Financial Reporting Quality and Voluntary Disclosure:
Evidence from Internal Control Weaknesses
William Floyd∗
Stanford Graduate School of Business
Latest version available at: stanford.box.com/floyd-jmp
January 6, 2016
Abstract
I explore how changes in investors’ financial reporting quality expectations influence
managers’ voluntary disclosures. I use the auditor’s evaluation of internal controls,
provided in the Form 10-K, as a source of variation in investors’ financial reporting
quality expectations. An internal control weakness (ICW) indicates an elevated risk
of material misstatement. I examine the disclosures provided in the Management’s
Discussion and Analysis section of the Form 10-K. Consistent with changes in financial
reporting quality expectations influencing managers’ incentives to provide additional
disclosures, I find that disclosure increases are higher in years with a new ICW and
lower in years following the resolution of an ICW. I use text analysis to link accountspecific disclosures to the source of the ICW. Finally, looking at bid-ask spreads around
Form 10-K filings, I find evidence that additional disclosures attenuate the negative
information environment effects of an ICW.
∗
I thank my dissertation committee, Maureen McNichols (chair), Ivan Marinovic, and Joe Piotroski for
their insightful feedback and guidance, as well as Rob Daines, Lisa De Simone, Kurt Gee, Rimmy Tomy, and
workshop participants at Stanford GSB for helpful comments.
1
Introduction
How do investors’ financial reporting quality expectations influence managers’ voluntary
disclosures? Managers shape the information environment of their firm through a combination
of mandatory and voluntary disclosures.1 The discretionary nature of the latter has inspired
a long literature in accounting that seeks to understand the frictions and incentives that
influence a manager’s choice to provide information in excess of that required in regulatory
filings (e.g., Healy and Palepu 2001; Beyer et al. 2010). An overarching goal of disclosure is
to address information asymmetries between managers and outside parties. In particular,
if mandatory disclosures do not sufficiently address information problems, a manager may
have greater incentive to make additional voluntary disclosures. With this relation in mind, I
examine how investors’ expectations of financial reporting quality influence the voluntary
disclosures that managers provide alongside financial statements in Management’s Discussion
and Analysis (MD&A).
I use the auditor’s annual assessment of internal controls, mandated for accelerated filers
by Section 404 of the Sarbanes Oxley Act of 2002 (SOX 404), as a source of within-firm
temporal variation in investors’ financial reporting quality expectations.2 Internal controls
over financial reporting serve as safeguards within the firm to prevent erroneous information
from flowing through into the financial statements. The high-profile accounting restatements
of the early 2000s, in which misstated accounting numbers led to billions in investor losses
and broad concerns over the reliability of accounting information, highlighted the importance
of well-functioning internal controls. In response, Section 302 of the Sarbanes-Oxley Act
required that management evaluate and report on the effectiveness of their internal controls
on a quarterly basis, while Section 404 further mandated that accelerated filers have their
assessment of internal controls audited by an independent auditor on an annual basis. If,
1
The information environment of the firm is a function of the quality and quantity of information about
the firm that is available to investors
2
The SEC defines accelerated filers as firms with a public float greater than $70 million
1
in the process of evaluating internal controls, the auditor finds design or implementation
flaws that make a material misstatement at least reasonably possible, they must report this
internal control weakness (ICW) to investors.
The presence of an ICW damages the credibility of aggregate accounting amounts and
negatively impacts the information environment. Investors are rationally hesitant to rely on
potentially misstated numbers for valuation purposes.3 Firms announcing ICWs experience
negative abnormal returns (e.g., Beneish et al. 2008). Accruals quality is lower in the
presence of an ICW and higher following its resolution (Ashbaugh-Skaife et al. 2008). Lenders
reduce their use of accounting-based covenants following an ICW (Costello and WittenbergMoerman 2011). Consistent with damage to the information environment, prior literature
has documented a higher cost of capital for firms following the disclosure of an ICW (e.g.,
Ashbaugh-Skaife et al. 2009; Dhaliwal et al. 2011).
While the characteristics of, and consequences for, firms receiving ICWs have been welldocumented, less is known about how firms respond to, and perhaps attenuate, this damaged
reporting credibility. This relative lack of evidence stands in contrast to empirical and
theoretical disclosure literature that suggests managers may attempt to address shortcomings
of mandatory disclosures with additional voluntary disclosures. A common element of classical
models of disclosure is a threshold strategy for disclosure due to some friction, in which
managers disclose favorable information only if the benefits of disclosure exceed the costs
of overcoming the friction (e.g., Verrecchia 1983). As such, investors cannot assume that
any undisclosed information was unfavorable. This threshold is a function of how disclosure
and non-disclosure, respectively, are interpreted by investors. In such models, this threshold
is lower when the information environment is poorer (i.e., investors’ prior beliefs are less
precise). Greater uncertainty leads investors to assign a higher likelihood that withheld
disclosure is unfavorable, resulting in a higher probability of disclosure (e.g., Verrecchia 1990).
In other words, in poorer information environments, non-disclosure is relatively more costly
3
Average restatement announcement returns can range from -2 to -20 percent, depending on the size and
nature of the misstatement (e.g., Palmrose et al. 2004; Hennes et al. 2008)
2
for the manager, as investors will price the firm lower. Similarly, in stronger information
environments, non-disclosure is relatively less costly for the manager. It is this intuition that
guides my main predictions: that firms will have greater incentive to increase disclosure when
receiving a new ICW and less incentive to increase disclosure when resolving an ICW. This,
however, requires that the credibility of the manager’s private information is not relatively
more impacted by the ICW than the credibility of the financial statements, as voluntary
disclosures must be credible enough for investors to be sufficiently responsive to them and
justify their issuance (e.g., Verrecchia 1990).
The annual evaluation of internal controls by the auditor offers several advantages as
a proxy for financial reporting quality expectations.4 First, investors cannot observe the
internal controls of the firm and rely on the auditor’s annual assessment in forming their
expectations. Second, while managers endogenously choose the quality of their internal
controls, the revelation of this private information through the SOX 404 opinion is the
choice of the auditor.5 Third, while some firms with weaknesses in controls, as evidenced
by subsequent restatements, do not receive preemptive ICWs (Rice and Weber 2012), it is
expected that ICWs are accurate for the firms which they do identify (i.e., low Type I error).
Finally, the discrete and binary nature of the annual opinion, indicating the presence or
absence of a material weakness, provides a 2x2 design for comparing year-over-year changes.
Firms that receive a new ICW in the current year will have lower financial reporting quality
expectations relative to the prior year, while firms that resolve an ICW in the current year
will have higher financial reporting quality expectations. It is assumed that firms maintaining
strong internal controls or failing to resolve an ICW maintain a similar level of financial
reporting expectations from one year to the next, conditioned on the auditor’s assessment.
To observe managers’ voluntary disclosures, I examine the quantitative content provided
4
For discussion of proxies for earnings quality and financial reporting quality see Dechow et al. (2010) and
Defond and Zhang (2014)
5
Managers can preempt this revelation in their quarterly SOX 302 assessments. As I examine year-over-year
changes in the 10-K, it does not matter if a SOX 404 ICW is affirming a SOX 302 weakness disclosed in
an previous interim period or reporting a new weakness. It only matters that this weakness was not public
knowledge at the time of the filing of the prior Form 10-K.
3
in the MD&A. Following recent literature (e.g., Blankespoor 2014; Lundholm, Rogo, and
Zhang 2014), I examine the extent of quantitative disclosure with the assumption that
these represent ex post verifiable disclosures which add context and support to the financial
statement amounts, thereby improving the overall information set of investors. This is in
contrast with the recent perspective on qualitative content, which has suggested longer
and more complex text may obfuscate rather than inform (e.g., Li 2008; Bloomfield 2008;
Loughran and McDonald 2014).
For my analysis, I examine year-over-year changes in the quantitative content of MD&A
for a large sample of accelerated filers receiving SOX 404 opinions for fiscal years 2004-2013.
I focus on MD&A as this represents the most immediate and direct voluntary disclosure
channel to address an ICW, included alongside the financial statements and internal control
opinion in the Form 10-K filing. While the inclusion of an MD&A section itself is mandatory
and the SEC offers guidance on topics to address, the content is largely at the discretion
of the manager. A changes specification avoids the influence of an upward time-trend in
the amount of disclosure provided in the 10-K (e.g., Li 2008) which could confound the
interpretation of elevated disclosure in a levels specification. Examining changes in disclosure
also allows me to use each firm as its own control, comparing its current level of disclosure
under current financial reporting quality expectations to that in the prior period under
a potentially different level of financial reporting quality expectations. This controls for
time-invariant aspects of the firm that affect observed levels of disclosure, including those
that are unobservable or difficult to include as controls (e.g., managerial preferences).
Consistent with my predictions, I find that firms increase quantitative disclosures relatively
more when receiving an ICW and relatively less when resolving it. Relative to an intercept of
9.3%, ICW firms, on average, incrementally increase disclosure by an additional 3.6% in the
year of the weakness. Conversely, when resolving an ICW, firms, on average, incrementally
increase disclosure by 3.9% less. Consistent with changes in expectations driving disclosure
responses, I find no evidence of incremental disclosure changes by firms who maintain low
4
financial reporting quality expectations with an ICW that continues into the current year.
Finally, I find that this pattern is evident for quantitative disclosures provided both within
the text and in supporting tables.
A common challenge for any voluntary disclosure study is attributing observed disclosures
to changes in incentives rather than changes in the information set available to disclose. In
particular, ICWs can coincide with other corporate events that impact the information set of
the manager, potentially affecting the amount of observed disclosures even in the absence of
any change in incentives. My approach to addressing this threat to my inferences is three-fold.
First, in my main changes analysis, in addition to controls for changes in firm characteristics,
I include controls for events such as restructurings, acquisitions, and restatements, as well
as year fixed effects to control for macro shocks. Second, I repeat this analysis of disclosure
changes in the year of an ICW with a propensity score matched sample. Recognizing that
ICWs are not randomly assigned, and factors that influence ICWs may influence disclosure, I
replicate my analysis with a matched sample of control firms that do not receive an ICW yet
are observationally similar to ICW firms along the many dimensions that predict ICWs.
Lastly, I include two analyses that highlight the association of disclosure incentives with
the observed disclosure responses. First, I use text analysis to identify disclosures specific
to accounts (e.g., revenue, costs of good sold) and examine how these disclosures change
for firms that do and do not report a weakness specific to that account. Consistent with
managers targeting the source of misstatement risk, I find that ICW firms make incremental
changes to account-specific disclosures only if that account is the source of the ICW. In
additional analysis, I find that disclosure responses are stronger for firms at a greater risk of
disclosure litigation.
I conclude with an analysis of the economic consequences of increased disclosure with
ICWs. Specifically, I examine changes in the extent to which bid-ask spreads tighten around
the filing of the Form 10-K. Consistent with ICWs negatively impacting the information
environment, bid-ask spreads tighten relatively less with a new ICW and relatively more
5
following its resolution. When interacting the change in quantitative disclosure with the
indicator for a new ICW, I find marginally significant evidence that increased disclosure does
indeed attenuate the negative impact. This suggests that managers are able to attenuate the
information environment damage through additional disclosure.
My results make several contributions. First, I contribute to the literature on financial
reporting quality and disclosure, demonstrating how firms handle a distinct shock to perceptions of their financial reporting quality. My setting offers the advantage of observing
increases and decreases in financial reporting quality expectations over time for the same
firm. Second, my study also highlights the importance of verification mechanisms, specifically
internal controls, in providing credibility to aggregate numbers, potentially limiting the
need for additional supporting disclosures and shaping the information environment of a
firm. My study highlights a benefit to firms from well-functioning internal controls that
produce credible aggregate accounting numbers. As the audits of internal controls have been
controversially costly, particularly for smaller firms, demonstrating this impact on disclosure
highlights a benefit for consideration. Lastly, my study contributes to the literature on
internal controls by exploring how managers respond to, and may attenuate, the negative
consequences of an ICW. This study therefore provides a more complete assessment of how
ICWs impact the information available to investors.
2
Related Literature and Hypotheses
This paper is motivated by the literature on internal control weaknesses and a consideration
of the findings from this literature in the context of a rich literature on voluntary disclosure
incentives. Internal controls enhance financial reporting quality by providing assurances
that the accounting amounts do not contain material misstatements. Credible financial
statements serve as an integral reference for stakeholders and play a central role in shaping
6
the information environment of the firm.6 Managers also play an active role in shaping the
information environment through voluntary disclosures. As such, I explore how variation in
the credibility of financial statements, and therefore variation in their contribution to the
information environment, affects managerial disclosure decisions.
2.1
Internal Control Weaknesses
In response to the high profile restatements of the early 2000s, the U.S. Congress passes
the Sarbanes-Oxley Act of 2002. Perhaps the most controversial aspect of this legislation
pertained to internal controls. While firms had been required to maintain internal controls
prior to the legislation, SOX further required firms to provide investors with assurances
of their effectiveness.7 Section 302 of the Sarbanes-Oxley Act required that management
evaluate and report on the effectiveness of their internal controls on a quarterly basis, while
Section 404 further mandated that accelerated filers have their assessment of internal controls
audited by an independent auditor on an annual basis. In particular, the costs of SOX
404 compliance have been much debated, as some have have argued they are especially
burdensome for smaller firms (e.g., Illiev 2004).
Subsequent empirical literature has found that ICWs are informative about the quality of
accounting information and have negative consequences for the disclosing firms. AshbaughSkaife et al. (2008) find that ICWs are associated with decreases in accruals quality, while the
resolution of ICWs is associate with an increase in accruals quality. Costello and WittenbergMoerman (2011) find that lenders rely less accounting-based debt covenants following an
ICW, while Dhaliwal et al. (2011) find that firms face a higher cost of debt following an ICW.
Consistent with investors assessing a higher information risk, Ashbaugh-Skaife et al. (2009)
document that firms face an increased cost of equity capital following an ICW and a decreased
6
In addition to providing information to investors, credible financial statements serve to verify and
discipline previous disclosures (e.g., Ball et al. 2012).
7
Under the Foreign Corrupt Practices Act of 1977, firms are required to maintain internal controls that
protect corporate assets and facilitate GAAP reporting.
7
cost of equity capital following its resolution8 . Collectively, these results suggest that ICWs
are indicative of lower quality accounting information and therefore a poorer information
environment. As such, this paper explores whether managers attempt to attenuate this
damage with additional voluntary disclosures.
2.2
Voluntary Disclosure
The voluntary disclosure literature in accounting builds off the unraveling result (Grossman
1981; Milgrom 1981). The unraveling result predicts that, absent frictions, managers voluntarily disclose all of their private information, as investors rationally infer that any withheld news
is unfavorable. Recognizing that managers, in practice, appear to withhold some information,
subsequent work has explored specific frictions that impede full unraveling. One prominent
friction offered is the presence of disclosure costs, either in assembling and communicating
the information or in the proprietary nature of the information itself (e.g., Verrecchia 1983,
Dye 1986). In the presence of such costs, investors cannot rationally infer whether a firm is
withholding information because it is unfavorable or it is too costly to disclose. The disclosure
decision for a particular information item in the presence of frictions is thus influenced by
its impact on the information environment. That is, the disclosure decision depends on how
investors interpret their information set following disclosure and non-disclosure, respectively.
In such models, the threshold for disclosure is lower when the information environment is
poorer, as investors assign a higher likelihood that the information was unfavorable and
price the firm lower following non-disclosure, resulting in a higher probability of disclosure
(e.g., Verrecchia 1990). In other words, in poorer information environments, non-disclosure
is relatively more costly for the manager. Similarly, in stronger information environments,
non-disclosure is relatively less costly for the manager. It is this intuition that guides my
main predictions: that managers will have greater incentives to make additional disclosures
when financial reporting quality is weaker, and weaker incentives when financial reporting
8
Ogneva et al. (2007), however, do not find a significant association with cost of capital
8
quality is stronger.
Prior empirical literature finds evidence that managers attempt to use voluntary disclosures
to address information environment problems stemming from their financial reporting, arising
both from firm characteristics and external shocks to credibility. Lang and Lundholm (1993)
find that firms with a low correlation between earnings and returns, a proxy for how well
earnings capture changes in economic value, have higher disclosure ratings by analysts.
Further work has found firms with less informative earnings are more likely to host conference
calls (Tasker 1998; Frankel et al. 1999), include balance sheet data in press releases (Chen
et al. 2002), and offer more pro-forma earnings amounts (Lougee and Marquardt 2004).
Schrand and Leuz (2009) find that firms responded to transparency concerns in the wake
of the Enron scandal with additional disclosure, attenuating negative cost of capital effects.
In recent work, Guay et al. (2015) find that firms with more complex financial statements
provide additional voluntary disclosures, in the form of management forecasts, to mitigate
negative effects on the information environment.
The preceeding theoretical and empirical literature presents strong evidence that a manager
will address information environment problems with additional disclosure. However, this
ability depends on the quality of his private information, as investors are less responsive
to less precise signals, reducing the probability of disclosure (e.g., Verrecchia 1990). In the
case of an ICW, the manager’s private information, some of which may also be a product of
the imperfect accounting system, may also be less credible. Consistent with this, Feng et al.
(2009) document that earnings guidance provided by firms during periods with ICWs is less
accurate. Recent work has also found that managers make suboptimal operating decisions in
periods with ICWs, consistent with less accurate internal information (e.g., Cheng et al. 2013;
Feng et al. 2015). As such, the manager may be limited in his ability to address information
problems with additional disclosures.
Even though the manager’s private information may also be affected by the ICW, that
does not, however, mean that investors would not benefit from its disclosure. So long as
9
the mandatory disclosure is not a sufficient statistic for the manager’s private information,
communicating all its information with greater precision, then any voluntary disclosure of
this information by the manager will have information content for investors. The extent to
which investors use this information is directly related to its credibility (e.g., Holthaussen and
Verrecchia 1988). While an ICW may also indicate a lower level of precision in the manager’s
private information, it is the assumption of this analysis that this loss in credibility does
not exceed that of the mandatory disclosure. For example, following a revenue recognition
ICW, the manager may have information on store openings or product shipments that, while
revenue related, is less susceptible to the revenue recognition concerns, and would thus be
valuable to investors attempting to gauge the true economic performance of the firm in that
period.
To summarize, the presence of an ICW may result in a poorer information environment,
which may provide the manager with incentives to increase voluntary disclosure in response,
though the extent to which the manager is limited by reduced credibility of his private
information is unclear. Recall that prior literature documents a trend of increasing disclosure
over time. I therefore frame my hypothesis in terms of relative increases in voluntary disclosure
following changes in ICWs.
H1a. Firms increase disclosure more when receiving an ICW
In the preceding discussion, managers are predicted to have less incentive to make voluntary
disclosures in better information environments. This does not, however, suggest that they
will cut back on previously issued disclosures following the resolution of an ICW, as this is
generally assumed to be costly. Einhorn and Ziv (2008) show that managers consider the
implications of providing a disclosure in future periods when deciding whether to make it in
the current period, as the issuance of a disclosure is an implicit commitment to maintain this
disclosure. The survey evidence of Graham et al (2005) supports this assumption of disclosure
precedents, as managers state that they make voluntary disclosures to reduce information
risk, while trying to avoid disclosures that will be difficult to maintain. The combination of
10
having increased disclosures in the ICW period, along with the reduced incentive to disclosure
any additional private information leads me to predict that firms resolving an ICW will be
less likely to increase disclosure.
H1b. Firms increase disclosure less when resolving an ICW
ICWs often pertain to specific accounts. In the event that an account-level weakness is
cited, this provides a particular source of the weakness in the information environment. If
incentives to address information problems are driving disclosure behavior, I should find that
firms with specific account ICWs focus their disclosures on that account, while firms with
other ICWs do not adjust their disclosures to that particular account. As such, I predict that
the source of an ICW is associated with the disclosure changes.
H2. Firms adjust disclosures specific to the source of the ICW
In general, greater information asymmetry may compel investor to engage in more costly
private information acquisition and be more wary of trading with better informed parties,
which can lead to a higher cost of capital and/or reduced share liquidity (Diamond 1985;
Diamond and Verrecchia 1991). Consistent with ICWs affecting information asymmetry,
Ashbaugh-Skaife et al. (2009) find that firms face an increased cost of capital following an
ICW and a reduced cost of capital following its resolution. I hypothesize that managers make
additional disclosures to address this information asymmetry, which should attenuate the
negative information environment impact of an ICW. However, as stated previously, it is
unclear the extent of credibility damage to the private information of the manager. As such,
while managers may make additional disclosures in hopes of attenuating the effects of the
ICW, it is unclear the extent to which investors will find these disclosures credible and use
them.
H3. Increasing disclosure attenuates the negative effects of an ICW on the
information environment
11
3
Sample Selection, Data, and Descriptive Statistics
3.1
Sample Selection
For my analyses, I examine firm-years for accelerated filers with data availability on Compustat,
CRSP, and SOX 404 opinion data from Audit Analytics. I further require data availability
on institutional ownership from ThompsonReuters, and incorporate, but do not require, data
on analyst coverage on IBES. Lastly, I lose some firm-years for which an MD&A section is
not identifiable using text parsing procedures. Consistent with prior disclosure literature, I
also exclude firm-years with 4 digit SIC codes 4900-4999 (utilities) and 6000-6999 (banks), as
their regulatory environment provides different disclosure incentives than those of industrial
firms. This results in a sample of 12,952 firms-years from fiscal year 2004 to 2013.
Table 1 provides the distribution of firm-years and ICW statuses. New ICW firms are
those in which there was not an ICW in the prior year. To maximize the amount of ICW
firm-years in my sample, I count firms receiving an ICW in fiscal year 2004, the first year of
internal control audits, as new ICWs, even though an auditor’s opinion did not confirm the
lack of a weakness in the prior year.9 ContICW firm years are those in which an ICW was
present in both the prior and current years. F ixICW firm years are those in which the firm
reports auditor confirmation of the resolution of an ICW from the prior year. Consistent with
observed trends in ICWs, my sample has relatively more observations in the earlier years. In
general, ICW rates, as indicated in N ewICW have decreased over time since 2004.10
9
I also have slightly fewer firm-years in 2004, as SOX 404 audits became mandatory for fiscal years ending
after November 15, 2004
10
While this may represent firms resolving initial weaknesses and learning how to better maintain wellfunctioning controls over time, there is also concern that it is also evidence of material weaknesses going
undetected or unreported (e.g., Rice and Weber 2012)
12
3.2
Data
To proxy for voluntary disclosure, I examine the content of the Management Discussion
and Analysis (MDA) section of the 10-K. For many disclosure purposes, the MDA is not a
timely source of information; however, in the case of an auditor’s opinion on internal controls,
included in that same 10-K, it represents one of management’s most immediate and direct
voluntary disclosure channels. From a design perspective, it also offers the advantage of
being a required disclosure, but one whose content is largely at the discretion of management.
The SEC instructs managers to use MDA to help investors “see the company through the
eyes of management”, provide the context within which financial information should be
analyzed, and provide information to assist investors in understanding the implications of
current performance in projecting future performance (SEC 2003).11 As such, it provides
an appropriate disclosure channel through which managers may address financial reporting
quality issues.
To construct my quantitative disclosure measures, I retrieve firms’ Form 10-Ks from
EDGAR. A Python program extracts the MD&A and prepares the text for analysis.12 Unlike
many studies that examine the MD&A, particularly those focused on readability, I do not
discard tables, as the quantitative disclosure content provided in these tables is the large
component of my analyses. I also require that the identified MD&A text contains at least
500 words and 50 numbers. When counting numbers, I exclude years and dates. Any residual
non-relevant numbers (e.g., page numbers) represent measurement error in my proxy. To the
extent that this measurement error is time invariant within-firm, it is differenced out in my
changes analysis.
11
Brown and Tucker (2011) present evidence that firms with larger economic changes modify their MD&A
more and the stock price responses to the 10-K filing are positively associated with the extent of MD&A
modification
12
I extract the portion contained within Item 7. Management’s Discussion and Analysis, ending at Item 8.
Financial Statements and Supplementary Data, with various steps in place to avoid misidentification from
references to these sections in other parts of the filing.
13
3.3
Descriptive Statistics
Table 2 presents summary statistics for my firm-year sample. While my analyses use changes,
I also present levels for descriptive purposes. By examining accelerated filers, I am looking at
a sample of relatively larger firms by construction; this is evident in the mean log assets of
6.785, which translates to roughly $884 million. The mean log number count, logN um, is
6.266, which translates to roughly 525 numbers provided in the MD&A.
Table 3 presents correlations. Consistent with intuition, changes in the amount of
quantitative disclosure in MD&A, ∆logN um, is positively associated with changes in firm size
(∆logAssets), earnings volatility (∆EarnV ol), intangibles (∆Intangibles), and R&D expense
(∆R&D). Consistent with greater demand for disclosure, it is also positively associated
with changes in institutional ownership (∆Inst), while consistent with improvements in the
information environment from other information providers, it is negatively, albeit weakly,
associated with changes in analyst coverage (∆logN umEst).
4
Research Design and Results
4.1
Changes in Reporting Quality Expectations and Disclosure
The binary nature of the auditor’s annual assessment of internal controls under SOX 404(b),
either providing an unqualified opinion on internal controls (i.e., No ICW) or indicating
a material weakness (i.e., ICW), along with its joint issuance with the MDA provides an
amenable 2x2 design for examining year-over-year changes in the disclosure, as illustrated
below:
Year-Over-Year Changes in ICW Status
ICWt
N oICWt
ICWt−1
ContICW
F ixICW
N oICWt−1
N ewICW
-
14
With the assumption that investors use the auditor’s assessment of internal controls
in generating expectations of financial reporting quality, it is possible to make directional
predictions on belief revisions, illustrated below, where Fd
RQ represents investors’ financial
reporting quality expectation. In particular, investors are assumed to revise their financial
reporting quality expectations downward when observing a N ewICW . Similarly, investors
are assumed to revise upward their financial reporting quality expectations when observing
the resolution of a prior weakness, F ixICW . When an ICW continues from one year to the
next, conditional on the auditor’s assessment, investors are assumed to maintain a low level
of financial reporting quality expectations. Similarly, for the large majority of firms that do
not report an ICW in the current or prior years, conditional on the auditor’s assessment,
investors are assumed to maintain the same level of financial reporting quality expectations.
Hypothesized Changes in Expectations
ICWt−1
N oICWt−1
ICWt
N oICWt
-
∆Fd
RQ > 0
∆Fd
RQ < 0
-
Unviariate results are consistent with my hypothesis that changes in financial reporting
quality expectations influence changes in disclosure, and more specifically that firms increase
disclosure more when receiving a new ICW and increase disclosure less when resolving an ICW.
In the table below, I present the change in the log of the MD&A number count. Consistent
with a general upward trend, firms without ICWs in either period increase disclosure, on
average, by about 3%. In support of the role of changes in financial reporting quality
expectations, firms that maintain an ICW, and therefore sustain lower expectations, also
increase disclosure year-over-year, on average, by about 3%. Firms reporting a new ICW,
however, increase disclosure, on average, by around 9%, while firms resolving an ICW, on
average, do not increase disclosure year-over-year.
Mean Change in Log Number Count
15
ICWt
N oICWt
ICWt−1
.03
.00
N oICWt−1
.09
.03
The extent of inferences that can be drawn from these univariate results is, of course,
limited by the many other economic changes associated with ICWs that could drive disclosure
behavior. To control for other determinants of disclosure, I incorporate this 2x2 design into a
regression specification. I examine the relation between changes in financial reporting quality
expectations and changes in voluntary disclosure by estimating regressions of the form:
∆logN umi,t =α + β1 N ewICWi,t + β2 ContICWi,t + β3 F ixICWi,t + ∆Controlsi,t + i,t
(1)
In equation (1) above, the coefficients on the respective ICW statuses capture the
incremental change in quantitative disclosure relative to the baseline of firms with no
weaknesses in the current or prior year. That is, do the univariate differences between
disclosure changes for firms with new or resolved ICWs and firms without ICWs in either
period persist in a multivariate analysis. Hypothesis 1a predicts a positive coefficient on
N ewICW , while hypothesis 1b predicts a negative coefficient on F ixICW .
I control for various changes in firm characteristics and economic events that prior literature
has found to influence disclosures. To proxy for changes in the amount of information available
to a manager for disclosure, I include the change in firm size, ∆logAssets. To proxy for
changes in the other parties shaping the information environment of the firm, I include the
changes in the number of analyst estimates, ∆logN umEst, institutional ownership, ∆Inst,
and the ratio of debt-to-assets, ∆Leverage. To proxy for changes in uncertainty, I include the
change in earnings volatility, ∆EarnV ol. To control for changes in performance, I include
both year-over-year earnings growth, ∆Earnings, and revenue growth ∆Sales. I also include
the stock return over the fiscal year, Return, and an indicator for loss years, Loss. To
control for changes in items that may warrant greater disclosure, I include the changes in
16
intangibles, ∆Intangibles, and research and development expense, ∆R&D. Lastly, to control
for corporate events that may influence disclosure, I include indicators for the presence of
restructuring costs, Restruct, acquisitions, Acquisition, and restatements announced during
the prior year up to the Form 10-K filing date, Restate. To control for macro shocks and
industry differences in disclosure trends, I include year and industry fixed effects. Further
detail on variable definitions and measurement is available in Appendix A.
Table 4 presents the main results. In column 1, the change in the log of the MD&A
number count is regressed on ICW status indicators and control variables. Consistent with
hypothesis 1a, the coefficient on N ewICW is positive and significant. This indicates that
firms experiencing a reduction in their financial reporting quality expectations through an
ICW increase disclosure, on average, by approximately an additional 3.6% relative to an
intercept of 9.4% for firms experiencing no such revision in expectations. Based on the
average number count of 525 numbers, this represents an incremental increase in disclosure,
on average, of an additional 19 numbers by ICW firms. This moderate difference seems
reasonable in the context of providing additional supporting information pertaining to a
specific misstatement risk.
Further, the coefficient on ContICW is insignificant. While these firms years have low
financial reporting quality expectations, the continuation of an ICW from the prior year
implies no revision in expectations and therefore no incremental disclosure response. Finally,
the coefficient on F ixICW is negative and significant, and implies that the disclosure increase
of firms that resolve ICWs and improve their financial reporting quality expectations is, on
average, approximately 3.9% lower relative to an intercept of 9.4% for firms that do not
experience an ICW in either period. Again, based on a sample average of 525 numbers, this
means that firms resolving ICWs increase disclosure by roughly 20 numbers less than control
firms. This is consistent with these firms having increased disclosure in the prior period, and
thus maintaining that level of disclosure from the N ewICW firm-year, but lacking incentive
to make additional disclosures now that their financial reporting quality concerns have been
17
addressed.
Managers use both textual discussion and supporting tables to convey information to
investors in the MD&A. It is unclear, which, if either, is a preferable channel through which
managers might provide investors with additional disclosure, and likely, a combination of
both is most effective. In columns (2) and (3), I repeat the analysis for the numbers found in
tables, when identifiable, and text, respectively. Inferences are consistent with those from the
aggregate analysis in (1), and demonstrate that managers use both channels in increasing
disclosure. This evidence of disclosure changes in both channels potentially reduces concerns
that concurrent events, such as a restatement, which might predominantly impact one channel
(e.g., financial tables) over the other, could be driving the results.
4.2
Nature of Weakness and Specific Disclosures
One particularly useful aspect of ICWs is that they identify the account (or accounts) that
are the source of the elevated misstatement risk, in cases where the weaknesses are not solely
company-wide.13 Recent work in disclosure has begun to use text analysis to attempt to
identify specific topical disclosures. For example, Merkeley (2011) uses keywords to identify
research and development disclosures. I adopt a similar methodological approach and examine
disclosures specific to two common weaknesses: revenue recognition and costs of goods sold
(COGS). Of the 425 N ewICW observations in my sample, 115 relate to revenue recognition
and 112 relate to COGS. While these represent common ICWs, these accounts are also
important for the forecasting of future earnings, and as such, likely candidates for increased
disclosure.
Similar to Merkeley (2011), I identify a parsimonious list of words and phrases commonly
found in such account disclosures and use their occurrence in sentences and tables in the
MDA to identify the amount of quantitative disclosure pertaining to that account.14 Further
13
Common company-wide ICWs relate to the competency of accounting personnel and quality of internal
accounting systems generally.
14
For example, a sentence that contains the keyword “revenue” is identified as a revenue-related sentence
18
details on the keywords used and process of identifying related disclosures is included in
Appendix B. While this approach is basic in nature, any imprecision in either not fully
identifying account-related disclosures or misidentifying account-related disclosures is likely
to work against my hypothesis.
I predict in hypothesis 2 that any disclosure changes by firms around ICWs will be
focused on the implicated account that is the source of the reduced financial reporting quality
expectations. For my analysis, I partition ICWs based on whether or not they include a
revenue (COGS) weakness and re-estimate equation 1 for the number of revenue-related
(COGS-related) numbers15 . I also include, as a control, the number of non-revenue (nonCOGS) numbers to control for general increases in overall disclosure. This is measured as
the total number count less the number count for disclosures related to the account.
In table 5, column 1 presents the results from estimating changes in revenue disclosures.
Consistent with general increases in disclosure, changes in the amount of revenue-related
disclosures are positively associated with changes in disclosures related to all other accounts.
Consistent with hypothesis 2, firms receiving revenue ICWs increase their revenue disclosures
incrementally more, while firms resolving revenue ICWs increase their revenue disclosures
incrementally less. Also worth noting is the lack of association between non-revenue ICWs
and revenue disclosures, providing supporting evidence that the source of the ICW is the
particular target of disclosure changes.
Column 2 presents the results for cost of goods sold disclosures. Consistent with the main
result, COGS ICW firms increase their disclosures by relatively more in N ewICW , however
they do not appear to exhibit a significant difference in the F ixICW period. Consistent with
the revenue analysis, non-COGS ICW firms do not make noticeable changes to their COGS
disclosures during the weakness period. Collectively, these results provide more evidence in
support of ICWs affecting disclosure incentives.
and any numbers in this sentence are counted as revenue-related numbers. Any table that includes “revenue”
is revenue-related table and any numbers in this table are counted as revenue-related numbers
15
Revenue and COGS weaknesses are identified in Audit Analytics by reason keys 39 and 32, respectively.
19
4.3
Economic Consequences of Increased Disclosure
Lastly, I examine the economic consequences of firms’ disclosure response to an ICW. If ICWs
result in financial statements that are less reliable, they will be less effective at reducing
information asymmetry. If managers seek to compensate for this with additional supporting
disclosures, this may attenuate the effect of the ICW. However, it is also possible that the
ICW sufficiently discredits the manager’s private information and limits the extent to which
any additional disclosures are effective in addressing information problems.
I define a new variable, SpreadImpact, which captures the relative change in bid-ask
spreads from the 10 days prior to the 10-K filing to the 10 days after the 10-K filing, with
negative values indicating that spreads have tightened:
SpreadImpact = log(AvgSpread1,10 ) − log(AvgSpread−10,−1 )
SpreadImpact captures the extent to which bid/ask spreads change following the issuance
of the 10-K. Bid-ask spreads are a common proxy for information asymmetry.
Keeping with my year-over-year changes design, I examine ∆SpreadImpact, which measures the relative change in the ability of the 10-K to address information asymmetry, as
captured by tightening spreads.
∆SpreadImpacti,t =α + β1 ∆logN umi,t + β2 N ewICWi,t + β3 ContICWi,t +
(2)
β4 F ixICWi,t + β5 ∆logN umi,t ∗ N ewICWi,t + ∆Controlsi,t + i,t
I include all controls from my disclosure change model, as well as two additional controls
that may impact spreads. I control for any news in the filing, AbnReturn − F iling, which is
the 3-day abnormal return for the filing date and subsequent two trading days. I also control
for the year-over-year change in abnormal volume around the filing, AbnV olume − F iling,
where abnormal volume captures the extent to which volume around the filing is different
20
from that observed in the prior quarter.
ICWs are expected to reduce the ability of financial statements to address information
asymmetry, and therefore increase SpreadImpact (i.e make it less negative, indicating that
spreads tighten less around the filing of the 10-K). As such, a positive coefficient is predicted
on N ewICW . Similarly, a negative coefficient is predicted on F ixICW . The coefficient of
interest is on the interaction between ∆logN um and N ewICW , which captures the extent to
which increases in disclosure appear to attenuate the impact of N ewICW , with a predicted
negative coefficient.
Table 7 presents the results. The results in Column 1 illustrate the general information
environment effects of ICWs, as the positive coefficient on N ewICW indicates that spreads
tighten relatively less in the presence of a new ICW, while the negative coefficient on
F ixICW indicates that spreads tighten relatively more following the resolution of an ICW.
Also, included in the table is the coefficient on REST AT E, an indicator variable for the
announcement of a restatement during the prior fiscal year. Similar to N ewICW , it has a
positive and significant coefficient. Column 2 provides the test of hypothesis 3 by interacting
the change in disclosure ∆logN um with N ewICW . The negative coefficient on this interaction
term, is marginally significant at the 10% level and indicates that increasing quantitative
disclosure in MD&A may attenuate the impact of the ICW. This also suggests that the
manager’s private information is not discredited by the ICW to the point that it is no longer
informative to investors.
5
Additional Analyses
I now present two additional analyses, focusing on the documented disclosure increase
associated with receiving an ICW. First, I show that this response is robust to the use of
a propensity score matched sample. Second, I explore the role of litigation risk in firms’
disclosure response. By replicating the result in a matched sample and showing that the
21
result is stronger for firms with potentially higher disclosure incentives related to financial
reporting quality concerns, I provide additional evidence that suggests ICWs, rather than
omitted factors, drive the observed results.
5.1
Propensity Score Matched Sample
ICWs are not randomly assigned, and as such, a major concern in this setting is the extent
to which other factors could drive both the issuance of an ICW and changes in disclosure,
thereby confounding inferences. In particular, prior literature has found ICW firms to be
smaller, younger, financially weaker, more complex, high growth, and recently restructured
(e.g., Ge and McVay 2005; Doyle et al. 2007). In my main analysis, I attempt to address
potential differences between ICW and non-ICW firms in two ways. First, by employing a
change specification, I control for time-invariant differences between firms that could influence
observed levels of disclosure. Second, I attempt to control for time-varying differences between
firms through the various variables included in the model. To further address concerns that
differences between ICW and non-ICW firms could drive observed results, following recent
literature on ICWs, I employ a propensity score matched control sample.
In true random assignment, firm characteristics would not be correlated with the likelihood
of receiving treatment. In an attempt to create a sample that resembles random assignment,
propensity score matching identifies particular control firms that are observationally similar
to the treated firms that received ICWs, indicating a similar likelihood of receiving treatment
despite not actually receiving the treatment. This procedure offers the advantage of matching
firms on numerous dimensions (rather than simply industry and size, for example) while
placing minimal restrictions on the functional form that underlies this matching.
Among my sample of ICW firms, I take the first N ewICW firm-year for each firm. My
sample of potential control firm-years is comprised of firms which do not receive a 404 ICW
in any year during the sample period. As matching on the resolution of an ICW is less
clear, I focus my analysis on providing a robustness check disclosure changes in the year
22
of an ICW (i.e., re-examining the coefficient on N ewICW ). This results in sample of 389
N ewICW firm-years and 9,550 potential control firm-years. I estimate a logit model for
the likelihood of receiving an ICW, from which the fitted value is the ”propensity score”.
I include numerous variables from prior literature on the determinants of ICWs. Table 7
presents the results from this estimation. With a pseudo R2 of .16, this model appears to have
reasonable explanatory power, adding credibility to the resulting matches. Each treatment
firm is matched to a control firm with a sufficiently close score, as defined by the caliper,
which I set at the commonly used value of .01. I am able to match 354 ICW firm-years
with control firm-years, with covariate balance, as no explanatory variable has a significance
difference between treatment and control samples.
Table 8 presents a re-estimation of the main model, focusing on disclosure changes in the
year of the new ICW. The coefficient on N ewICW is positive and significant, representing
roughly an incremental 2.5% increase in disclosure due to receiving an ICW in that year.
Consistent with the main results, when using a propensity score matched sample, firms
receiving an ICW still appear to increase disclosure incrementally more to address the
resulting financial reporting quality concerns.
5.2
Impact of Litigation Risk on Disclosure Response
Finally, I explore the influence of litigation risk on firms’ disclosure response. The relation
between disclosure and litigation risk remains an open question in the accounting literature.
Early work hypothesized that the risk of disclosure litigation would incentive managers to
accelerate the disclosure of bad news, in an attempt to minimize the size of the class and
duration of the claims period (e.g., Skinner 1994). Subsequent work, however, found no
support for such benefits to disclosure, and that early disclosure may even invite litigation
(e.g., Francis et al. 1994). While Field et al. (2005) find some evidence that disclosure deters
litigation, Rogers and Van Buskirk (2009) find that firms reduce their disclosure following
litigation.
23
ICWs present an interesting setting in which to further explore this relation with regards to
litigation that may result from a restatement. An ICW represents a distinct acknowledgement
by management that their financial statements may contain errors. It is unclear whether
this early warning, similar to accelerating the disclosure of bad earnings news, might reduce
claims against management in the wake of a restatement, or reduce their ability to plausibly
claim they were unaware of the conditions leading to the restatement. Consistent with the
latter, Rice et al. (2014) find that restatements preceded by an ICW are more likely to face
litigation. With this risk in mind, managers may seek to limit the extent to which they
provide potentially misstated numbers for which they may be held accountable in subsequent
litigation. However, they may also seek to provide shareholders with more transparency, to
limit the extent to which they could be accused of withholding information that could have
allowed investors to see through the misstated numbers earlier.
Following prior literature (e.g., Francis et al. 1994), I define an indicator variable
HighLitigation for firms in SIC codes 2833-2836, 3570-3577, 3600-3674, 5200-5961, and
7370.16 I include HighLitigation in equation 1 and interact it with the ICW indicators to
examine the extent to which an elevated risk of litigation influences disclosure responses.
In untabulated results, the coefficient on the interaction between N ewICW and HighLitigation
is positive and marginally significant at the 10% level (t=1.77), though the power of the test
is somewhat low by splitting the relatively small N ewICW sample. This indicates that firms
in industries with historically high rates of shareholder litigation may increase disclosure
by a greater amount in response to an ICW. This is consistent with managers facing a
greater difficulty justifying withheld information if a control weakness leads to an eventual
restatement. The interaction coefficient on F ixICW and HighLitigation is insignificant.
16
Francis et al. (1994) identify these industries as having a high incidence of disclosure. More recent
litigation samples have continued to find a high incidence of litigation in these industries (e.g., Rogers and
Van Buskirk 2009)
24
6
Conclusion
In this paper, I explore the relation between the financial reporting quality expectations
and voluntary disclosure. In particular, I use the auditor’s annual evaluation of internal
controls, and the identification of material weaknesses, as a source of inter-temporal variation
in these expectations. I hypothesize that managers have stronger incentives to increase
disclosure when their financial reporting quality declines, and weaker incentives to increase
disclosure when their financial reporting quality improves. Consistent with this, I find that
firms increase the amount of quantitative disclosure in their MD&A incrementally more when
receiving an ICW, and incrementally less when resolving an ICW. I find that these disclosures
changes are related to the accounts implicated by the ICW, and that increasing disclosure
appears to attenuate the information environment damage of an ICW. My paper extends the
literature exploring the relation between mandatory and voluntary disclosures, and provides
new evidence on how firms respond to credibility concerns arising from ICWs. My results
provide a more complete picture of how the audits of internal controls, and their impact on
the credibility of aggregate accounting numbers, shape the information environment of the
firm.
25
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31
Appendix A: Variable Definitions
Variable
Definition
Disclosure Analysis (changes relative to prior year)
∆logN um
Change in log of MD&A number count
N ewICW
Indicator for firm-years with a new ICW
ContICW
Indicator for firm-years with an ICW in current and prior year
F ixICW
Indicator for firm-years in which a prior ICW is resolved
∆logAssets
Change in log of total assets
∆logN umEst
Change in log of the number of analyst estimates (from IBES)
∆Inst
Change in the percentage of institutional ownership (from Thompson
Reuters)
∆EarnV ol
Change in earnings volatility, measured as the standard deviation of
earnings before extraordinary items for up to the past 12 quarters
(requiring a minimum of 4 quarters available)
∆Leverage
Change in the ratio of current and long-term liabilities to total
assets
∆Intangibles
Change in ratio of intangible assets to total assets
∆R&D
Change in R&D expense scaled by total assets
∆Earnings
Change in net income scaled by total assets
∆Sales
Percentage year-over-year change in total revenue
Return
Buy and hold absolute return for fiscal year
Acquisition
Indicator for acquisition in fiscal year (Compustat AFNT #1)
Restructure
Indicator for the presence of restructuring costs in the fiscal year
Restate
Indicator for the announcement of a restatement during prior year,
as of 10-K filing date, using Audit Analytics Advanced Restatement
Database
Loss
Indicator for firms reporting a net loss in the fiscal year
32
Bid-Ask Spread Analysis
∆SpreadImpact
Year-over-year change in the SpreadImpact of the 10-K filing, where
SpreadImpact is defined as the mean log bid-ask spread in the 10
trading days following the filing less the mean log bid-ask spread in
the 10 trading days prior to the filing
AbnReturn − F iling
Abnormal return for the three-day period of the filing date and two
subsequent trading days
∆AbnV olume − F iling
Year-over-year change in the AbnV olume − F iling. AbnV olum −
F iling measures the abnormal trading volume around the filing of
the 10-K, where abnormal volume is measured average volume on
days t=0 and t=1 relative to the 10-K filing, less the average daily
volume on days -5 to -50, scaled by the standard deviation of daily
volume on days -5 to -50
Propensity Score Analysis
MB
Market value scaled by total common equity
ROA
Operating income before depreciation scaled by total assets
logSegments
Log of the number of business segments reported in the fiscal year
F oreignSales
Indicator for firms reporting foreign in the fiscal year
Dividend
Indicator for firms paying a cash dividend in the fiscal year
Litigation Analysis
HighLitigation
Indicator for membership in a high litigation risk industry, defined
as SIC codes 2833-2836, 3570-3577, 3600-3674, 5200-5961, and 7370
33
Appendix B: MD&A Text Analysis
Based on the descriptions of revenue and COGS weaknesses provided by Audit Analytics and
the disclosure content of a sample of MD&As, I develop the following parsimonious keyword
lists to identify disclosures related to these accounts:
Revenue Keywords: revenue, sales, margin, product, store, customer, contract, rebate, resale
Cost of Goods Sold Keywords: inventory, vendor, cost of sale, cost of goods sold
I identify individual sentences and tables that contain at least one of the keywords as a
disclosure related to that account. I count the numbers contained in these sentences and
tables to arrive at my measure of account-specific quantitative disclosure.
34
Table 1: Distribution of Firm-Years
Fiscal Year
Firm-Years
N ewICW
ContICW
F ixICW
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Total
944
1,256
1,343
1,286
1,274
1,359
1,375
1,387
1,349
1,379
12,952
110
83
59
41
15
15
13
21
32
36
425
0
23
30
20
13
6
4
3
4
7
110
0
94
83
60
53
24
17
13
15
31
390
This table presents the distribution of sample firm-years across time and ICW status. Sample of firm-years is
comprised of accelerated filers receiving SOX 404 audits with data availability for tests. N ewICW indicates
firm-years reporting a new ICW. ContICW indicates firm-years reporting an ICW continuing from the prior
year. F ixICW indicates firm-years resolving an ICW from the prior year.
35
Table 2: Summary Statistics
Variable
Levels
logN um
logAssets
logN umEst
Inst
EarnV ol
Leverage
Intangibles
R&D
Return
N
Mean
SD
P25
P50
P75
12,952
12,952
12,952
12,952
12,952
12,952
12,952
12,952
12,952
6.266
6.785
1.968
.721
.025
.188
.192
.049
.210
.480
1.557
.795
.233
.034
.190
.195
.087
.557
5.951
5.635
1.386
.578
.006
.002
.023
.000
-.130
6.267
6.653
2.079
.768
.012
.150
.130
.007
.138
6.573
7.778
2.565
.889
.028
.306
.309
.067
.440
Changes
∆logN um
∆logAssets
∆logN umEst
∆Inst
∆EarnV ol
∆Leverage
∆Intangibles
∆R&D
∆Earnings
∆Sales
12,952
12,952
12,952
12,952
12,952
12,952
12,952
12,952
12,952
12,952
.031
.089
.037
.022
-.001
.000
.006
.000
.012
.129
.159
.213
.333
.109
.022
.090
.063
.031
.117
.301
-.048
-.016
-.147
-.033
-.002
-.029
-.013
.000
-.021
-.002
.023
.064
.000
.014
.000
.000
.000
.000
.008
.087
.104
.162
.223
.069
.002
.012
.010
.001
.037
.205
Indicators
Restruct
Acquisition
Restate
Loss
12,952
12,952
12,952
12,952
.352
.184
.152
.227
.478
.388
.359
.419
0
0
0
0
0
0
0
0
1
0
0
0
Market Variables
∆SpreadImpact
AbnReturn − F iling
∆AbnV olume − F iling
12,952
12,952
12,952
.000
.000
.095
.128
.060
2.998
-.033
-.021
-.709
.000
-.001
.014
.032
.021
.787
All continuous variables are winsorized at 1% and 99% levels, except for ∆SpreadImpact, which is winsorized
at 2% and 98% to address additional influential observations. Variable definitions provided in Appendix A.
36
37
Variables
∆logN um
∆logAssets
∆logN umEst
∆Inst
∆EarnV ol
∆Leverage
∆Intangibles
∆R&D
∆Earnings
∆Sales
Return
Restruct
Acquisition
Restate
Loss
1
1.00
0.10
-0.02
0.05
0.05
0.11
0.07
0.03
-0.07
0.09
-0.07
-0.03
0.07
0.03
0.03
1.00
0.17
0.20
-0.14
0.36
0.34
-0.36
0.21
0.43
0.23
-0.17
0.29
-0.03
-0.25
2
4
5
6
7
1.00
0.11 1.00
-0.07 -0.07 1.00
-0.03 0.03 -0.00 1.00
0.02 0.06 -0.21 0.22 1.00
-0.04 0.00 0.06 -0.04 -0.02
0.07 -0.02 -0.11 -0.09 0.02
0.14 0.15 -0.03 0.06 0.11
0.15 -0.02 -0.06 -0.08 -0.01
-0.07 -0.09 0.02 0.00 -0.01
0.01 0.05 -0.02 0.21 0.41
-0.03 0.02 0.01 -0.01 -0.01
-0.07 -0.04 0.12 0.05 -0.07
3
9
10
11
12
13
14
15
1.00
-0.29 1.00
-0.07 0.26 1.00
-0.16 0.30 0.09 1.00
0.01 -0.02 -0.15 -0.05 1.00
-0.00 -0.03 0.12 -0.02 0.04 1.00
0.01 -0.01 -0.01 -0.07 0.05 -0.00 1.00
0.10 -0.26 -0.07 -0.12 0.09 -0.06 0.01 1.00
8
Table 3: Pearson Correlations
Table 4: Change in Quantitative Disclosure in 10-K MD&A
N ewICW
Prediction
+
ContICW
F ixICW
∆logAssets
∆logN umEst
∆Inst
∆EarnV ol
∆Leverage
∆Intangibles
∆R&D
∆Earnings
∆Sales
Return
Restruct
Acquisition
Restate
Loss
Intercept
Industry and Year FE
R2
N
-
(1)
∆logN um
0.0364∗∗∗
(4.48)
-0.0052
(-0.31)
-0.0395∗∗∗
(-3.10)
0.0504∗∗∗
(3.96)
-0.0083∗
(-1.80)
-0.0229∗
(-1.68)
0.4129∗∗∗
(6.63)
0.1033∗∗∗
(4.08)
0.1019∗∗∗
(4.30)
0.1161∗∗
(2.02)
-0.0799∗∗∗
(-4.16)
0.0237∗∗∗
(4.44)
-0.0029
(-0.82)
0.0003
(0.12)
0.0061
(1.36)
0.0141∗∗∗
(2.66)
0.0108∗∗
(2.40)
0.0937∗∗∗
(13.56)
Yes
0.0773
12,952
(2)
(3)
∆logN um − T ables ∆logN um − T ext
0.0507∗∗∗
0.0333∗∗∗
(2.28)
(3.11)
-0.0014
-0.0247
(-0.06)
(-1.16)
-0.0381∗∗
-0.0537∗∗∗
(-1.90)
(-3.60)
∗∗
0.0467
0.0384∗∗∗
(2.10)
(2.84)
-0.0074
-0.0055
(-0.85)
(-0.91)
∗∗
-0.0494
0.0001
(-2.08)
(0.01)
∗∗
0.3253
0.4248∗∗∗
(2.37)
(6.09)
0.1149∗∗∗
0.1140∗∗∗
(3.18)
(4.14)
0.0757
0.1312∗∗∗
(1.58)
(5.28)
0.0342
0.0547
(0.41)
(0.96)
∗∗
-0.0600
-0.0939∗∗∗
(-2.19)
(-4.87)
∗∗∗
0.0429
0.0178∗∗
(3.77)
(2.42)
0.0060
-0.0069
(1.16)
(-1.36)
-0.0013
-0.0010
(-0.29)
(-0.31)
0.0009
0.0076∗
(0.13)
(1.93)
0.0134
0.0186∗∗∗
(1.56)
(3.54)
∗∗∗
0.0203
0.0101∗∗
(2.79)
(2.36)
∗∗∗
0.1297
0.0444∗∗∗
(9.79)
(6.81)
Yes
Yes
0.0294
0.0731
12,314
12,952
∆logN um is the change in the log number count. N ewICW indicates firm-years reporting a new ICW.
ContICW indicates firm-years reporting an ICW continuing from the prior year. F ixICW indicates firmyears resolving an ICW from the prior year. Variables defined in Appendix A. t statistics in parentheses,
clustered by firm and fiscal period end. ∗ p < 0.10, ∗∗ p < 0.05, ∗∗∗ p < .01, where p-values are one-sided if
there is a predicted sign and two-sided otherwise. 38
Table 5: ICW Accounts and Account-Specific Disclosures
Prediction
∆logN um − Other
N ewICW − Other
ContICW − Other
F ixICW − Other
N ewICW − Account
+
ContICW − Account
F ixICW − Account
Controls
Industry and Year FE
R2
N
-
(1)
(2)
Account = Revenue
Account = COGS
∆logN um − Account ∆logN um − Account
0.2191∗∗∗
0.2478∗∗∗
(13.90)
(8.86)
0.0169
0.0248
(1.35)
(1.11)
0.0028
0.0488
(0.16)
(1.61)
0.0043
0.0050
(0.36)
(0.25)
0.0636∗∗∗
0.0569∗∗∗
(4.00)
(2.04)
0.0190
-0.0635
(0.74)
(-0.97)
∗∗∗
-0.0636
-0.0330
(-3.23)
(-0.82)
Yes
Yes
Yes
Yes
0.0724
0.0452
12,952
12,952
This table presents results from regressions of account-specific disclosures on indicators for whether an
ICW pertains to that account or other accounts. Column (1) examines revenue and non-revenue disclosures;
Column (2) examines cost of goods sold (COGS) and non-COGS disclosures. ∆logN um − Account is the
change in the log number count for disclosures pertaining to that account. ∆logN um − Other is the change
in the log number count for disclosures not pertaining to that account. N ewICW − Account indicates
firm-years reporting a new ICW related to that account; N ewICW − Other indicates firm-years reporting a
new ICW not related to that account. ContICW − Account indicates firm-years reporting a continuing ICW
from the prior year related to that account; ContICW − Other indicates firm-years reporting a continuing
ICW from the prior year not related to that account. F ixICW − Account indicates firm-years resolving an
ICW from the prior year related to that account; F ixICW − Other indicates firm-years resolving an ICW
from the prior year not related to that account. Control variables from prior regressions included and defined
in Appendix A. t statistics in parentheses, clustered by firm and fiscal period end. ∗ p < 0.10, ∗∗ p < 0.05,
∗∗∗
p < .01, where p-values are one-sided if there is a predicted sign and two-sided otherwise.
39
Table 6: Change in 10-K Impact on Bid-Ask Spreads
N ewICW
Prediction
+
ContICW
F ixICW
-
∆logN um
∆logN um ∗ N ewICW
-
Restate
AbnReturn − F iling
∆AbnV olume − F iling
Controls
Industry and Year FE
R2
N
(1)
(2)
∆SpreadImpact ∆SpreadImpact
0.0142∗∗∗
0.0167∗∗∗
(2.75)
(2.72)
0.0028
0.0027
(0.15)
(0.15)
∗∗
-0.0123
-0.0123∗∗
(-1.69)
(-1.68)
-0.0067
-0.0050
(-1.16)
(-0.85)
-0.0293∗
(-1.48)
0.0069∗∗
0.0070∗∗
(2.44)
(2.45)
-0.1400∗∗∗
-0.1399∗∗∗
(-2.74)
(-2.73)
∗
-0.0009
-0.0009∗
(-1.88)
(-1.89)
Yes
Yes
Yes
Yes
0.0136
0.0137
12,952
12,952
This table presents results on the impact of ICWs and changes in disclosure on bid-ask spreads.
∆SpreadImpact is the year-over-year change in the extent to which bid-ask spreads tighten around the filing of
the Form 10-K. N ewICW indicates firm-years reporting a new ICW. ContICW indicates firm-years reporting
an ICW continuing from the prior year. F ixICW indicates firm-years resolving an ICW from the prior year.
Restate is an indicator for the announcement of a restatement in the prior year. AbnReturn − F iling is the
abnormal return for the Form 10-K filing and AbnV olume − F iling is the abnormal trading volume for the
Form 10-K filing. Variables defined in Appendix A. t statistics in parentheses, clustered by firm and fiscal
period end. ∗ p < 0.10, ∗∗ p < 0.05, ∗∗∗ p < .01, where p-values are one-sided if there is a predicted sign and
two-sided otherwise.
40
Table 7: Propensity Score Logit Model of Receiving an ICW
(1)
ICW
-0.2735∗∗∗ (-3.81)
-0.2215∗∗ (-2.13)
0.0024
(0.19)
-0.9697
(-1.62)
0.0620
(0.76)
0.4824
(1.26)
0.0590
(0.43)
0.0983
(0.68)
0.0891
(0.49)
-0.5722
(-1.07)
5.8180∗∗∗ (3.49)
-0.2257
(-1.56)
0.0323
(0.09)
-3.9730∗∗∗ (-3.89)
-0.3332∗∗ (-2.55)
0.1410
(0.45)
0.0425
(0.31)
0.1462
(0.78)
∗∗∗
1.3320
(9.44)
-0.1835
(-0.39)
.1622
9,939
logAssets
logN umEst
MB
ROA
logSegments
Leverage
Restruct
Acquisition
∆Sales
∆Earnings
EarnV ol
Dividend
Intangibles
R&D
Return
Inst
F oreignSales
Loss
Restate
Intercept
Pseudo R2
N
This table presents the results of a propensity score logit model for the likelihood of receiving an ICW in the
current firm-year. My sample of treatment firms seeking matched controls is comprised of 389 N ewICW
firm-years that are the first ICW for that firm. My sample of potential controls is comprised of all firm-years
for firms that do not receive an ICW during my sample period, resulting in 9,550 potential control firm-years.
ICW indicates whether or not a firm-year received an ICW. Variables defined in Appendix A. t statistics in
parentheses, clustered by firm. ∗ p < 0.10, ∗∗ p < 0.05, ∗∗∗ p < .01, where p-values are one-sided if there is a
predicted sign and two-sided otherwise.
41
Table 8: Change in Quantitative Disclosure in 10-K MD&A - PSM Sample
Prediction
+
N ewICW
∆logAssets
∆logN umEst
∆Inst
∆EarnV ol
∆Leverage
∆Intangibles
∆R&D
∆Earnings
∆Sales
Return
Restruct
Acquisition
Restate
Loss
Intercept
Industry and Year FE
R2
N
(1)
∆logN um
0.0249∗∗
(2.06)
0.0568
(1.33)
-0.0404∗∗
(-2.46)
-0.0464
(-1.26)
1.0995∗∗∗
(4.85)
0.2374∗∗∗
(2.67)
0.0130
(0.14)
-0.0997
(-1.25)
-0.2346∗∗∗
(-3.92)
0.0200
(0.79)
-0.0020
(-0.18)
-0.0031
(-0.23)
-0.0005
(-0.02)
0.0496∗∗∗
(2.85)
0.0177
(1.24)
0.0964∗∗∗
(2.79)
Yes
0.1762
708
This table presents results from re-estimating my main regression on a propensity score matched sample.
N ewICW indicates a firm-years reporting a new ICW. ∆logN um is the change in the log number count.
Variables defined in Appendix A. t statistics in parentheses, clustered by fiscal period end. ∗ p < 0.10, ∗∗
p < 0.05, ∗∗∗ p < .01, where p-values are one-sided if there is a predicted sign and two-sided otherwise.
42