Audited Financial Reporting and Voluntary Disclosure as Complements

In the paper, Audited Financial Reporting and Voluntary Disclosure as Complements: A Test of the Confirmation Hypothesis, which was recently made publicly available on SSRN, we examine the hypothesis that audited financial reporting and voluntary disclosure of managers’ private information are complementary mechanisms for communicating with investors, not substitutes. More specifically, we test the hypothesis in Ball (2001) that independent verification and reporting of financial outcomes encourages managers to be more truthful and hence more precise in their disclosures. This allows managers to credibly disclose private information that is not directly verifiable, alleviating the problem (Crawford and Sobel, 1982) that private information disclosure as a stand-alone mechanism is uninformative because in equilibrium it is untruthful.

Consistent with the hypothesis, we show that the resources firms commit to financial statement verification by independent auditors are an increasing function of the extent of their management forecasting activity, and that the specificity of forecasts and the market reaction to them increase in the resources committed to audit. Additional tests suggest the relations are not driven by litigation risk and are robust to alternative empirical specifications. 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.

Caution should be exercised in generalizing the results to other types of voluntary disclosures, particularly non-financial disclosures. Earnings forecasts are more directly confirmed by actual earnings realizations than is the case for most other discretionary disclosures. Consequently, the confirmatory role of audited financial statements most likely is weaker when the disclosure cannot be so directly linked to specific financial statement outcomes.

The full paper is available for download here.