprehensive set of 22 explicit information items, including: economic rent proxies, conservative accounting proxies, earnings quality signals, transitory earnings proxies, industry characteristics, and risk and growth proxies. While analysts’ forecasts capture 45–83% of the information from these sources depending on model specifications, they do not appear to fully incorporate certain information items. In particular, proxies for conservative accounting and transitory earnings are incrementally useful in predicting future earnings; proxies for economic rents, conservative accounting, and risk are incrementally useful in explaining the market-to-book ratio. Collectively, these results validate the use of analysts’ forecasts as a parsimonious proxy for forward-looking information in accounting-based valuation and suggest how to improve on their use.

The Role of Analysts' Forecasts in Accounting-based Valuation: A Critical Evaluation

This paper critically evaluates the use of analysts' forecasts in accounting-based valuation. Specifically, I assess the usefulness and the limitation of analysts' forecasts in predicting future earnings and in explaining the market-to-book ratio, in light of a comprehensive set of twenty two explicit information items, including: economic rent proxies, conservative accounting proxies, earnings quality signals, transitory earnings proxies, industry characteristics, and risk and growth proxies. While analysts' forecasts capture 45-83% of the information from these sources depending on model specifications, they do not appear to fully incorporate certain information items. In particular, proxies for conservative accounting and transitory earnings are incrementally useful in predicting future earnings; proxies for economic rents, conservative accounting, and risk are incrementally useful in explaining the market-to-book ratio. Collectively, these results validate the use of analysts' forecasts as a parsimonious proxy for forward-looking information in accounting-based valuation and suggest how to improve on their use.