Narrative Disclosure and Earnings Performance

The following post comes to us from Kenneth Merkley of the Department of Accounting at Cornell University.

In the paper, Narrative Disclosure and Earnings Performance: Evidence from R&D Disclosures, which was recently made publicly available on SSRN, I examine whether earnings performance relates to the quantity of narrative R&D disclosure that firms provide concurrently in their financial reports. A large body of research examines how managers’ incentives to voluntarily disclose information depend on whether that specific disclosure would reveal good or bad news. This study differs from prior work on the relation between performance and disclosure in that I examine whether earnings performance, a mandatory disclosure, relates to firms’ decisions to provide narrative disclosures – one of the main channels used to convey contextual information about a firm’s operations to investors. While more quantitative disclosures such as earnings guidance have received considerably more attention, narrative information makes up a comparatively large amount of disclosure information and helps to bridge the gap between a firm’s economic reality and its financial statements.

I focus specifically on how earnings performance relates to the quantity of narrative disclosures about R&D. The unique nature of R&D investments and the limitations of financial statements to communicate information about their value highlight the role of narrative disclosure as an important supplement to the financial statements. Based on a detailed analysis of R&D-related disclosures in financial reports from 1996-2007, I predict and find that changes in current earnings performance (adjusted for R&D expense) are negatively related to changes in the quantity of narrative R&D disclosure. I also find that this relation is more pronounced for firms that place more importance on R&D and for firms with higher outside monitoring.

These results highlight the role of different market participants in the disclosure decision process and also shed light on the interaction between mandatory and voluntary disclosure. Prior empirical research suggests that mandatory disclosure serves a confirmatory role and increases the credibility of voluntary disclosure. My findings complement these studies by providing evidence that the extent to which voluntary narrative disclosure supplements mandatory disclosure varies with earnings performance – firms provide more narrative disclosure when earnings performance is poor.

Additionally, I find that R&D firms’ decision to provide earnings guidance, a more quantitative disclosure, is positively, rather than negatively, related to earnings performance, suggesting that earnings performance relates differently to different disclosure choices. While some studies measure disclosure based solely on whether a firm provides earnings guidance, my results suggest that this approach likely over-generalizes disclosure policies to only the more quantitative aspects of disclosure and overlooks the significant quantity of disclosure that is more qualitative in nature.

The full paper is available here.

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