The More Investors Know, the More Executives Disclose

Executives in the U.S. face this dilemma all the time, and the solution isn’t always clear-cut.

The Securities and Exchange Commission (SEC) mandates that publicly traded companies disclose key financial information, including their earnings, each quarter and at the end of their fiscal year in the form of 10-Qs and 10-Ks. But companies also routinely share additional information—notably, earnings forecasts. Companies are not required to share these expectations about their future performance, but many choose to do so voluntarily.

Unsurprisingly, firms are more likely to voluntarily disclose information about their expected future performance when they expect strong earnings, because sharing this good news will help boost stock prices. The motivation to disclose is particularly intense if executives have personal reasons for keeping those short-term stock prices high (perhaps because they have stock options about to vest, for instance).

The flip side is that when firms fail to provide voluntary earnings forecasts, investors could suspect poor performance and begin discounting stock prices anyway. This has led some academics to reason that staying mum should never be a good strategy.

Unless, that is, there are other, benign reasons why an executive might withhold earnings guidance.

The extent to which an executive can get away with withholding a negative earnings forecast, then, is dependent on the uncertainty around their motivations, hypothesized Jung Min Kim, an assistant professor of accounting information and management at Kellogg. This should mean that, as uncertainty decreases, so will the benefits of withholding a negative forecast.

In a recent study relying on empirical data, she found just this: executives were more likely to share bad news voluntarily when the uncertainty around their own personal motives for maximizing the short-term stock prices decreased.

Shedding light on disclosure motivations

Executives and directors often hold equity in the corporations that they run. If an executive has equity incentives that will vest in the short term, or they are otherwise incentivized to keep the short-term price of the stock high, they may be motivated not to disclose a negative earnings forecast, which would drive the stock price down immediately.

But critically, this is not the only reason an executive might not disclose earnings forecasts. They could, for instance, be planning to keep those holdings for the long term. If so, they may be indifferent to the stock-price fluctuations, as these will dissipate over time.

When an executive’s motivations are unclear, then, it creates uncertainty for investors, who can’t be sure what it means when a company does not release an earnings forecast.

But in 2006, the uncertainty changed in an important way due to SEC regulatory efforts aimed at enhancing executive compensation transparency.

During the 1980s and 1990s, equity compensation became an increasingly large part of executive compensation packages and in some cases grew to more than half of total compensation. For instance, options were seen as a way to align the incentives of shareholders and management, but because this was still a relatively new phenomenon, the SEC did not yet require detailed information about options packages to be disclosed.

The regulatory agency changed all that with its 2006 mandate, which required companies to share details about executive compensation, including the specifics of stock and option grants, performance metrics and targets used, the time over which those targets need to be achieved, and the payout triggered by their achievement. The rule’s aim was to give investors a clearer and more-complete picture of the compensation earned by the executives.

The change also allowed Kim to investigate whether the additional information—which reduced uncertainty around executives’ short-term stock price maximization motives—would also change how these managers approached earnings forecasts.

More transparency, more voluntary disclosure

She was able to test the theory thanks to a variation in the implementation schedule of the SEC rule. When it came into effect on December 15, 2006, not all companies had to adhere right away. Those with a fiscal year that ended after December 15 had to comply right away, while those with a fiscal year that ended before December 15 had nearly a full additional year. This allowed Kim to study how disclosure changed in companies that had to abide by the rule immediately, compared with those that did not.

In addition, she classified the companies into two different groups based on their management team’s desired timeline (or horizon) for boosting the stock price: one group’s management had more short-term financial interests, while the other group’s management had more long-term interests.

Kim looked at the fiscal years from 2004 to 2007, a period that spanned the new rule. She found that, once the rule was introduced, the affected firms increased the likelihood of earnings forecasts. Moreover, the likelihood of earnings forecasts conveying negative information increased as well for these firms.

This change was driven primarily by the companies whose executives would benefit more from having higher short-term stock prices, Kim found. Their voluntary disclosures increased significantly, while those companies whose executives would not benefit as much from having higher short-term stock prices stayed about the same. This suggests that prior to the mandate, managers with short-term stock price maximization motives who had bad earnings news had indeed been able to obscure this bad news in the uncertainty about managerial horizon.

New regulations can have wider implications

To Kim, the findings show that regulations intended to improve transparency in compensation disclosure can influence other disclosure behaviors, too.

“Broadly, these findings tell you that disclosure about executive compensation can actually help investors make sense of other types of reporting decisions that managers make,” Kim says.

“The first-order objective of the SEC’s mandate was to ensure transparency, but there is also a second-order effect where investor uncertainty feeds back into the reporting decisions that management makes,” she adds. “And in that sense, this research provides insights into how different types of disclosures might be interacting.”