We present new theory and experimental findings indicating that investors ascribe value to firms that use higher financial reporting quality (FRQ), controlling for the influence of higher FRQ on their estimates of these firms' fundamental value. To guide our investigation, we draw on the cooperation literature in accounting, finance, and psychology. We identify expanded audit reports, particularly auditor commentary, as a mechanism that credibly communicates whether a firm uses higher FRQ. Auditor commentary increases investors' willingness to pay (WTP) more for shares of a firm using higher FRQ than a competing firm using lower FRQ. We also provide process evidence that investors perceive higher FRQ as cooperative behavior by measuring their affective responses and cognitive beliefs, which mediate the influence of audit commentary on investors' increased WTP for higher FRQ. A second experiment bolsters the link between investors' affective and cognitive responses to a firm's FRQ and perceived cooperative behavior.
In recent years, regulators have considered several initiatives to lower the threshold for disclosing risks to investors. We examine two ways in which disclosing more risks can actually lower investors' perceptions of risk. Utilizing an experiment, we find evidence of two unintended consequences on different types of investors. First, we demonstrate that the addition of low-probability risks to a disclosure can dilute (rather than add to) more probable losses, leading certain investors to lower their perceptions of overall risk. Second, since lowering the threshold changes the overall composition of the disclosure by adding low-probability losses, firms could adopt a tactic of minimization that characterizes the entire disclosure as unimportant, presenting the lowest risks most saliently, using compliance with the low threshold as a plausible reason for giving a lengthy disclosure of generally unimportant risks. Our findings suggest that such a tactic can be persuasive.
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SYNOPSIS: In the Financial Accounting Standards Board’s (FASB) project, “Disclosure of Certain Loss Contingencies,” a central issue underlying the debate is whether existing implementation of FASB Accounting Standards Codification Topic 450-20 (previously Statement of Financial Accounting Standards No. 5) provides sufficient and timely information to financial statement users. The Exposure Draft explains that constituents’ assertions of inadequate disclosures are the primary motive underlying the FASB’s re-examination of this issue (see, for example, page v of the Exposure Draft). However, little actual data are available to indicate the extent of the alleged problem. This manuscript presents the results of a study undertaken to provide such data.
For a sample of litigation-related losses, we find a surprisingly large incidence of non-disclosure of contingent losses that cannot be readily explained. Moreover, even where there is disclosure, we find many cases where firms do not provide estimates of expected losses, presumably under the permitted exception for cases where firms claim to be unable to estimate the magnitude of expected losses. On the other hand, we find relatively frequent disclosure of the items called for in the Exposure Draft, consistent with the conjecture that at least some of these items are being demanded by users.
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