The Effect of Firms' Financial Disclosure Strategies on Stock Prices.

Abstract Financial reporting has been the subject of serious criticism in recent years. Managers argue that the inundation of new accounting standards are burdensome because they impose new reporting requirements but do not help them communicate effectively with outside investors.¹ For example, current accounting rules do not permit managers to show the benefits of investments in quality improvements, human resource development programs, research and development, and customer service on their balance sheets in a timely fashion. Some argue that these omissions create pressures for managers to smooth reported earnings, or to avoid pursuing strategies with long-term payoffs that reduce short-term earnings.² These concerns have even led some critics of accounting, including a recent presidential candidate, to advocate the abolition of quarterly reporting as one way to improve the global competitiveness of US corporations. Current empirical research is of little help to managers in addressing the above challenges. Most of the research assumes that equity markets are efficient, and concludes that investors "see through" the limitations of accounting. Empirical studies have focused on the role of debt and compensation contracts, as well as political considerations on managers' accounting decisions.³ But there has been only a modest amount of empirical research on how capital markets influence accounting decisions. However, recent theoretical studies in accounting have begun to address accounting and disclosure decisions from a capital market perspective. This research, which draws on "information models" in economics and finance, assumes that managers have superior information on their firms' current and future performance than outside investors. Disclosure strategies then provide a potentially important means for corporate managers to impart their knowledge to outside investors, even if capital markets are efficient. In this paper, we summarize the key ideas of the accounting information models in a form that is accessible to corporate managers, accounting educators, and empirical researchers. Implications of these ideas for corporate disclosure management, as well as for teaching and research in the area of financial statement analysis are discussed.