Supplemental Disclosures Research Articles

The Impact of Disclosure and Auditing on the Reliability of Fair Value Estimates in the Real Estate Industry

Despite the importance of measurement-related disclosures in a principles-based accounting framework, it is unknown whether those disclosures influence the reliability of the measurement method chosen itself. We build on previous literature by investigating whether supplementary disclosures improve the reliability of the fair value method itself. Within the fair value context of investment property in the real estate industry, we find that model fair value, which demands extensive judgment and estimation on the underlying assumptions, must be supplemented by disclosures to gain reliability. However, if the measurement process is based on external information, i.e. for market fair value and comparables, supplementary disclosures do not have any effect. Overall, results are important for the standard setting process as they show that in a principles-based accounting framework without extensive disclosure guidelines capital market participants perceive judgment-based disclosures as useful.

Financial Statement Presentation and Nonprofessional Investors’ Interpretation of Fair Value Information

Fair value estimates reported in the financial statements differ in the subjectivity with which the estimates are measured. Mandated supplemental disclosures are intended to enable users to assess the nature of the inputs used to develop the fair value measurements, including their relative reliability, although prior research suggests some investors may have difficulty doing so. We draw on information processing research to predict and find that isolating fair value information in a separate column on the face of the income statement facilitates nonprofessional investors’ ability to incorporate into their perceived reliability and P/E judgments not only the fair value estimates, but also the disclosed measurement differences that underlie those estimates. Our results have implications for standard setters and researchers concerned with the effects of financial statement presentation on nonprofessional investors. Namely, we demonstrate how income statement presentation can improve reliance on mandated supplemental disclosures, thereby resulting in greater financial statement transparency.

Do Voluntary Disclosures that Disavow the Reliability of Mandated Fair Value Information Reflect Legitimate Concerns About Reliability?

One consequence of the shift to fair value measurement is the emergence of voluntary disclosures in audited financial statements that question the reliability of mandated fair value information. We refer to these disclosures as reliability disavowals and address three questions: Are fair value estimates less reliable for firms that disavow? Do managers of disavowal firms have reason to believe that they cannot reliably estimate the disavowed fair values? Are factors indicative of reliability problems associated with the decision to disavow? We address these questions in the context of managers’ stock option compensation estimates disclosed under SFAS 123. Our results suggest reliability disavowals reflect legitimate reliability concerns, consistent with managers believing that supplemental disclosures about fair value estimates provide useful information about the limitations of the estimates, which is the FASB’s position in SFAS 157.

Can Supplementary Disclosures Eliminate Post-Earnings-Announcement Drift? The Case of Management Earnings Guidance

We investigate whether earnings guidance can reduce or eliminate post-earnings-announcement drift. We find that firms that provide earnings guidance simultaneously with their earnings announcements experience significantly less drift than other firms, consistent with our expectations. Furthermore, the reduction in drift is strongly related to current and prior guidance accuracy. Drift is eliminated for firms that provide accurate prior (or current) guidance, but is significant for low-guidance-accuracy firms. Finally, we find post-guidance-announcement drift for stand-alone earnings guidance, but not for guidance that is provided simultaneously with earnings. Our results suggest that simultaneous earnings and guidance announcements enhance analysts' and investors' ability to extract useful information about future earnings from both earnings and guidance announcements. More importantly, our results indicate that investors can use past guidance accuracy to identify firms whose post-earnings-announcement drift is unaffected, or eliminated, by the issuance of management earnings guidance.

Financial Reporting and Supplemental Voluntary Disclosures

ABSTRACTA standard result in the voluntary disclosure literature is that when the manager's private information is a signal correlated with the firm's liquidation value, mandatory disclosures substitute for voluntary disclosures. In this paper, we assume that the manager's private information complements the mandatory disclosure and show that the content and likelihood of a voluntary disclosure depend on whether the mandatory reports contain good or bad news. This different information asymmetry produces new, testable implications regarding the probability of and market reaction to voluntary disclosures. We also show that changes in mandatory disclosure regulations can have unintended consequences due to their effects on the manager's willingness to voluntarily provide supplemental disclosures.

Market risks and oilfield ownership—Refining oil and gas disclosures

Market risk exposures of balance sheet asset values are becoming an increasingly important accounting issue. In oil and gas, oilfield exposures to oil prices are specific and contractual, presenting a contingency problem for investors, financial analysts, standard setting bodies and government agencies. Our paper uses an extensive sample of 292 oilfields to provide evidence that the US Securities and Exchange Commission (SEC) supplementary disclosures do not capture the price sensitivities of oil and gas disclosures implicit in the two main forms of oilfield ownership, concession and production sharing contracts (PSCs). Current asset disclosures neither distinguish between global variations in oilfield ownership terms, nor on market risk implications for the value of oilfield assets. Importantly, we show that unlike concessions, reserve and production disclosures vary in response to oil price movements for PSC regimes. Our results highlight the need to differentiate PSC disclosures from concession fields, and to fully reflect price risks implicit in oilfield ownership contracts. We extend findings by Rajgopal [1999. Early evidence on the informativeness of the SEC's market risk disclosures: the case of commodity price risk exposure of oil and gas producers. The Accounting Review 74, 251–280] and propose refinements to capture market risk in financial reporting.

The Use of Derivatives in Italian SMEs: How to Avoid New Mistakes

This article explores the recent diffusion of derivatives in Italian SMEs. It focuses on the main causes of a number of critical situations and on some guidelines to possible resolutions. It also analyses the scope and limits set by recent legislation on derivatives in the balance sheet and on financial risk disclosure, with particular regard to the emerging role of supplementary disclosure.

Equity accounting adoption in regulated and unregulated settings: an empirical study

This article examines equity accounting adoption by Australian companies before and after standard AAS 14 (1984), the first standard on equity accounting in Australia. To bypass a legal constraint, AAS 14 and its successor ASRB 1016 (1989) required that equity accounting of associates appear in supplementary disclosures (third‐column or footnote) and not in consolidated accounts. Before AAS 14, extensive voluntary adoption of equity accounting occurred in consolidated accounts. Equity accounting adopters from 1971 to 1989 were matched in their adoption years with companies that could have used equity accounting but did not. Throughout, equity accounting adopters’ EPS tended to be declining and equity accounting adoption tended to increase reported earnings. After AAS 14, adopters showed equity accounting via a third column if it increased reported earnings but in footnote disclosures if it reduced reported earnings. Leverage is associated with adoption before but not after AAS 14, perhaps because the standards required equity accounting in supplementary disclosures which had no impact on borrowing constraints, while no such restriction on equity accounting existed before regulation. Pre‐AAS14 adopters tended not to be audited by large audit firms. Adopters after AAS 14 had higher ratios of investments in associates to total tangible assets; before AAS 14 they did not. The results are consistent with equity accounting being adopted opportunistically; there is limited evidence to support contractual efficiency motives.

FAS 133: What Is Accounting Truth?

FAS 133, the rule that governs accounting for derivatives, has been controversial since its inception. Besides being expensive to implement and maintain, the rules often cause accounting treatment to diverge markedly from economic reality, making financial statements less transparent and less useful. For example, by marking to market only one side of what are in fact two-sided (hedged) positions, FAS 133 often introduces artificial volatility into earnings and, in so doing, discourages companies from hedging. How should companies tackle financial disclosure and balance the economic and accounting effects of hedging? This article recommends that companies make economically sensible hedging decisions and then present two sets of earnings numbers to the investment community: (1) the first prepared and audited in strict accordance with GAAP; and (2) a supplemental calculation showing what earnings would have been had the firm qualified for hedge accounting treatment. This kind of supplemental disclosure should be viewed by companies as an opportunity to explain to their investors, creditors, and counterparties how they conceptualize, measure, and manage risk.

Beyond Financial Reporting An Integrated Approach to Disclosure

A company's market value is a key determinant of its future success, affecting its ability to raise capital, recruit and retain key employees, and make strategic acquisitions. Confident, well‐informed investors are necessary for achieving and maintaining accurate valuation of a company's stock. But standard disclosure practice has left many companies releasing a great deal of data while conveying only limited understanding to outsiders.This article presents the outline of an integrated approach to corporate disclosure in which each of the three major elements–required financial reports, supplemental disclosure, and interactions with investors and intermediaries–are consistent and mutually reinforcing. Such an approach begins with required reports that refiect as closely as possible the economic reality of a company's business. But if GAAP income statements and balance sheets are often useful for communicating current and past performance, they are not designed to convey management's strategic vision and the company's prospects for creating value. To achieve and maintain accurate valuation, management must supplement mandated financial reporting with voluntary communication that highlights value drivers and helps investors understand both the company's strategic goals and management's progress in meeting those goals. Finally, management must interact with investors and capital market intermediaries in ways that provide them with a clear and compelling picture of the company's prospects, which should help both analysts and institutional investors become more effective monitors of the firm's performance.Through consistent communication that goes well beyond the sell side's focus on quarterly earnings per share, management will discover that it has the power to set the agenda for how the company's performance is evaluated by the market. In the process, companies are also likely to find that their investors (and analysts) are more patient than they thought, while their operating managers feel less pressure to take shortsighted steps to boost EPS. Both of these expected benefits of an integrated disclosure policy should end up increasing a company's value.

The Role of Supplementary Statements with Management Earnings Forecasts

ABSTRACTWe investigate managers' decisions to supplement their firms' management earnings forecasts. We classify these supplementary disclosures as qualitative “soft talk” disclosures or verifiable forward‐looking statements. We find that managers provide soft talk disclosures with similar frequency for good and bad news forecasts but are more likely to supplement good news forecasts with verifiable forward‐looking statements. We examine the market response to these forecasts and find that bad news earnings forecasts are always informative but that good news forecasts are informative only when supplemented by verifiable forward‐looking statements, supporting our argument that these statements bolster the credibility of good news forecasts.

Intangible Assets and Firms' Disclosures: An Empirical Investigation

This study examines how research and development (R&38;D) and advertising expenditures affect firms' disclosures. Generally accepted accounting principles (GAAP) mandate that these expenditures be immediately expensed in financial reports, despite the fact that they often benefit the firm for longer periods. Prior studies find, however, that investors consider intangible assets in their valuation of firms. These studies argue that current GAAP, by not recognizing the value generated by these assets, severely impairs the usefulness of accounting reports. I investigate if firms with higher levels of R&38;D and advertising expenditures place greater reliance on voluntary, and therefore more flexible, disclosures such as voluntary publications and investor relations. Using analysts' ratings of firms' disclosures, I find that firms with higher levels of intangible assets are more likely to receive significantly higher ratings for their investor relations programs or voluntary publications than for their annual reports. These findings suggest that firms with higher levels of intangible assets emphasize supplemental disclosures because mandated accounting disclosures inadequately present their financial performance. These results have important policy implications for regulators and investors since they indicate that voluntary disclosures, which are unregulated and unaudited, are an important means of disclosure for these firms.

Market Efficiency, Bounded Rationality, and Supplemental Business Reporting Disclosures

The AICPA Special Committee on Financial Reporting has urged disclosure of relevant forward‐looking information on risks and opportunities to supplement conventional financial statements. We conduct a laboratory market experiment to assess the effects of such disclosures on capital allocation decisions. We develop two sets of competing hypotheses regarding how capital markets react to supplemental disclosures. One set is based on the assumption of semi‐strong market efficiency, while the other posits that the bounded rationality of individual traders leads to inefficient market prices. We find that explicit disclosure of management’s best estimate of an uncertain quantity improves market efficiency, even though this disclosure is redundant with information in financial statements. Second, we find disclosure of an upper bound of management’s estimate has the potential to bias security prices upward, while informationally equivalent disclosure of both upper and lower bounds removes this bias. These results suggest that experimental market reactions to these supplemental disclosures are inconsistent with market efficiency. Supplemental analyses of individuals’ price predictions and trading behavior support our conclusion that inefficiencies are at least partially attributable to individual information processing biases.

The Role of Supplementary Statements with Management Earnings Forecasts

We investigate managers' decisions to supplement their firms' management earnings forecasts. We classify these supplementary disclosures as either qualitative soft talk disclosures or verifiable forward-looking statements. We find that managers provide soft talk disclosures with similar frequency for good and bad news forecasts, but are more likely to supplement good news forecasts with verifiable forward-looking statements. We examine the market response to these forecasts and find that bad news earnings forecasts are always informative but that good news forecasts are informative only when supplemented by verifiable forward-looking statements, suggesting that these statements bolster the credibility of good news forecasts.

Evaluating the exploration efficiency of oil and gas firms using SFAS 69 supplemental disclosures

Investors and other users of financial statements often analyze financial statement information to evaluate the exploration efficiency of oil and gas firms. One approach commonly employed is to calculate an average per-unit cost of finding and developing oil and gas reserves using data disclosed by oil and gas firms in the footnotes to their financial statements. These average finding costs ratios, while widely used, are by no means universally accepted as providing meaningful insight into the exploration efficiency and potential profitability of an oil and gas firm. In fact, a number of financial analysts who specialize in oil and gas firms have argued that these finding costs ratios in fact provide no useful insights into how well a company has done. The purpose of our paper is to evaluate the usefulness of these finding costs measures as indicators of exploration efficiency and potential profitability. Our approach involves comparing the statistical association between various finding costs measures to a benchmark measure of exploration efficiency derived from a Cobb-Douglas regression. We also compare these finding costs measures to two commonly used financial statement measures of profitability—return on sales and return on assets—to evaluate whether finding costs are useful as indicators of profitability. Our results indicate that finding costs ratios calculated from readily available financial statement data provide useful insight into both exploration efficiency and the potential profitability of an oil and gas firm. Our findings are important because they provide empirical evidence useful in resolving a debate within the financial analyst community concerning the utility of these finding costs ratios.

Intangible Assets and Equity Valuation in the Pre-SEC Era

Some have recently called for expanded reporting of intangible asset values asserting that their limited recognition under U.S. GAAP has eroded the usefulness of financial statements. In response to this interest, accounting researchers have sought to provide empirical evidence on the role of intangibles in equity valuation. Aboody and Lev [1998] document that the software development cost assets which some firms elect to capitalize under SFAS 86 are positively related to share prices. Extending this research to other intangibles is difficult since U.S. GAAP takes a conservative view towards recognition of such assets. Consequently, other studies have examined off-balance sheet measures of intangible asset values (see Lev and Sougiannis [1996], Barth, et al. [1998], and Ittner and Larcker [1998]) or data from other countries where firms face less restrictive reporting rules (see Barth and Clinch [1998]). We contribute to this literature by investigating the role of intangibles in equity valuation under a reporting regime where managers are allowed virtually unrestricted discretion to capitalize intangible assets. Our sample consists of firms with common equity traded on the New York Stock Exchange (NYSE) in the 1920's. These firms operated in a reporting environment which permitted managers broad discretion to initially capitalize intangibles, determine subsequent amortization and revaluation policies, and structure supplementary disclosures (if any). Consequently, pre-SEC industrials firms reported a broad range of intangibles with material carrying amounts on their balance sheets. We investigate the value-relevance of intangible assets using valuation models where intangibles play two possible roles in equity valuation. The first is a direct role where intangibles can map positively into share price and the second is an interactive role where the level of intangibles conditions investor evaluation of reported earnings. If investors perceive capitalized intangibles to be legitimate assets, their carrying values will be positively related to share price. Alternatively, if investors view the capitalization of intangibles as a means for managers to overstate reported earnings, then the coefficient mapping earnings into price will decline as the level of capitalized intangibles increases. The results from our primary tests indicate no significant positive relation between capitalized intangibles and share prices. We do find evidence that the coefficient relating earnings to share price decreases with the level of capitalized intangibles, consistent with a perception by investors that managers may overstate earnings by capitalizing intangibles. We also document that separate reporting for intangible assets strengthens the relation between price and summary balance sheet measures. Book value is not significantly related to share price but the coefficient mapping tangible book value into share price is positive and highly significant when intangibles are disaggregated from book value. Finally, earnings are a highly significant determinant of equity price suggesting that, at least for our sample, investors may identify the existence of economically relevant intangibles on the basis of reported earnings rather than carrying values for intangibles reported in the balance sheet.

Options Reporting and the Political Costs of CEO Pay

Managers' systematic influence on accounting policy is well documented in the earnings management literature. Recent studies in the “management of information” line of research suggest that such influence is exhibited in financial reporting more generally, including supplemental disclosures in proxy statements. Using 1996 compensation data, I extend recent research on how firms report the value of options paid to their CEOs. I conduct several tests of the argument that potential political costs of unexplained compensation explain cross-sectional variation in how aggressively firms report option awards. Even after incorporating several variables not considered previously, I find strong support for the assertion that firms whose CEOs receive unexplained pay relative to performance tend to report lower grant date values for their CEOs' option awards. The evidence also suggests that the tendency to report lower grant date values is stronger for firms under more scrutiny from institutional owners. Contrary to previous research, I find that unexplained pay also increases the likelihood that the firm will choose grant date reporting methods (over the allowable alternative) in their proxy disclosures. I interpret the overall results as consistent with the argument that political costs related to compensation influence options reporting. The findings have implications for accounting standard-setters and for researchers who rely on estimates of option values reported in proxy statements.

An Experimental Investigation of Forward-Looking Non-Financial Performance Disclosures

The AICPA's Special Committee on Financial Reporting has urged disclosure of relevant forward-looking and non-financial information to supplement conventional financial statements. We conduct an experiment consisting of 20 laboratory security markets with eight participants each to assess the effects of such disclosures on capital allocation decisions. We observe four markets in each of five accounting information conditions: a baseline condition with an income statement and balance sheet only and four conditions that combine this baseline with supplemental disclosures of proved reserves (a best estimate), total reserves (an upper bound), and minimum reserves (a lower bound). We find first that proved reserve disclosures improve capital allocation decisions, even though these disclosures are redundant with information in the primary financial statements. Second, disclosures of the upper bound (total reserves) in the absence of lower bound (minimum reserves) has the potential to bias security prices upwards, while disclosures of both total and minimum reserves remove this bias. Third, a comparison of individual price predictions to actual market prices reveals both a systematic prediction error and a differential effect of supplemental disclosures on security prices, suggesting that experimental investigations of capital allocation decisions should include market settings. The paper concludes with a discussion of implications for accounting standard setters.

The compatibility of multicurrency accounting with functional currency accounting

In today's high-tech and global economy, this study introduces multicurrency accounting as an effective tool to manage resources and compares its reporting capabilities with current generally accepted accounting principles. Further, it proposes a means to integrate multicurrency accounting into internal reporting and external reporting as supplemental disclosures. Multicurrency accounting has the merit of reflecting the true exposure position of each hard currency, in addition to the dollar-based consolidated financial statement. It lends itself readily to mark-to-market accounting; its application for external reporting is foreseeable in the near future.

Relative versus Incremental Information Content*

Abstract. This study distinguishes between incremental and relative information content. Incremental comparisons ask whether one accounting measure provides information content beyond that provided by another, and apply when one measure is viewed as given and an assessment is desired regarding the incremental contribution of another (e.g., a supplemental disclosure). Relative comparisons ask which measure has greater information content, and apply when making mutually exclusive choices among alternatives, or when rankings by information content are desired (e.g., when comparing alternative disclosures). Questions of both incremental and relative information content arise frequently in accounting. However, few previous studies have examined questions of relative information content. Possible explanations include unfamiliarity with the relative versus incremental distinction, and the additional statistical complexity involved in testing for relative information content.First, we examine analytically the relation between incremental and relative information content, demonstrating that they address different research questions and require different tests for statistical significance. Second, we identify accounting research contexts in which questions of relative and incremental information content arise. Third, we propose a new regression‐based test for relative information content. This test applies to both returns and valuation studies, generalizes to any number of predictor variables, and can be used in conjunction with White's (1980) adjustment for heteroskedasticity. Fourth, we illustrate tests for relative and incremental information content in a familiar research setting that compares the information contents of net income, cash flows, and net sales in 40 industries.Résumé. Les auteurs établissent la distinction entre le contenu marginal et relatif en information. Les comparaisons du contenu marginal visent à déterminer si une mesure comptable livre un contenu en information supérieur à celui d'une autre, et elles s'appliquent dans les cas où une mesure est considérée comme étant donnée et où l'on souhaite évaluer la contribution marginale d'une autre mesure (par exemple, la présentation de renseignements complémentaires). Les comparaisons du contenu relatif visent à déterminer quelle mesure livre un contenu en information supérieur, et elles s'appliquent dans les cas où les choix entre différentes possibilités sont mutuellement exclusifs ou lorsqu'il s'agit d'établir des classifications selon le contenu en information (par exemple, dans la comparaison de différentes possibilités en ce qui a trait à la présentation d'information). La question du contenu marginal aussi bien que du contenu relatif en information se pose fréquemment en comptabilité. Dans les études réalisées jusqu'à maintenant, l'on s'est peu intéressé aux questions touchant le contenu relatif en information. Cette lacune pourrait s'expliquer, entre autres, par le caractère inusité de la distinction entre contenu relatif et contenu marginal en information et par la complexité statistique accrue que supposent des tests portant sur le contenu relatif en information.Selon un schéma analytique, les auteurs examinent en premier lieu la relation entre le contenu marginal et le contenu relatif en information, en démontrant que les mesures correspondantes se rapportent à des questions de recherche différentes et qu'elles exigent des tests de signification statistique différents. Ils déterminent en deuxième lieu quels sont les contextes de recherche comptable dans lesquels se posent les questions pertinentes au contenu relatif et marginal en information. Ils proposent, en troisième lieu, un test inédit fondé sur la régression et s'appliquant au contenu relatif en information. Ce test convient à la fois aux études de rendement et aux études d'évaluation, peut être généralisé à n'importe quel nombre de variables prédictives et peut être utilisé en association avec l'ajustement de White (1980) relatif à l'hétéroscédasticité. Ils illustrent, en quatrième lieu, l'application de tests du contenu relatif et marginal en information dans un contexte de recherche familier où le contenu informationnel du bénéfice net, des flux de trésorerie et du chiffre d'affaires net est comparé dans 40 entreprises.