The effect of earnings characteristics on firms\u27 discretionary disclosure decisions

This study examines whether firms expand accounting disclosures in response to perceived market underevaluation. Using a signaling theory framework, this paper predicts that managers will use discretionary accounting disclosures to align the market\u27s expectations about future earnings performance with their own. More specifically, this study predicts that the market undervalues positive (negative) abnormal earnings firms when the persistence of the abnormal earnings is higher (lower) than market expectations. Therefore, these firms will signal this information to the market by expanding their accounting disclosures. Furthermore, positive and negative abnormal growth firms are expected to seek different types of disclosures to correct the perceived undervaluation. In order to accurately specify the relationships between the earnings characteristics and management\u27s disclosure decisions, it is necessary to evaluate these two categories separately. The underlying motivation for this study comes from the observation that prior research does not identify the theoretical determinants of management\u27s accounting disclosure decisions. The primary contribution is that this study uses a signaling theory framework to explain why managers expand accounting disclosures and provides empirical tests of the predicted determinants. The findings demonstrated a significant relationship between the persistence of the earnings components with firms\u27 changes in discretionary disclosures. The change in abnormal earnings were not significantly related to the changes in firms\u27 disclosure changes. However, the firms who increased their discretionary diclosures had significantly larger earnings components relative to the firms who decreased their discretionary disclosures. Therefore, this study concludes that management\u27s response in disclosure changes does not occur contemporaneously with changes in the earnings components. This would imply that either (1) management can not make quick changes in its disclosure policy, or (2) management does not change its discretionary disclosures until after it observes the market\u27s undervaluation. These findings do conclude that characteristics of the firms earnings are significantly associated with changes in their disclosure policies. Therefore, any analysis of the benefits to expanded disclosures should also consider the economic characteristics of the reported earnings when isolating the benefits attributed to expanded discretionary accounting disclosures