Showing papers in "The Accounting Review in 2002"
TL;DR: In this paper, the authors suggest a new measure of one aspect of the quality of working capital accruals and earnings, i.e., the ability to shift or adjust the recognition of cash flows over time so that t...
Abstract: This paper suggests a new measure of one aspect of the quality of working capital accruals and earnings. One role of accruals is to shift or adjust the recognition of cash flows over time so that t...
3,578 citations
TL;DR: In this paper, the authors examined whether auditor fees are associated with earnings management and the market reaction to the disclosure of auditor fees and found evidence that nonaudit fees are positively associated with small earnings surprises and the magnitude of discretionary accruals, while audit fees are negatively associated with these earnings management indicators.
Abstract: This paper examines whether auditor fees are associated with earnings management and the market reaction to the disclosure of auditor fees. Using data collected from proxy statements, we present evidence that nonaudit fees are positively associated with small earnings surprises and the magnitude of discretionary accruals, while audit fees are negatively associated with these earnings management indicators. We also find evidence of a negative association between nonaudit fees and share values on the date the fees were disclosed, although the effect is small in economic terms.
1,178 citations
TL;DR: Using both a market-based and an accrual-based measure of conservatism, this article found that firms facing more severe conflicts over dividend policy tend to use more conservative accounting.
Abstract: Using both a market‐based and an accrual‐based measure of conservatism, we find that firms facing more severe conflicts over dividend policy tend to use more conservative accounting. Furthermore, we document that accounting conservatism is associated with a lower cost of debt after controlling for other determinants of firms' debt costs. Our collective evidence is consistent with the notion that accounting conservatism plays an important role in mitigating bondholder‐shareholder conflicts over dividend policy, and in reducing firms' debt costs.
887 citations
TL;DR: The authors compared samples of publicly and privately held bank holding companies to examine whether the high frequency of small earnings increases relative to small earnings decreases reported by public firms is attributable to earnings management.
Abstract: This study compares samples of publicly and privately held bank holding companies to examine whether the high frequency of small earnings increases relative to small earnings decreases reported by public firms is attributable to earnings management. We expect public banks' shareholders to be more likely than private banks' shareholders to rely on simple earnings‐based heuristics in evaluating firm performance, so we expect public banks to have more incentives to report steadily increasing earnings. Consistent with this expectation, we find that relative to private banks, public banks: (1) report fewer small earnings declines, (2) are more likely to use the loan loss provision and security gain realizations to eliminate small earnings decreases, and (3) report longer strings of consecutive earnings increases. These results suggest that the asymmetric pattern of more small earnings increases than decreases, first documented by Burgstahler and Dichev (1997), is attributable to earnings management and is not ...
846 citations
TL;DR: In this paper, the authors developed diagnostic measures of the joint effect of investment and conservative accounting, and they found that these measures forecast differences in future return on net operating assets relative to current return on Net Operating assets.
Abstract: When a firm practices conservative accounting, changes in the amount of its investments can affect the quality of its earnings. Growth in investment reduces reported earnings and creates reserves. Reducing investment releases those reserves, increasing earnings. If the change in investment is temporary, then current earnings is temporarily depressed or inflated, and thus is not a good indicator of future earnings. This study develops diagnostic measures of this joint effect of investment and conservative accounting. We find that these measures forecast differences in future return on net operating assets relative to current return on net operating assets. Moreover, these measures also forecast stock returns—indicating that investors do not appreciate how conservatism and changes in investment combine to raise questions about the quality of reported earnings.
743 citations
TL;DR: This article found that audit committee independence increases with board size and board independence and decreases with the firm's growth opportunities and for firms that report consecutive losses, while no relation is found between audit committee independent and creditors' demand for accounting information.
Abstract: This paper provides empirical evidence that audit committee independence is associated with economic factors. I find that audit committee independence increases with board size and board independence and decreases with the firm's growth opportunities and for firms that report consecutive losses. In contrast, no relation is found between audit committee independence and creditors' demand for accounting information. Although the analyses are based on data from 1991 to 1993, these results have implications for NYSE and NASDAQ listing requirements for audit committees adopted in December 1999. Specifically, the new requirements give firms the option of including non‐outside directors on their audit committees if it is in the best interests of the firm to do so.
664 citations
TL;DR: This paper found that Canadian managers are relatively more likely to issue forecasts during interim periods in which earnings decrease, whereas U.S. managers do not exhibit that tendency and issue more forecasts when earnings are increasing, and their forecasts are of annual rather than interim earnings.
Abstract: Citing fear of legal liability as a partial explanation, prior research documents (1) managers' reluctance to voluntarily disclose management earnings forecasts, and (2) greater forecast disclosure frequencies in periods of bad news. We provide evidence on how management earnings forecast disclosure differs between the United States (U.S.) and Canada, two otherwise similar business environments with different legal regimes. Canadian securities laws and judicial interpretations create a far less litigious environment than exists in the U.S. We find a greater frequency of management earnings forecast disclosure in Canada relative to the U.S. Further, although U.S. managers are relatively more likely to issue forecasts during interim periods in which earnings decrease, Canadian managers do not exhibit that tendency. Instead, Canadian managers issue more forecasts when earnings are increasing, and their forecasts are of annual rather than interim earnings. Also consistent with a less litigious environment, Ca...
527 citations
TL;DR: In this paper, the authors investigated whether insider trading is informative about earnings quality and the valuation implications of accruals and found that the one-year-ahead persistence of income-increasing accrual is significantly lower when accompanied by abnormal insider selling and greater when accompanied with abnormal insider buying.
Abstract: This paper investigates whether insider trading is informative about earnings quality and the valuation implications of accruals. We show that (1) the one‐year‐ahead persistence of income‐increasing accruals is significantly lower when accompanied by abnormal insider selling and greater when accompanied by abnormal insider buying; (2) the accrual mispricing phenomenon observed in previous work (e.g., Sloan 1996) is due to the mispricing of income‐increasing accruals; (3) one‐year‐ahead hedge returns to trading strategies based on the direction of accruals and insider trading significantly exceed those based on accruals alone; and (4) the lower persistence of income‐increasing accruals accompanied by abnormal insider selling appears to be at least partly attributable to opportunistic earnings management. Our evidence suggests that market participants and researchers can use managers' contemporaneous trading in ex ante assessing the likelihood that the firms' accruals are of high or low quality, and in asse...
394 citations
TL;DR: In this article, the authors investigate three explanations for prior studies' finding that the usefulness of earnings announcements, as measured by their absolute market responses, has increased over time, and they find no evidence that this over-time increase in the magnitude of the market reaction to their sample firms' earnings announcements is attributable to increases in the absolute amount of unexpected earnings conveyed in the announcements or to the intensity of investors' average reaction to unexpected earnings.
Abstract: We investigate three explanations for prior studies' finding that the usefulness of earnings announcements, as measured by their absolute market responses, has increased over time. We confirm this increase for a sample of 426 relatively large, stable firms over 1980–1999. We find no evidence that this over‐time increase in the magnitude of the market reaction to our sample firms' earnings announcements is attributable to increases in the absolute amount of unexpected earnings conveyed in the announcements or to increases in the intensity of investors' average reaction to unexpected earnings. To test the third explanation—an over‐time expansion in the amount of concurrent (with bottom line earnings) information in earnings announcement press releases—we analyze and code the contents of 2,190 earnings announcement press releases made by 30 of our sample firms over 1980–1999. Concurrent disclosures increased significantly over this period and we find that these concurrent disclosures, especially the inclusio...
391 citations
TL;DR: In this article, the authors investigate the relation between the trading VAR disclosed by a small sample of U.S. commercial banks and the subsequent variability of their trading revenues and find that VAR disclosures are informative in that they predict the variability of trading revenues.
Abstract: Value at Risk (VAR), a measure of the dollar amount of potential loss from adverse market moves, has become a standard benchmark for measuring financial risk. Spurred by regulators and competitive pressures, more institutions are reporting VAR numbers in annual and quarterly financial reports. To provide preliminary evidence on the informativeness of these new disclosures, I investigate the relation between the trading VAR disclosed by a small sample of U.S. commercial banks and the subsequent variability of their trading revenues. The empirical results suggest that VAR disclosures are informative in that they predict the variability of trading revenues. Thus, analysts and investors can use VAR disclosures to compare the risk profiles of banks' trading portfolios.
283 citations
TL;DR: In this article, the authors investigate the effect of conference calls on analysts' forecast error and dispersion and find that conference calls increase analysts' ability to forecast earnings accurately, suggesting that these calls increase the total information available about a firm.
Abstract: In 1998, the SEC expressed concern that conference calls encourage selective disclosure by revealing new information to financial analysts privy to the call. This study investigates whether the regular use of earnings‐related conference calls increases the amount of information available to financial analysts by examining the effect of conference calls on analysts' forecast error and dispersion. Results indicate that conference calls increase analysts' ability to forecast earnings accurately, suggesting that these calls increase the total information available about a firm. We also find some evidence that conference calls decrease dispersion among analysts. Given conference calls were generally restricted during our sample period, our evidence suggests that conference calls may have contributed to an information gap between analysts privy to the call and the remainder of the investment community. We also investigate whether conference calls differentially affect analysts' forecast errors depending on anal...
TL;DR: In this article, the authors consider a setting in which a firm uses residual income to motivate a manager's investment decision, and they consider a case where the residual income capital charge is adjusted for market risk.
Abstract: We consider a setting in which a firm uses residual income to motivate a manager's investment decision. Textbooks often recommend adjusting the residual income capital charge for market risk, but n...
TL;DR: The authors examined changes in the precision and the commonality of information contained in individual analysts' earnings forecasts, focusing on changes around earnings announcements, using the empirical proxies suggested by the Barron et al. model that are based on the across-analyst correlation in forecast errors.
Abstract: In this study we examine changes in the precision and the commonality of information contained in individual analysts' earnings forecasts, focusing on changes around earnings announcements. Using the empirical proxies suggested by the Barron et al. (1998) model that are based on the across‐analyst correlation in forecast errors, we conclude that the commonality of information among active analysts decreases around earnings announcements. We also conclude that the idiosyncratic information contained in these individual analysts' forecasts increases immediately after earnings announcements, and that this increase is more significant as more analysts revise their forecasts. These results are consistent with theories positing that an important role of accounting disclosures is to trigger the generation of idiosyncratic information by elite information processors such as financial analysts (Kim and Verrecchia 1994, 1997).
TL;DR: In this paper, the authors examine whether either of two practices (using budgets to allocate scarce resources, or providing information about co-workers) reduces budget slack and increases subordinate performance when organizations use budgets for performance evaluation.
Abstract: Business executives and academics frequently criticize budget‐based compensation plans as providing incentives for subordinates to build slack into proposed budgets. In this paper, we examine whether either of two practices—using budgets to allocate scarce resources, or providing information about co‐workers—reduces budget slack and increases subordinate performance when organizations use budgets for performance evaluation. The results from our experiment show that using budgets for both resource allocation and performance evaluation not only eliminates budget slack, but also increases subordinates' effort and task performance. Additionally, we find that an internal reporting system that provides information about subordinates' budgets and performance to their co‐workers mitigates budget slack when superiors do not use budgets as a basis for resource allocation. These results highlight the synergies between the planning (resource allocation) and control (performance evaluation) functions of managerial acc...
TL;DR: In this paper, the authors investigate the joint nature of the delegation and incentive compensation choices for lower-level managers in retail banks and find that high-growth, volatile, and innovative banks delegate more authority to branch managers.
Abstract: Top management faces two key organizational design choices: (1) how much authority to delegate to lower‐level managers, and (2) how to design incentive compensation to ensure that these managers do not misuse their discretion. Theoretical accounting literature emphasizes that top management makes these two choices jointly, but there is little empirical evidence on this assertion. Capitalizing on a unique database of branch manager practices in retail banks, this study provides some of the first evidence on the joint nature of the delegation and incentive compensation choices for lower‐level managers. A simultaneous model of these two choices indicates that high‐growth, volatile, and innovative banks delegate more authority to branch managers. In turn, branch managers with more authority receive more incentive‐based pay. However, in contrast with principal‐agent theory, I find no evidence that the extent of incentive compensation plays a significant role in explaining the extent of delegation.
TL;DR: In this article, the authors hypothesize that firms' 10-K market risk disclosures, recently mandated by SEC Financial Reporting Release No. 48 (FRR No. 6), reduce investors' uncertainty and diversity of opinion about the implications, for firm value, of changes in interest rates, foreign currency exchange rates, and commodity prices.
Abstract: We hypothesize that firms' 10‐K market risk disclosures, recently mandated by SEC Financial Reporting Release No. 48 (FRR No. 48), reduce investors' uncertainty and diversity of opinion about the implications, for firm value, of changes in interest rates, foreign currency exchange rates, and commodity prices. We argue that this reduced uncertainty and diversity of opinion should dampen trading volume sensitivity to changes in these underlying market rates or prices. Consistent with this hypothesis, we find that after firms disclose FRR No. 48‐mandated information about their exposures to interest rates, foreign currency exchange rates, and energy prices, trading volume sensitivity to changes in these underlying market rates and prices declines, even after controlling for other factors associated with trading volume. The observed declines in trading volume sensitivity are consistent with FRR No. 48 market risk disclosures providing useful information to investors.
TL;DR: In this article, the authors examine whether earlier knowledge of supervisors' views increases subordinates' tendency to agree with those views because subordinates predecisionally distort evidence in a going-concern task.
Abstract: With the current shift toward real‐time audit review, subordinates become aware of supervisors' views earlier in the audit process I use an experiment to examine whether earlier knowledge of supervisors' views increases subordinates' tendencies to agree with those views because subordinates predecisionally distort evidence In a going‐concern task, I find that auditors who learn the partner's view before evaluating evidence (1) evaluate individual evidence items as more consistent with the partner's view, and (2) make going‐concern judgments that are more consistent with the partner's view, than do auditors who learn the same partner's view after evaluating evidence In a second experiment, I examine whether auditors anticipate the distortion's effect on subordinates' judgments I find that auditors expect subordinates to make judgments that agree with supervisors' views, but auditors do not expect subordinates to agree even more with those views when subordinates learn those views earlier in the audit p
TL;DR: In this article, the authors examined the relation between financial performance and just-in-time (JIT) adoption and found that JIT adopters improve financial performance relative to non-adopters, and that profit margin rather than asset turnover is the primary source of such improvement.
Abstract: Empirical research provides scant evidence that just‐in‐time (JIT) adopters outperform their non‐adopting industry peers. Using a sample of 201 JIT adopters and matched non‐adopters, we examine the relation between financial performance and JIT. Our sample‐wide results indicate that JIT adopters improve financial performance relative to non‐adopters, and that profit margin, rather than asset turnover, is the primary source of such improvement. However, results of additional analyses suggest that JIT adopters below a firm‐size threshold do not improve financial performance, a finding that reconciles our study to Balakrishnan et al. (1996), which examined a JIT adopter sample that included a greater proportion of small firms.
TL;DR: The authors investigated whether oil and gas producing firms use abnormal accruals and hedging with derivatives as substitutes to manage earnings volatility and found that managers will use these smoothing mechanisms as substitutes at the margin, and suggest a sequential process whereby managers first determine the extent to which they will use derivatives to hedge oil price risk, and then, especially in the fourth quarter, ma
Abstract: This research investigates whether oil and gas producing firms use abnormal accruals and hedging with derivatives as substitutes to manage earnings volatility Firms engaged in oil exploration and drilling are exposed to two kinds of risks that can cause earnings volatility: oil price risk and exploration risk Firms can use abnormal accrual choices and/or derivatives to reduce earnings volatility caused by oil price risk, but cannot directly hedge the operational risk of unsuccessful drilling Because hedging and using abnormal accruals are costly activities, and because prior research suggests managers do not eliminate all volatility (Haushalter 2000; Barton 2001), we expect that, at the margin, managers will use these smoothing mechanisms as substitutes to manage earnings volatility Our results suggest a sequential process whereby managers of oil and gas producing firms first determine the extent to which they will use derivatives to hedge oil price risk, and then, especially in the fourth quarter, ma
TL;DR: For example, the authors found that if firms adjust performance standards to fully reflect executives' past performance, then an executive's chances of earning an above-target bonus to be independent of his past performance.
Abstract: We provide evidence that CEOs' and lower‐level business unit executives' target bonuses are negatively associated with a proxy for measurement noise in accounting‐based performance measures, and positively associated with proxies for firms' growth opportunities and the extent of executives' decision‐making authority. Non‐CEO executives' target bonuses are also positively associated with their CEO's target bonus. In addition, we compare executives' actual and target bonuses over two consecutive periods to draw inferences about how firms revise executives' performance standards. If firms adjust performance standards to fully reflect executives' past performance, then we expect an executive's chances of earning an above‐target bonus to be independent of his past performance. We find evidence to the contrary; an executive is more likely to receive an above‐target bonus if he received an above‐target bonus in the prior year than if he did not. This suggests that firms do not adjust standards to fully reflect e...
TL;DR: In this paper, the authors investigate which of these two metrics maximizes the likelihood that a researcher correctly detects the presence or absence of a response, and they provide evidence that volume-based measures, especially measures based on numbers of transactions, provide more powerful tests of investor response to public disclosures than do return-based metrics.
Abstract: Prior research addressing questions such as whether investors respond to a hypothesized information event used tests of unusual return and/or trading activity as alternative measures of investor response. We investigate which of these two metrics maximizes the likelihood that a researcher correctly detects the presence or absence of a response. Building on the repeated‐sample framework established in Brown and Warner (1980, 1985) and Dyckman et al. (1984), we provide evidence that (1) volume‐based metrics, especially measures based on numbers of transactions, provide more powerful tests of investor response to public disclosures than do return‐based metrics; and (2) supplementing return‐based measures with trading‐based measures increases the power of tests designed to detect investor response. Our conclusions are particularly relevant when power is critical (i.e., when sample sizes are small or anticipated investor response is small). Our evidence also suggests that before concluding that investors do no...
TL;DR: The authors investigate whether analysts who are forecasting earnings use processes consistent with scenario thinking: envisioning a sequence of events in which proposed actions lead to future outcomes, and investigate whether forecast optimism is an unintentional consequence of analysts' reactions to the structure of information about managers' future plans, finding that analysts make more optimistic two-year-ahead earnings forecasts when provided information about a manager's future plans framed as scenarios than when provided the same information framed as lists.
Abstract: Archival studies report that analysts' annual earnings forecasts are optimistic, particularly for firms reporting recent losses. This study addresses whether forecast optimism is an unintentional consequence of analysts' reactions to the structure of information about managers' future plans. I investigate whether analysts who are forecasting earnings use processes consistent with scenario thinking: envisioning a sequence of events in which proposed actions lead to future outcomes. I study professional sell‐side analysts in a 2×2 between‐subjects experiment with the structure of information (scenario vs. list) and the sign of prior earnings (loss vs. profit) as independent variables. I find that analysts make more optimistic two‐year‐ahead earnings forecasts when provided information about a manager's future plans framed as scenarios than when provided the same information framed as lists. I also find that scenario‐induced optimism is greater for a firm with prior losses than for a firm with prior profits....
TL;DR: The authors investigate how unique features of charities affect the manner in which they compensate their executives and find that changes in compensation are significantly positively associated with changes in spending on programs that advance organization objectives, whether changes in program spending are attributable to changes in revenue raised or to the relative costs of administering the charity.
Abstract: We investigate how unique features of charities affect the manner in which they compensate their executives. We find that changes in compensation are significantly positively associated with changes in spending on programs that advance organization objectives, whether changes in program spending are attributable to changes in revenue raised or to changes in the relative costs of administering the charity. The results suggest that accounting performance measures can play a role in nonprofit organizations whose objectives are typically subjective and nonfinancial, and thus, whose progress toward objectives is difficult to quantify.
TL;DR: This paper used the relative performance of the earnings capitalization, the book value and the residual income valuation models to explore the valuation properties of International Accounting Standards and U.S. Generally Accepted Accounting Principles earnings and book values reported by non-U.S., cross-listed firms trading in a common equity market.
Abstract: Despite the increasing integration of global capital markets, there is little evidence on the valuation properties of cross‐listed, non‐U.S. firms' accounting variables. We use the relative performance of the earnings capitalization, the book value, and the residual income valuation models to explore the valuation properties of International Accounting Standards and U.S. Generally Accepted Accounting Principles earnings and book values reported by non‐U.S., cross‐listed firms trading in a common equity market. Using non‐U.S./non‐U.K. firms whose shares trade on the International Stock Exchange Automated Quotation system in London, we find that the earnings capitalization model is the dominant accounting‐based valuation model when crosslisted firms report under International Accounting Standards. In contrast, we find that when cross‐listed firms report under U.S. Generally Accepted Accounting Principles, the residual income model is the dominant accountingbased valuation model. Our exploratory study provid...
TL;DR: The authors investigated the effect of an increase in the individual (shareholder level) income tax rate on share values and found that the higher the firm's dividend yield, the more negative the stock price reaction to the increase in individual income tax rates (i.e., the dividend tax rate) enacted in the Revenue Reconciliation Act of 1993.
Abstract: We investigate the effect of an increase in the individual (shareholder‐level) income tax rate on share values. We regress cumulative daily abnormal stock returns surrounding the passage of the Revenue Reconciliation Act of 1993 on firm dividend yield, tax status of the investor as represented by level of institutional ownership, the interaction of these two variables, and control variables. Consistent with our expectations, we find that (1) the higher the firm's dividend yield, the more negative the firm's stock price reaction to the increase in the individual income tax rate (i.e., the dividend tax rate) enacted in the Revenue Reconciliation Act of 1993, and (2) institutional holdings mitigate this negative reaction. Our results suggest that both the dividend policy of the firm and the tax status of the marginal investor influence the extent to which dividend taxes are reflected in share values. Our evidence is consistent with the traditional view that firm dividend policy influences the extent to which...
TL;DR: In this paper, the authors investigate the market's perception of the economic effect of employee stock options (ESOs) on firm value for a sample of 85 profitable computer software companies and find that the market appears to value these firms' ESO expense not as an expense but as an intangible asset.
Abstract: We use the Ohlson (1995, 1999) and Feltham and Ohlson (1999) valuation models to investigate the market's perception of the economic effect of employee stock options (ESOs) on firm value for a sample of 85 profitable computer software companies. Our results suggest that the market appears to value these firms' ESO expense not as an expense but as an intangible asset (even after controlling for the endogeneity bias arising from the mechanical relation between ESOs and the underlying stock prices). However, we also find a conflict between: (1) the positive manner in which investors appear to value ESO expense, and (2) the negative relation between current ESO expense and future abnormal earnings. This conflict not only could be an artifact of the restrictiveness of the abnormal earnings forecasting equation we estimate, but it also calls into question whether investors assess correctly the effect of ESOs on profitable software firm value.
TL;DR: In this article, the authors examine whether these expectations of fairness extend to the actual prices that result from real-cash negotiations and find that the extent to which questionnaire-based judgments of social behavior generalize to actual behavior depends on the whether the competitive environment suppresses or reinforces the social presence of the parties.
Abstract: Questionnaire responses reported by Luft and Libby (1997) reveal that transfer price negotiators expect fairness‐based price concessions that moderate the influence of an outside market price when the outside market price strongly favors one of the parties. We examine whether these expectations of fairness extend to the actual prices that result from real‐cash negotiations. Findings indicate that expectations of fairness‐based price concessions do not survive actual negotiations when participants negotiate over a computer network with no communication other than bids, asks, and acceptances. Conversely, both expectations and actual negotiated outcomes reflect fairness‐based price concessions when participants negotiate in a face‐to‐face setting with unrestricted communication. Together, these results imply that the extent to which questionnaire‐based judgments of social behavior generalize to actual behavior depends on the whether the competitive environment suppresses or reinforces the social presence nec...
TL;DR: In this article, the authors provide evidence on how auditors' use of decision aids affects jurors' evaluation of auditor legal liability, based on an experiment in which actual jurors responded to a hypothetical audit lawsuit.
Abstract: This study provides evidence on how auditors' use of decision aids affects jurors' evaluation of auditor legal liability, based on an experiment in which actual jurors responded to a hypothetical audit lawsuit. The results suggest that decision aids can have positive, negative, or neutral effects on auditors' legal liability, depending on how auditors use the decision aid and the reliability of the decision aid. For high‐reliability aids, jurors attributed more responsibility for an audit failure to the auditor when the auditor overrode the recommendation of a decision aid than when the auditor did not use the decision aid. However, jurors attributed lower responsibility to an auditor who relied on the recommendation of a highly reliable decision aid, even though the aid turned out to be incorrect. In contrast to the high‐reliability conditions, auditors' use of the decision aid had virtually no impact on jurors' liability judgments when the reliability of the decision aid was low.
TL;DR: In this article, the authors show that a firm's trade-offs between reporting good news to reduce the cost of capital and bad news to minimize proprietary costs can induce the firm's manager to provide truthful disclosures when the opposing effects balance each other.
Abstract: This paper demonstrates that a firm's trade‐offs between reporting good news to reduce the cost of capital and bad news to minimize proprietary costs can induce the firm's manager to provide truthful disclosures when the opposing effects balance each other. We also show that greater proprietary costs can make a firm's disclosures more credible, increase the frequency of voluntary adverse disclosures, and improve the disclosing firm's welfare. Further, we find that potential shareholder litigation can interact with capital and product markets' influences to make voluntary disclosures more credible, but only under certain circumstances. For example, although product market competition can complement the capital market effects in inducing the manager to provide truthful disclosures, shareholder litigation cannot complement the capital market in the same way. Nevertheless, while shareholder litigation can never induce misreporting, a very strong product market influence can prompt a firm to underreport its tr...