Management Earnings Forecasts, CEO Incentives and Risk-Taking

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Author Information : Susan Albring (Syracuse University, Whitman School of Management)

Xiaolu Xu (University of Massachusetts, Boston)

Year of Publication : Advances in Accounting (2018)

Summary of Findings : We find more disclosure to be associated with less risk-taking activities that can enhance long-term value and we find that managerial ownership attenuates the negative relation between voluntary disclosure and risk-taking.

Research Questions : Voluntary disclosure is negatively associated with firm risk-taking.

The negative relation between voluntary disclosure and risk-taking is attenuated by managerial ownership.

What we know : New accounting regulations and laws, e.g., Sarbanes-Oxley Act 2002, emphasize greater disclosure because there is a prevailing view that an expanded disclosure policy is beneficial to a firm’s investors. An expanded disclosure policy can reduce the information disadvantage of uninformed investors by reducing the information asymmetry between informed and uninformed investors and between the firm and its outside investors (e.g., Amihud and Mendelson 1986; Diamond and Verrecchia 1991; Verrecchia 2001). Such a reduction in information asymmetry is beneficial to a firm because it can improve liquidity and lower a firm’s cost of capital (Verrecchia 1983). Moreover, an expanded disclosure policy can allow for better monitoring by a firm’s outside investors (Bushman and Smith 2001). As a consequence, it is more difficult for insiders to expropriate assets from the firm or to pursue value-reducing projects without detection by other stakeholders. Thus, better monitoring can improve a firm’s cash flow. Given that managers select the level of voluntary disclosure, there is a limited understanding of why mangers submit to monitoring by disclosures, especially in a corporate setting, where managers bear the cost of monitoring (i.e., private consumption forgone) and shareholders reap the benefits.

Novel Findings : Our study contributes to several strands of existing research. First, we contribute to the literature examining the effects of disclosure. Prior research has noted that an expanded disclosure policy improves firm information environment (Lang and Lundholm 1996), lowers the cost of external funds (e.g., Botosan 1997; Sengupta 1998), improves stock liquidity (Welker 1995, Schoenfeld 2017), and improves firm growth (Khurana et al. 2006). However, in this study, we evaluate recent theory which notes that disclosure can involve considerable costs. We find evidence in support of this position. Specifically, we find more disclosure, using earnings management forecasts as our proxy, to be associated with less risk-taking activities that can enhance long-term firm value.
Second, we contribute to the literature on managerial incentives and ownership. To date, studies have emphasized factors such as firm size and complexity as factors which determine managerial incentive compensation. However, theory contends firm information environment could also have a bearing on managerial incentive compensation. We show a consequence of managerial ownership. Specifically, we find that managerial ownership attenuates the negative relation between voluntary disclosure and risk-taking.
Last, we contribute to the literature on the determinants of firm risk-taking. Prior research has pointed to the role of incentive managerial compensation in inducing managers to undertake risky projects (Jensen and Murphy 1990). Separately, studies have also pointed to the impact of institutional factors such as the nature of a country’s laws in place on risk-taking (John et al. 2008). We depart from earlier studies by focusing on firm disclosure policy. In the presence of an expanded disclosure regime, managers may become reticent to act in the interest of improving a firm’s long-term value. If this is the case, then disclosure will have a negative impact on managerial risk-taking. Our evidence is consistent with this implication.

Full Citations : Susan Albring, and Xiaolu Xu. 2018. Management Earnings Forecasts, CEO Incentives, and Risk-taking. Advances in Accounting. 42 (September), pp. 48-69.

Abstract : We examine the relation between voluntary disclosure and firm’s risk-taking. Theory posits that disclosure can induce managers to forgo investments that can benefit the firm’s long-term value. As such, we predict a negative relation between disclosure and firm’s risk-taking activities. We also predict that the negative relation is attenuated by managerial stock ownership, suggesting that managerial ownership can attenuate the decreased risk-taking activities associated with disclosure. Our evidence is consistent with these predictions. Specifically, we find a robust negative relation between disclosure and risk-taking and that a higher level of managerial ownership attenuates the relation. Overall, our findings provide evidence that disclosure can be costly in that it can induce less risk-taking.

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We find more disclosure to be associated with less risk-taking activities that can enhance long-term value and we find that managerial ownership attenuates the negative relation between voluntary disclosure and risk-taking.

Susan Albring

Professor Albring is an associate professor of accounting. Her research is focused on the effect of repatriation of foreign earnings on firm capital structure decisions.
Susan Albring
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