Relationship between Voluntary Disclosures and the Economic Cycle : Empirical Research Findings

By Cox, Raymond A. K.; Dayanandan, Ajit et al. | Journal of Financial Management & Analysis, January-June 2015 | Go to article overview

Relationship between Voluntary Disclosures and the Economic Cycle : Empirical Research Findings


Cox, Raymond A. K., Dayanandan, Ajit, Donker, Han, Journal of Financial Management & Analysis


Introduction

Management is assigned to operate the corporation efficiently and effectively and to report the results with financial statements to its owners in a timely manner. Sometimes the profit performance falls short of expectations producing an earnings surprise. Leading up to this earnings announcement the firm may be aware of this looming outcome and for various reasons choose to issue a profit warning. The action by managers to disseminate such a cautionary note follows the old English proverb "If you can't be good, be careful".

Given this new piece of information the capital markets will react and the stock price will adjust. How and when the stock price will adapt to the news is of interest to both the company and investors. This paper studies the announcement effect and any subsequent underreaction or overreaction as well as information leakage prior to the profit warning release. Further exploration is conducted to detect any association between the degree of stock impact and the stage of the business cycle and the firm characteristics. That is, it is hypothesized stockholders' behavior to profit warnings is connected to economic conditions and firm specific attributes.

Prelude

Jackson and Madura1 found profit warnings associated with negative abnormal returns during the announcement window, not significantly correlated with the length of advanced notice to earnings announcement, evidence of information leakage, no overreaction correction in the post warning period, and a greater abnormal return on smaller versus large firms. The negative stock return impact is further supported by Bulkley and Herrerías2, and Xu3. Church and Donker4 showed that greater transparency in news disclosure of profit warnings dampens the negative market response even though Tucker5 reported that firms with a large amount of bad news (not necessarily profit warnings) are worse off in the short-term for having warned than for being silent.

The rationale for issuing profit warnings rather than wait until the earnings announcement to realize an earnings surprise has been researched. Skinner showed that managers behave as if they face an asymmetric loss function when choosing to disclose bad news. One reason given for this conduct is litigation risk, bolstered by data from Soffer, et al6, Baginski, et al7, and Field, et al8 but not from Francis, et al9 and Johnson, et al10. That is, by announcing adverse earnings news early firms avoid large stock price declines on the earnings announcement date and thereby reduce the expected costs of any potential stockholder litigation.

Kasznik and Lev" and Helbok and Walker12 showed that firms with permanent earnings disappointments, as opposed to transitory earnings disappointments, are more likely to issue a warning consistent with the litigation cost argument. Firms with lower levels of managerial ownership are more likely to disclose in required annual and quarterly reports according to a survey of external financial analysts, however, for informed and flexible aspects of disclosure no relation was found between disclosure and the level of managerial ownership (Gelb13).

A second explanation posited is the reputational costs incurred when managers refrain from informing stakeholders such as money managers, shareholders, bondholders, and security analysts. Libby and Tan14 experimentally demonstrated that if firms release profit warnings, management has more integrity and analysts were more likely to continue coverage and to hold the firm's securities as well as minimizing the damage to the analyst's own reputation for not divulging a profit warning. Atiase, et al found the warning effect is more negative for high-litigation-risk firms than for low-litigation-risk firms. Skinner15 displayed evidence that more timely disclosure is correlated with lower settlements. Nagata and Hachiya16 displayed results that reflect conservative earnings management was associated with higher initial public offering prices on JASDAQ. …

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