Audited financial reporting and voluntary disclosure as complements: A test of the Confirmation Hypothesis

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Abstract

We examine the “confirmation” hypothesis that audited financial reporting and disclosure of managers' private information are complements, because independent verification of outcomes disciplines and hence enhances disclosure credibility. Committing to higher audit fees (a measure of financial statement verification) is associated with management forecasts that are more frequent, specific, timely, accurate and informative to investors. Because private information disclosure and audited financial reporting are complements, their economic roles cannot be evaluated separately. Our evidence cautions against drawing inferences exclusively from market reactions around “announcement periods” because audited financial reporting indirectly affects information released at other times and through other channels.

Highlights

► Firms doing more forecasting spend more on audits. ► Auditing actual financial outcomes makes forecasts more credible. ► Backward-looking financial reporting enhances forward-looking disclosure. ► Forward-looking information and audited reports are complements. ► Financial reporting cannot be evaluated independently of its effect on disclosure.

Introduction

We test the hypothesis that audited financial reporting and voluntary disclosure of managers' private information are complementary mechanisms for communicating with investors, not substitutes. The basic idea is that commitment to independent verification of financial outcomes allows managers to credibly disclose private information that is costly for investors or auditors to verify directly. This alleviates the problem that private information disclosure is uninformative as a stand-alone mechanism because in equilibrium it is untruthful (Crawford and Sobel, 1982). Managers are encouraged to be more truthful when they are aware their disclosures of private information subsequently will be confirmed more accurately and freer of their own manipulation. Commitment to the independent verification of financial reporting therefore enhances the credibility of managers' disclosures of private information, and hence financial reporting and disclosure are complements.

Consistent with the hypothesis that audited financial reporting and voluntary disclosure of managers' private information are complements, we show that the resources firms commit to financial statement verification by independent auditors are an increasing function of the resources devoted to management forecasting, our proxies for which are forecast frequency, specificity, and timeliness (i.e., horizon). Further, the accuracy of management forecasts and the market reaction to them increase in the resources committed to independent audit.

The mechanisms by which managers can commit to truthful disclosure of private information are not well understood. An obvious and important mechanism is commitment to a reporting regime: notably, to listing as a public versus private firm (Ball and Shivakumar, 2005, Ball and Shivakumar, 2008a, Burgstahler et al., 2006, Leuz et al., 2008), or to listing in a particular jurisdiction (Coffee, 1999, Ball et al., 2000, Rock, 2002). Commitment to a regime incurs the costs of meeting its minimum reporting and disclosure standards, or the costs of failing to meet those standards (litigation costs, fines, jail, etc.). However, little is known about how firms within a particular regime can credibly commit to different levels of disclosure of private information.

We propose that one mechanism by which firms make different within-regime commitments to truthful disclosure of private information is by committing to different levels of audit of actual financial outcomes. Credible disclosure must incur some cost (Spence, 1973). The cost of committing to a particular level of independent audit includes audit firm fees (a function of both the quantity and quality of audit resources supplied), associated internal accounting and control costs, internal audit costs, management time, and reduced utility from managers restricting their ability to manipulate the financials. The chosen level of independent audit affects the measurement accuracy and independence from managerial manipulation of the reported financial outcomes. In turn, the expectation of more accurate and independent ex post accounting disciplines managers to be more truthful ex ante in their private information disclosure.1

Complementarity implies the resources allocated to voluntary disclosure and auditing financial reporting are positively correlated. We therefore hypothesize that: (1) firms committing more resources to disclosing private information also commit to higher levels of audit verification; and (2) commitment to higher levels of audit verification is associated with increased forecast accuracy and larger investor responses to disclosures. These hypotheses treat audit as a differentiated product that allows firms some choice over the level of audit effort, not as a standardized commodity determined exclusively by regulation. This treatment is consistent with the auditing literature, discussed below, and with the substantial variation observed in audit fees even after controlling for variables such as firm size and complexity.

We test these hypotheses by focusing on a specific type of voluntary disclosure, namely, management earnings forecasts. Caution should be exercised in generalizing our results to other voluntary disclosures, particularly non-financial disclosures. Forecasts of earnings and other financial statement variables such as revenues and expenses are more directly confirmed by audited outcomes than is the case for more qualitative disclosures such as product market strategies. 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.

We report a variety of evidence that audited financial reporting and voluntary disclosure of managers' private information are complements. First, there is wide variation across firms in the resources committed to both management forecasting activity (forecast frequency, specificity and horizon) and financial statement verification via audit fees (before and after controls for size, complexity, etc.). Second, the amounts of forecasting and audit activity are positively correlated: one standard deviation increases in forecast frequency, specificity and horizon are associated with 4.6 percent, 8.4 percent, 4.9 percent increases in excess audit fees (after controls), respectively. Third, forecasting accuracy and audit activity levels also are positively correlated: a one standard deviation increase in forecast accuracy is associated with a 2.5 percent increase in excess audit fees. Fourth, the market reaction to the disclosure of management forecasts increases by approximately 10% with a one standard deviation increase in resources committed to financial statement verification (excess audit fees), consistent with investors perceiving the credibility of voluntary disclosures to be a function of the resources spent on independent verification of subsequent outcomes. Overall, voluntary disclosure of private information and audited financial statement outcomes appear to play complementary roles in communicating information.

Under our complementarity hypothesis, we expect resource allocation decisions for voluntary disclosure (in particular, earnings forecasting) and independent audit to be made jointly. Consequently, forecasting activity is endogenous to the audit decision, and Ordinary Least Squares (OLS) estimates of the relation between them could be biased (Arora, 1996). Our primary results therefore are based on a Three Stage Least Squares (3SLS) specification that models the simultaneous relation between financial statement verification and forecasting activity. The conclusions are not altered by using OLS and Two Stage Least Squares (2SLS) specifications.2 Nor are they altered in firm-fixed effects regressions, indicating that the relation is not entirely due to time-invariant firm characteristics. The inferences also are robust with respect to one-way clustering of the standard errors (by firm) or two-way clustering (by firm and by year). In addition, we verify that the results are robust to including only one observation per firm. We estimate a robust regression and find the results are not affected by outliers. We obtain similar results using a simpler model to estimate excess audit fees, controlling only for firm size. The results for forecast specificity and forecast horizon, which are based only on firms making management forecasts, are robust to controlling for selection biases using a Heckman model. The conclusions are not affected when individual forecast attributes are orthogonalized to the information in other forecast attributes. Finally, the results are robust to alternative proxies for the level of commitment to audit verification and for management forecast properties.

Litigation risk is a potentially correlated omitted variable, since firms with greater litigation risk both make more disclosures (Skinner, 1994, Field et al., 2005) and pay higher audit fees (Simunic, 1980, Dye, 1993, Lys and Watts, 1994, Shu, 2000). However, we find the relation between audit fees and management forecasts typically is weaker for high-risk firms, which is inconsistent with litigation risk explaining the relation between audit fees and forecasting activity.

Our paper offers several contributions to the literature. We empirically document the complementarity between audited financial reporting and voluntary disclosure. Complementarity implies financial reporting usefulness depends on its contribution to the total information environment, whereas substitutability implies usefulness depends on the new information reports release on a stand-alone basis (as measured for example by the surprise value of earnings announcements).3 Second, we demonstrate one mechanism (commitment to independent audit of financial outcomes) by which managers can credibly commit to truthfully disclose private information. Third, our study contributes to the management forecast literature by documenting how financial statement verification affects forecast credibility and other forecast characteristics. Prior research reports that forecasts are associated with favorable market reactions (e.g., Foster, 1973, Patell, 1976, Penman, 1980, Waymire, 1984, Waymire, 1985, Healy et al., 1999), reduced information asymmetry (e.g., Frankel et al., 1995, Coller and Yohn, 1997) and lower litigation risk (e.g., Skinner, 1994, Field et al., 2005).4 Our evidence suggests an explanation for these positive outcomes: firms can credibly commit to more informative and truthful management forecasts by requiring enhanced auditor authentication of financial statement outcomes. Fourth, our evidence that the amount of resources committed to audit fees is robustly related to voluntary forecasting activity is consistent with the existence of a private (i.e., market) demand for auditing, as argued by Watts and Zimmerman, 1983, Watts and Zimmerman, 1986, and with auditing being more than a commodity mandated by regulation.

The study also contributes to our understanding of the economic role of financial reporting, and hence to standard-setting (for example, to the role of fair value accounting). If one accepts the factual premise that independently verifiable information consists primarily of backward-looking actual outcomes and that managers' private information consists primarily of forward-looking expectations that are costly (perhaps infinitely) to independently verify, then the efficient equilibrium involves the following separation: financial statement information is constrained to a subset that is independently verifiable, which is information that is primarily backward-looking and less timely when considered in isolation; but in consequence managers increase the quantity of credible forward-looking, timely private information that they disclose. Because audited financial reporting and private information disclosure complement each other in this fashion, their economic roles cannot be evaluated separately by researchers, regulators or standard-setters. For example, price reactions and bid-ask spread reactions during “announcement periods” are not sufficient measures of financial reporting effects on capital markets because audited financial reporting indirectly affects information released at other times and through other media.

The rest of the paper is arranged as follows: Section 2 presents the hypotheses. Section 3 presents the research design and Section 4 presents results on the relation between audit fees and properties of management forecasts. Section 5 presents results that examine the role of litigation risk and Section 6 describes the robustness checks. Section 7 concludes.

Section snippets

Confirmation Hypothesis: financial reporting and disclosure are complements

In this section, we outline the hypothesis that audited financial reporting and voluntary disclosure of managers' private information are complementary mechanisms for communicating with investors, not substitutes. We build on the Ball (2001) argument that the primary (but not exclusive) role of financial reporting is to supply auditable financial outcome variables for use in efficient contracting with the firm, including providing of a mechanism through which managers can credibly commit to

Definition and measurement of variables

Testing the Confirmation Hypothesis requires measures of the resources committed to voluntary disclosure and independent audit. These are described in the following two sub-sections. Section 3.3 discusses measures of the stock market reaction to voluntary disclosures.

Sample and descriptive statistics

Audit fee data are from Audit Analytics, management forecasts of earnings per share (EPS) are from First Call, stock market data are from CRSP and financial statement data are from Compustat. The sample covers the period 2000 to 2007 and consists of 44,883 firm-year observations for 9,172 unique firms with non-missing data for all variables.16

Alternative explanation: Litigation Risk Hypothesis

One potential explanation for an association between management forecasts and audit fees documented in Table 3 is that litigation risk is a correlated omitted variable in the audit fee regression. We refer to this alternative possibility as the Litigation Risk Hypothesis. There are two reasons to be concerned that litigation risk links audit fees to earnings forecasting activity, even after controlling for other determinants of audit fees. First, prior studies find that firms with greater

Robustness tests

We conduct a battery of robustness checks, using alternative model specifications and alternative proxies for resources used by firms in financial statement verification and in management forecasting. We discuss these tests below.

Conclusions

This paper examines the hypothesis that audited financial reporting and voluntary disclosure of managers' private information are complementary mechanisms for communicating with investors, not substitutes. 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,

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      Citation Excerpt :

      To the extent audit regulation motivates greater auditor effort, theory from Ball et al. (2012) would suggest that audit regulation could affect management forecast accuracy through a commitment effect. However, our tests provide evidence that the effect we observe regarding auditor-induced improvements to the internal information environment is incremental to, and distinct from, the commitment effect shown in Ball et al. (2012). Thus, we complement the work from Ball et al. (2012) and identify another channel through which audit regulation can affect management forecasts.

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    We are grateful for comments from Gus DeFranco, Pingyang Gao, Joseph Gerakos, Kerry Jacobs, William Kinney, Katherine Litvak, Jonathan Rogers, Tom Smith, Mark Wilson, Andy Van Buskirk, seminar participants at Australian National University, Indiana University, 2010 University of Illinois (Urbana-Champaign) Audit Symposium, University of Toronto, the referee, and the editor (Ross Watts). Ball's work is supported by the Business and Public Policy Faculty Research Fund at the University of Chicago Booth School of Business. A previous version was circulated under the title “The Complementary Roles of Audited Financial Reporting and Disclosure of Private Information: A Test of the Confirmation Hypothesis.”

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