In a comprehensive and detailed working paper 'The complementary roles of audited financial reporting and voluntary disclosure: A test of the confirmation hypothesis' the authors prove the validity of their hypothesis that audited financial reporting and voluntary disclosure complement each other and provide the best possible information for managers, investors and regulators.
Lakshmanan Shivakumar, Professor of Accounting at London Business School, along with Ray Ball (Sidney Davidson Professor of Accounting at The University of Chicago Booth School of Business) and Sudarshan Jayaraman (Assistant Professor of Accounting at Olin Business School of Washington University in St. Louis) reached this conclusion by carefully testing their hypothesis that reporting audited, backward-looking outcomes enhances the precision and credibility of managers’ disclosure of private forward-looking information.
Using management earnings forecasts as the voluntary disclosure variable, they found that those firms committing to higher audit fees, which are a measure of the extent of financial statement verification and thus the accuracy and freedom from manipulation of reported outcomes, tend to provide more frequent and more specific management forecasts. They also were able to show that this relationship is not driven by litigation risk.
They used management forecasts as an important and informative voluntary disclosure variable (examining the number, specificity and horizon of forecasts) and measured the commitment to an audit level by expenditures on audit fees. The audit fee data they used are from Audit Analytics; management forecasts examined were forecasts of earnings per share from First Call. The stock market data were from CRSP, and financial statement data from Compustat. The sample they used included the years 2000 to 2007 and consisted of 51,284 firm-year observations. Their tests of the market reaction to management forecasts were based on a sample of 27,088 firm-year observations starting in 2001. As part of their inquiry, they measured the stock return and volume reactions to management forecasts.
They subjected this wealth of data to a series of regression analyses that verified their belief that (1) managers with more forward-looking private information to disclose commit to higher levels of audit verification of actual outcomes and (2) commitment to higher levels of audit verification is associated with larger investor response to managers’ disclosures.
When it comes to management earnings forecasts, since the timing of both earnings forecasts and earnings announcements is known, the authors were able to control for the forecast horizon and thus measure how informative the forecasts were by comparing them with either actual earnings outcomes or consensus analyst forecasts and by estimating the market reaction to the forecast announcements. They determined that an important economic role of financial reporting is backward looking, in the sense of accurate and independent verification of actual outcomes, as distinct from the provision of new forward-looking information. They also were able to demonstrate that a commitment to an independent audit of financial outcomes was a way for managers to show that they truthfully disclosed private information.
Prior research had reported that forecasts are associated with favourable market reactions, reduced information asymmetry and lower litigation risk; but the authors found that a possible explanation for these positive outcomes was that firms can credibly commit to informative and truthful management forecasts by requiring enhanced auditor authentication of financial statement outcomes, thereby mitigating the problem that private information disclosure tends to be untruthful and hence uninformative. They also show that voluntary disclosure is associated with an additional cost — the cost of establishing credibility via enhanced financial statement verification.
Voluntary disclosure is expected to be particularly relevant to stock market investors. Hence, if additional verification of financial statements is intended to improve the reliability of voluntary disclosures, one should observe a greater stock market reaction to voluntary disclosures that are associated with greater financial statement verification levels. The resources firms commit to financial statement verification by independent auditors are an increasing function of the extent of their management forecasting activity, and the specificity of forecasts and the market reaction to them increases the resources committed to audit.
These results imply that firms commit to greater auditor financial statement authentication when their managers make more frequent and more informative voluntary forecasts and that investors then perceive the forecasts to be more credible. Thus, financial statement verification enhances the information value of management forecasts. In other words, the signals are complements, not substitutes.
Lakshmanan Shivakumar (firstname.lastname@example.org) is Professor of Accounting and Chair of Accounting Faculty at London Business School.