£> 1993 American Accounting Association

Accounting Horizons . ,
Vol. 7 No. 1 0'
March 1993
pp. 1-11

The Effect of Firms' Financial

Disclosure Strategies
on Stock Prices
Paul M. Healy and Krishna G. Palepu
Paul M. Healy is a Professor at MIT Sloan School of Management and Krishna G.
Palepu is a Professor at Harvard Business School.

SYNOPSIS AND INTRODUCTION: Financial reporting has been the subject of serious criticism in
recent years. Managers argue that the inundation of new accounting standards are burdensome
because they impose new reporting requirements but do not help them communicate effectively
with outside investors.^ For example, current accounting ruies do not permit managers to show the
benefits of investments in quality improvements, human resource development programs, research
and development, and customer service on their balance sheets in a timely fashion. Some argue
that these omissions create pressures for managers to smooth reported earnings, or to avoid pur-
suing strategies with long-term payoffs that reduce short-term earnings.^ These concerns have
even led some critics of accounting, including a recent presidential candidate, to advocate the abo-
lition of quarterly reporting as one way to improve the global competitiveness of US corporations.
Current empirical research is of little help to managers in addressing the above challenges. Most
of the research assumes that equity markets are efficient, and concludes that investors "see through"
the limitations of accounting. Empirical studies have focused on the roie of debt and compensation
contracts, as well as political considerations on managers' accounting decisions.^ But there has
been only a modest amount of empirical research on how capital markets influence accounting
decisions.
However, recent theoretical studies in accounting have begun to address accounting and disclo-
sure decisions from a capital market perspective.* This research, which draws on "information models"
in economics and finance, assumes that managers have superior information on their firms' current
and future performance than outside investors. Disclosure strategies then provide a potentially im-
portant means for corporate managers to impart their knowledge to outside investors, even if capi-
tal markets are efficient.
In this paper, we summarize the key ideas of the accounting information models in a form that is
accessible to corporate managers, accounting educators, and empirical researchers. Implications

*'Will 'FASBEE' Pinch Your Bottom Line/" Fortune. December 19,1988, 93-108.
^See for example, the discussion in "The Folly of Inflating Quarterly Profits," New York Times, March 2,1986.
^Researchers have recognized that these contracts and political considerations can lead accounting decisions to
have indirect eifects on stock prices (Watts 1977; Holthausen and Leftwich 1983; and Watts and Zimmerman 1990).
^Some ofthe earlier researchers who have considered financial disclosure under conditions of information asymme-
try are Ronen (1979); Holthausen and Leflwich (1983); Verrecchia (1983, 1986, 1990); Demski, et al. (1984)- I^e
(1988); Titman and TVueman (1988); Beaver (1989); Stein (1989); Schipper (1989); Myers (1991).

This paper is a revision ofthe paper "Financial Reporting and Firm Value." We wish to thank Jim Manegold (the
editor), two anonymous referees, Andrew Alford, Mary Barth, Vic Bernard, Ravi Bhushan, Bob Kaplan, Fred Kofman,
Baruch Lev, David Scharfstein, Richard Sloan, Jeremy Stein, Amy Sweeney, Peter Wilson, Ross Watts, and Jerry
Zimmerman for their valuable comments. The paper also benefited from comments of seminar participants at Laval
University, LSE, Michigan State University, MIT, and NYU Conference on Economics of Financial Statements and
the Financial Economics and Accounting Conference at SUNY Buffalo.
 Accounting Horizons/March 1993

of these ideas for corporate disclosure management, as well as for teaching and research in the
area of financial statement analysis are discussed.

Data Availability: The data on Patten Corporation used in this paper is drawn from the Harvard
Business School case, Patten Corporation (case #9-188-027), which is publicly available from HBS
Case Services, Harvard Business School, Boston, MA 02163.

I. FINANCIAL REPORTING cial reporting decisions in their own interest.

ENVIRONMENT
Financial reporting is a potentially useful
mechanism for managers to communicate
with outside investors. However, this process
is imperfect when the following three condi-
tions are satisfied: (1) relative to investors,
managers have superior information on their
firms' business strategies and operations; (2)
managers' incentives are not perfectly aligned
with all shareholders' interests; and (3) ac-
counting rules and auditing are imperfect. We
discuss below how these three conditions are
often satisfied in practice, and what they im-
ply for the effect offinancialreporting on firm
value.
(1) Managers'Information Advantage
Tbp management are hired because they
have expertise in managing firms' investment
and operating strategies. Managers acquire
this expertise through formal education, work
experience in the industry, and investment in
firm-specific information. It is therefore no
surprise that managers are typically better
than outside investors in interpreting their
firms' current condition, and forecasting fu-
ture performance.^ There is extensive evidence
consistent with this view. Management fore-
casts affect stock prices, as do managers' de-
cisions to change their firms' financial poli-
cies.® Because accrual accounting not only re-
quires managers to record past events, but to
make forecasts of future effects of these
events, financial statements have potential to
convey managers' superior information.
(2) Difference in Managers' and
Investors Interests
If there is divergence in owners' and man-
agers' objectives, managers may make finan-
Contracting mechanisms, such as compensa-
tion, that tie managers' rewards to long-term
share values, provide a means of mitigating
this conflict. However, it is costly to write con-
tracts that perfectly align managers' and own-
ers' objectives.
In practice, executives' personal rewards
and job secvirity are tied to imperfect measures
like earnings, both directly through profit-
based compensation plans, and indirectly
through the current value of their stock-
holdings. Jensen and Murphy (1990) and Lam-
bert and Larcker (1987) show that the most
important determinant of executive compen-
sation is earnings. Warner, et al. (1988) and
Weisbach (1988) show that the probability of
replacing the CEO is higher for firms with
poor earnings perfonnance. DeAngelo (1988,
1990) documents that reported accounting
numbers play a significant role in proxy con-
tests between managers and dissident share-
holders. Finally, in the extreme, poor earnings
performance and resulting stock declines in-
crease the threat of a hostile takeover, lead-
ing to a management change (Palepu 1986;
Morck, et al. 1988).
Another source of conflict between man-
agers and shareholders arises from differences
in the investment horizons of groups of stock-
holders. If some groups of investors intend
holding the firm's stock for longer than oth-
ers, managers have to choose whose interests
they will maximize in making disclosure de-
cisions (Dye 1988; Myers 1991).
If managers make decisions in their own
interest, they have incentives to distort re-
5Ross 1977; Miller and Rock 1985; Myers and Majluf
1984.
1976; Vermaelen 1981; Offer and Siegel 1987;
Healy and Palepu 1988, 1990; Lys and
Sivaramakrishnan 1988; Asquith, et al. 1989.
The Effect of Firms' Financial Disclosure Strategies on Stock Prices
ported profits (Dye 1988; Watts and
Zimmerman 1986; Ball 1988; Schipper 1989).
Healy (1985), McNicols and Wilson (1988),
Collins and DeAngelo (1992), among others,
provide evidence consistent with this predic-
tion. Similarly, managers, acting in the inter-
ests of stockholders who intend selling their
shares in the short-term, have an incentive
to manage current earnings. In either case,
earnings management reduces the credibility
of financial statements for investors, and in-
creases managers' communication costs.
(3) Accounting Rules and Auditing
As Akerlof (1970), Spence (1973), and Ross
(1979) note, regulation and third-party certi-
fication facilitate the functioning of markets
when there are incentive problems. Account-
ing regulation and auditing can be viewed as
such mechanisms (Antle 1982,1984; Baiman
et al. 1987; DeAngelo 1981). Accounting stan-
dards promulgated by the FASB and other
standard-setting bodies provide guidelines for
managers on how to make accounting deci-
sions, and provide outside investors with a
means of interpreting these decisions. Uni-
form accounting standards attempt to reduce
managers' ability to record similar economic
transactions in dissimilar ways either over
time or across firms. Compliance with these
standards is enforced by external auditors,
who attempt to ensiire that managers' esti-
mates are reasonable. In this way, auditors
reduce the likelihood of earnings manage-
ment.
However, standards and auditing are un-
likely to fully eliminate earnings manage-
ment. Standards are the result of compromises
between different interest groups (e.g.. audi-
tors, investors, corporate managers, and regu-
lators). For example, auditors are unlikely to
support rules that require them to exercise
significant business judgment in assessing a
transaction's economic consequences, espe-
cially given their legal liability risk. Conse-
quently, such transactions are typically either
excluded from the scope of financial state-
ments, or are recorded in a mechanical way.
The current debate on market value account-
ing for financial institutions illustrates this
point. While there is considerable agreement
that market value accounting produces rel-
evant information, auditors typically oppose
it, citing concerns over audit liability.
Auditing also may introduce its own er-
rors. While auditors have access to proprietary
information, they do not have the same un-
derstanding ofthe firm's business as manag-
ers. The divergence between managers' and
auditors' business assessments is likely to be
most severe forfirmswith distinctive business
strategies, or that operate in emerging indus-
tries. Auditor decisions in these circumstances
are likely to be dominated by concerns about
legal liability, hampering management's abil-
ity to use financial reports to communicate
effectively with investors.
Summary
Managers' superior information makes fi-
nancial reporting potentially informative to
outside investors. However, confiicts of inter-
est between managers and shareholders, and
imperfect accounting standards and auditing
create distortions in financial reports. The
extent of these distortions varies across firms.
When it is costly to assess the degree of dis-
tortion in financial reports, some firms are
misvalued, even in an efficient capital mar-
ket. This problem is analogous to the "lem-
ons" problem in the used car market discussed
by Akerlof (1970).
Given the penalty in public capital mar-
kets, firms that are undervalued have an in-
centive to rely on private markets where in-
formation costs are likely to be lower.' Private
capital suppliers can access managers' propri-
etary information more easily than dispersed
public stockholders. However, public markets
offer investors higher liquidity and increased
opportunities for diversification. Firms there-
fore choose their form of financing depending
on the relative costs of public and private
alternative strategy is for the manager to buy the
firm, as in a management buyout. However, this is
unlikely to be feasible for largefirmsgiven managers'
wealth constraints. Also, it may be inefficient to sell
the firm to the manager for risk-sharing reasons.

markets. In equilibrium, firms with more se-
vere information problems, for example hi-
tech start-up companies, are more likely to
rely on private financing. However, if benefits
fi"om access to public markets are sufficiently
large, somefirmsmight choose to remain pub-
lic even if they are undervalued.
Many argue that managers of firms that
are overvalued are likely to be less concerned
about the market's assessment than manag-
ers of undervalued firms. However, managers
of overvalued firms are legally liable for fail-
ing to disclose information relevant to inves-
tors. They may therefore not wish to see their
stock seriously overvalued, even though
overvaluation provides opportunities to issue
new equity at fiavorable rates.
The conclusion that some firms are mis-
valued by public capital markets because of
information problems, has important implica-
tions for corporate managers, teachers of fi-
nancial statement analysis, and empirical ac-
counting researchers. In the remainder ofthe
paper we discuss these implications.
II. IMPLICATIONS FOR
CORPORATE MANAGERS
Managers of firms whose stock is under-
valued have incentives to take actions to cor-
rect the mispricing. We discuss two potential
mechanisms available to the firm's managers
to make their financial reports more credible:
expanding financial disclosure and adopting
appropriate financing policies. To make our
discussion more concrete, we illustrate com-
munication challenges facing management
and potential responses using an actual com-
pany example.
Illustration of Management
Communication Challenge
The company example we use to illustrate
potential information problems between man-
agers and outside investors is Patten Corp.
Patten acqmres large undeveloped rural prop-
erties, subdivides these in lots of approxi-
mately 1.5 acres each, and sells them.^ As a
marketing tool, the company offers financing
of up to 90 percent ofthe purchase price to all
Accounting Horizons /March 1993
customers. This removes the difficulty most
customers would have in obtaining financing
from their own bank for purchasing undevel-
oped land outside their home state. Custom-
ers who utilize Patten's financing sign a prom-
issory note secured by a first mortgage on the
parcel sold. In 1986,21percent of Patten's cus-
tomers paid cash for their property, while 79
percent used the company's financing.
For financial reporting. Patten treats the
fiiU sales price as revenue when at least ten
percent of sales proceeds has been received as
down payment and collection of the balance
is reasonably assured. The difference between
the sales price and the down payment is re-
corded as contract receivables or notes receiv-
able, and a bad debt allowance is created to
refiect managers' forecasts of future customer
defaults. In 1986 the firm had net receivables
of $29.4 million (comprising $18.5 million re-
ported on the balance sheet, and a further
$10.9 million transferred to banks but for
which Patten is liable in the event of customer
default). The firm provided a bad debt allow-
ance of only $10,000 on these receivables and
justified this choice by stating that only
$104,000 of receivables were more than 30
days past due, and that the past collection ex-
perience had been excellent. Similar low bad
debt estimates were reported in previous
years. The bad debt estimate has a substan-
tial effect on Patten's reported earnings, which
were $3.95 million in 1986. For example, if
Patten had established a five percent allow-
ance on new receivables originated in 1986,
earnings after tax for the year would have
been $0.8 million (20 percent) lower.
In a January 12,1987 article "Old Game,
New Twist" Forbes magazine suggested that
Patten's earnings quality was suspect because
the company under-estimated its customer
default rates. Forbes noted that while Patten
had low historical delinquency rates, they may
not be representative of future rates given the
companj^s rapid growth. The article drew par-
allels between Patten and other real estate
Palepu (1988) for a more detailed description of
this situation.
The Effect of Firms' Financial Disclosure Strategies on Stock Prices
firms whose accounting estimates proved to
be too aggressive:
Negative cashflowand go-go accoiinting have
burned some nasty holes in investors pock-
ets over the years. Remember Putna Gorda
Isles, a Florida land sales and development
company? Its stock traded as high as 16 in
198i, before its similarly obscured negative
cash flow came to light. Now the shares lan-
guish at 2. Then there is Thousand Trails, a
company that sold lifetime campground mem-
berships. It was hot in 1984, following three
years of 40% annual revenue growth. Trails'
stock climbed to 29 a share. Soon, however,
membership sales evaporated. The stock re-
cently traded around 2 1/2.
During the week that the Forbes article
was published. Patten's share price fell by 13
percent, resulting in a market value loss of
$20 million to its shareholders. Patten's man-
agement disagreed with Forbes' assessment
of the default rates on the firm's long-term re-
ceivables and the market response to the ar-
ticle. Management appreciated that it now
faced a serious challenge in convincing inves-
tors that the company's prospects were still
strong. The cost of this information problem
was that the firm now faced a higher cost of
equity in the capital market. As discussed be-
low, voluntary disclosure and financial policy
changes are two potential managerial re-
sponses to this challenge.
Management Responses to
Communication Challenge
(1) ^bluntary Disclosure
One way for managers to improve the cred-
ibility of their financial reporting is through
voluntary disclosure. Accounting rules usually
prescribe minimum disclosure requirements,
but they do not restrict managers from vol-
untarily providing additional disclosures.
These disclosures could include articulation
of the company's long-term strategy, specifi-
cation of non-financial leading indicators use-
ful in judging the effectiveness of the strat-
egy implementation, and discussion of the re-
lation between the leading indicators and fu-
ture profits.
One constraint on expanded disclosure is
the competitive dynamics in product markets.
Disclosure of proprietary information on strat-
egies and their expected economic conse-
quences may hurt the firm's competitive posi-
tion. Managers then face a tradeoff between
providing financial reports that help capital
markets to value thefirm'sstock correctly, and
withholding information to maximize the
firm's product market advantage. When re-
ported information is valuable to the firm's
competitors, managers have to choose between
maximizing the current share price and maxi-
mizing future value (Verrecchia 1990;
Newman and Sansing 1992).
Applic€Uion to Patten Case
Expanded disclosure is likely to be an ef-
fective mechanism for Patten to counter criti-
cisms of its accounting estimates if managers
have superiorfirm-specificinformation on the
firm's future customer defaults. Patten's bad
debts are influenced by the type of customers
that the firm targets, tbe credit screening pro-
cedures it uses, and the incentive systems for
sales and credit personnel. Patten's manage-
ment is likely to have a better understanding
of these factors and their infiuence on future
defaults than outsiders do. Bad debts are also
influenced by macro considerations, such as
interest rates and unemplo3Tiient. Managers
may not have superior knowledge on these
factors. However, they may well have supe-
rior insights on how these macro shocks af-
fect their own customers' behavior.
Tb convince analysts and investors that the
firm's bad debt estimates are reasonable, man-
agers could provide additional disclosure on
the credit evaluation process used to screen
loan applicants, a detailed description of the
characteristics of accepted and rejected loan
applicants, year-by-year breakdowns of loan
default rates to provide investors with timely
information on changes in defaults, as well as
discussion of the control mechanisms in place
to monitor sales staff to ensure that they do
not infiuence credit decisions. The judgment
that Patten's managers must make is whether
disclosing additional information is harmful
to the company's competitive position in the
product market. This must be balanced

against the higher cost of capital the firm faces
in the absence of additional disclosure.
(2) Signaling with Finance Policies
Managers can also mitigate the vmdervalu-
ation problem by using corporatefinancepoli-
cies to reinforce the message in their firm's
financial reports. Finance policies useful in
this respect include firm's cash payout poli-
cies,financingchoices, and hedging strategies.
There is considerable evidence that cash
payout policy decisions can provide informa-
tion to investors on managers' assessments of
firms' future prospects. Investors interpret
dividend increases and stock repurchases as
signals of managers' confidence in the quality
of current and future earnings (Vermaelen
1982; Asquith and Mullins 1983; Miller and
Rock 1985; Healy and Palepu 1989; Offer and
Siegel 1987; Hertzel and Jain 1992; Dann et
al. 1992; Bartov 1992). A cash payout, either
through a dividend increase or a stock repur-
chase, is therefore one response available to
undervalued firms.
Financing choices can also affect a firm's
cost of capital when it faces information prob-
lems (Myers and Majluf 1984). The nature of
the information gap between managers and
owners is influenced by the choice between
public and private forms of financing, the de-
gree of concentration of ownership, and the
role of large block holders in corporate gover-
nance. It is easier for managers to share con-
fidential information with private debt and
equity holders than with public investors. Fi-
nancial communication problems are also
mitigated if the firm's ownership is concen-
trated, and these large-block shareholders
actively participate in the corporate gover-
nance process. This situation arises, for ex-
ample, in leveraged buyouts, venture capital-
backed start-ups, firms with equity partner-
ship investments, and in Japanese and Ger-
man corporations where large banks own both
debt and equity and have close working rela-
tions with firms' managers.
Hedging strategies provide another means
for managers to mitigate mispricing. If inves-
Accounting Horizons/March 1993
tors are unable to distinguish between \inex-
pected changes in reported earnings due to
management performance and transitory
shocks that are beyond managers control (e.g.
foreign currency translation gains and losses),
managers can counteract these effects by
hedging such "accounting^ risks. Even though
hedging is costly, it may be rational because
it reduces information problems that poten-
tially lead to misvaluation (Froot et al. 1991).
Finance policy changes are more costly
than accounting reports for communicating
information on afirm'sperformance. However,
these costly mechanisms may be needed when
financial reporting is inadequate to commu-
nicate the economics of thefirm.^As discussed
earlier, accounting rules sometimes force firms
to report short-term earnings declines from
activities that produce long-term benefits.
Additional disclosure may not be feasible with-
out revealing information that reduces a firm's
competitiveness, as in the case of R&D. Alter-
natively, additional disclosure may not be
credible because the firm does not have a track
record. Managers may then have to rely on
increased cash payouts or financing changes
to indicate their confidence in the realization
of long-term cash flow gains.
Application to Patten Case.
Patten could mitigate the uncertainty on
the quality of its receivables by selling them
to an independent financial institution. If re-
ceivables are sold without recourse, investors
will learn the value placed on them by a third
party. Patten may realize higher value for its
receivables through this independent party
than from public markets because it can share
additional proprietary information with the
buyer. For example, it can provide the buyer
with details on customer demographics, as
well as the company's credit policies and mar-
ket research. Patten may not wish to disclose
this information to public investors for com-
petitive reasons.
^See Healy and Palepu (1992) for a detailed analysis of
c u e International's use offinancialpolicies in inves-
tor communication.
The Effect of Firms' Financial Disclosure Strategies on Stock Prices
Another strategy for Patten's managers to
convince investors that receivables have high
value is to repurchase its stock at a premium
or pay a special dividend. These signals will
be more effective if management simulta-
neously increases its ownership in the com-
pany. Since Patten's managers already own a
significant share of the company, they could
achieve this objective by excluding themselves
from the share repurchase or by receiving ad-
ditional stock. Finally, in the extreme. Patten's
management could elect to take the company
private through a leveraged buyout.
III. IMPLICATIONS FOR
FINANCIAL STATEMENT
ANALYSIS TEACHERS
The financial reporting environment dis-
cussed in section II provides a sound motiva-
tion for teaching financial statement analysis
without contradicting the efficient market
hypothesis. Imperfect monitoring by regula-
tors and auditors creates an opportunity for
financial intermediaries, such as analysts, to
reduce the valuation problem by identifying
mispriced securities (Bernstein 1975). Finan-
cial analysts specialize in developingfirm-and
industry-specific knowledge which enables
them to assess firms' current performance and
their prospects. Analysts help to mitigate
misvaluation problems arising from imperfect
auditing and accounting standards. Analysts'
business and technical expertise differs from
that of auditors. Also, analysts' legal liability
and incentives differ from those of auditors.
Analysts, therefore, can potentially provide
incremental infonnation to investors for valu-
ing their securities.^"
Analysts add value in three ways. First,
they assess the quality of a firm's reported
numbers, and make any necessary adjust-
ments. Here the focus is on judging the effi-
cacy of accoimting rules in refiecting the firm's
underlying economics, and evaluating the ap-
propriateness of management's forecasts im-
plicit in reported accruals. This requires a
thorough understanding ofthe firm's business
and the relevant accounting rules used in the
preparation of its financial reports. Superior
analysts adjust reported accrual numbers, if
necessary, to refiect economic reality, perhaps
by using the cashflowstatement and the foot-
note disclosures.
Second, analysts evaluate a firm's current
performance using ratios and cashflowanaly-
sis. Superior analysis, however, requires rec-
ognition that imperfections in auditing and
accounting standards limit financial state-
ments' ability to fully reflect a firm's economic
performance. As discussed above, accounting
numbers do not capture the benefits of firms'
investments in R&D, quality improvement
programs, and human resource development
on a timely basis. Superior analysts incorpo-
rate these non-financial factors in judging the
firm's performance.
Third, financial analysts forecast a firm's
future prospects and estimate its value. This
exercise requires an understanding of modem
finance theory and valuation techniques. Here
again, analysts are not limited by accounting
conventions and auditing constraints.
Application to Patten Case
The stock market reaction to Forbes' re-
port on Patten's business and financial reports
shows that financial analysis can have a sub-
stantial economic efFect. Because there is un-
certainty about the assumptions underly-
ing Patten's reported performance, investors
make probabilistic assessments on the qual-
ity of earnings in determining stock prices.
Any events that cause revisions in these prob-
ability assessments, such as criticism of
management's accounting assumptions by in-
dependent analysts, will affect stock prices.
If a firm's audited financial statements report
low bad debts and analysts subsequently dis-
agree with this assessment, the firm's stock
price will decline. This explains why there is
a strong market reaction to Forbes' criticism
of Patten's accounting. Forbes' criticism will
affect Patten's stock price as long as there is
*°See Davies and Canes (1978) and Lys and Shon (1991)
for evidence that financial analysts' recommendations
provide new information to investors.
8 Accounting Horizons I March 1993
a positive probability that its analysis is cor-
rect and not already known by investors.^^
The market reaction to Forbes' accounting
critique of Patten is not unique. Foster (1979,
1985) dociunents that financial analyses by
Abraham Briloff also produce dramatic equity
value changes, even though Briloff relies
largely on public data. Further, the ability of
investors such as Warren Buffett to identify
undervalued stocks using public data is well
documented in the financial press.
IV. IMPLICATIONS FOR
EMPIRICAL RESEARCH ON
DISCLOSURE
Empirical research on financial reporting
has typically followed either an efficient mar-
kets or a contracting approach. These studies
can, in part, explain how earnings and stock
returns are related and how contracts influ-
ence managers' financial reporting decisions.
However, they provide little evidence useful
to managers in forming disclosure strategies
to communicate effectively with investors.
Consequently, as discussed in the beginning
of this paper, current research does not ad-
equately address managers' financial report-
ing concerns. The financial reporting environ-
ment discussed in this paper suggests several
avenues for future research to address this
limitation.
As discussed in section III, voluntary dis-
closure is one potential management response
to valuation problems in public markets. Fu-
ture research is needed to understand: (1)
What types of voluntary disclosures do firms
provide — which are credible and which are
not? (2) How does voluntary disclosure affect
analyst and institutional investor interest in
the firm? (3) How does voluntary disclosure
affect a firm's cost of capital?^^
Accounting standards also play an impor-
tant role in facilitating managers' communi-
cation with investors. It would be useful for
future research to focus on understanding
what types of standards are effective in per-
forming this role. For example, is communi-
cation more effective when standards are de-
tailed but rigid, as in the US, or is it more
effective to have broad guidelines, leaving
managers with considerable reporting discre-
tion?
The information perspective may also be
useful in fiirther extending our understand-
ing of earnings management incentives. While
the contracting literature has provided use-
ful evidence in this respect, many manage-
ment decisions remain unexplained
(Holthausen and Leflwich 1983; Watts and
Zimmerman 1990). For example, Palepu
(1987) shows that it is not possible to fully
explain accounting decisions made by
Hamischfeger Corporation using the contract-
ing framework alone. Holthausen (1983), Ber-
nard and Foster (1989), Healy and Palepu
(1990), and DeAngelo et al. (1992) find that
debt contracts do not explain many firms' ac-
counting decisions. Contracting theories also
cannot explain Skinner's (1992) findings that
firms voluntarily disclose bad news. The in-
formation environment discussed in this pa-
per provides one potential avenue for under-
standing further managers' accounting deci-
sions.
"Tax and contracting explanations for the stock price
decline appear to be less applicable than the informa-
tion explanation. Patten's bad debt estimate has no
tax implications, because for tax purposes revenues
are recognized on a cash basis. Contracting theory
argues that stock prices could decline if Forbes disclo-
sures led Patten's creditors to require the firm to
change their method of accounting for real estate
transactions, increasing the likelihood of technical vio-
lation of debt covenants. Patten could then be required
to renegotiate its outstanding debt at less favorable
terms. However, the cost of debt contract renegotia-
tions have to be approximately $20 million, the change
in market value of equity when Forbes' critique was
published. This is implausible given that Patten had
only $12 million of long-term and short-term debt out-
standing. Management bonus compensation may also
be aflFected by Forftes'disclosures. However, if the com-
pensation committee responds to the critique by re-
quiring managers to change the method of account-
ing for real estate transactions, executives' compen-
sation will decline, leading to a stock price increase,
not a decrease.
i^or examples of empirical research on voluntary dis-
closure see Lang and Lundholm (1992) and Skinner
(1992).
The Effect of Firms' Financial Disclosure Strategies on Stock Prices

V. CONCLUSIONS ing considerable room for managers to reflect

In this paper we examine why rational
managers would be concerned about the ef-
fect of financial reporting decisions on firm
value, even when capital markets are semi-
strong form efficient. We assume that there
is an information asymmetry between man-
agers and outside investors. Investors who do
not actively participate in firms' corporate
governance rely on financial statements to
value their claims because accounting data
potentially reflect managers' proprietary busi-
ness information. However, because manag-
ers have incentives to bias the numbers in
their self interest and to conceal proprietary
information from competitors, it is difficult for
managers to credibly communicate their firms'
current performance and future prospects to
investors.
Two well-known institutional mechanisms
mitigate the "information gap" between man-
agers £ind outside investors. First, accounting
conventions and standards restrict meuiagers'
ability to distort financial data while still leav-
their superior knowledge of their businesses.
Second, auditors increase the credibility of fi-
nancial statements by verifying management
estimates. These mechanisms, however, are
imperfect and do not fully resolve the infor-
mation gap between managers and outside
investors.
We argue that managers can improve their
communication with investors by developing
disclosure strategies. Voluntary disclosures
can help investors understand managers' busi-
ness strategies. Managers can also reinforce
the credibility of their financial disclosures by
choosing financing, payout and hedging poli-
cies that complement their reporting strate-
gies.
The financial reporting environment dis-
cussed in this paper provides a sound motiva-
tion for teaching financial statement analysis
without sacrificing the efficient market hy-
pothesis. Finally, it points to several avenues
of future research on voluntary and manda-
tory disclosure.

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