Unintended Consequences of Lowering Disclosure Thresholds

Abstract

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. Data Availability: Contact the authors.

Mitigating the Dilution Effect in Auditors' Judgments Using a Frequency Response Mode

“…In prior auditing research on the dilution effect, researchers required their participants to make probabilistic judgments about fraud (Hackenbrack 1992;Hoffman and Patton 1997;Wood 2012; Lambert and Peytcheva 2017), risk disclosure thresholds (Fanning et al 2015), goingconcern (Shelton 1999;Lambert and Peytcheva 2017), and to assess the risk of material misstatements in accounts receivable (Glover 1997;Waller and Zimbelman 2003). KME show 5 See Igou (2007) and Kemmelmeier (2007a, b) for an exchange on which approach has the most empirical support.…”

“…Hoffman and Patton (1997) proposed several steps to mitigate the dilution effect, such as making auditors aware of the issue and developing decision aids. Lastly, Fanning et al (2015) found that directional goals can ameliorate the dilution effect when investors are presented with post-decisional information in the context of litigation risk assessments. In the current study, we propose an alternative approach (i.e., use of a frequency response mode) to mitigate the dilution effect in auditors' fraud risk judgments.…”

“…Some of this evidence may be diagnostic (relevant) to the judgment task while some of it may be non-diagnostic (or irrelevant). 1 Numerous studies in psychology and auditing have demonstrated that people's probability judgments are systematically influenced by irrelevant or non-diagnostic evidence (e.g., Fanning, Agoglia, and Piercey 2015;Glover 1997;Hackenbrack 1992; Hoffman and Patton 1997;Nisbett, Zukier, and Lemley 1981;Shanteau 1975;Zukier 1982). The basic findings of this research indicate that the presence of non-diagnostic evidence leads to a dilution effect; that is, individuals make less extreme (more regressive) judgments than those in the presence of diagnostic evidence only.…”

“…2 The dilution effect has also been shown to occur in a legal context (Smith, Stasson, andHawkes 1998/1999) and in consumer behavior (Meyvis and Janiszewski 2002). Other accounting studies that have examined the dilution effect include Reneau and Blanthorne (2001), Waller and Zimbelman (2003), Seow (2009), Wood (2012), and Fanning et al (2015). Waller and Zimbelman (2003) provide a review of the dilution literature in accounting.…”

“…The non-zero difference between outcome judgments based on each group of cues indicates dilution. This contrasts with an alternative approach to testing dilution where diagnostic (relevant) and non-diagnostic (irrelevant) cue are combined into bundles and dilution is then measured by examining the averaging effect of such cue bundles on outcome judgments (e.g., Fanning et al 2015;Lambert and Peytcheva 2017). 4 We conduct two experiments to test one hypothesis and investigate a research question related to the mitigation of the dilution effect in fraud risk assessments.…”