Other determinants of disclosure

3.5.1

Organisational legitimacy and Managerial reputation

Chalmers and Rogers (2004) assert that firms disclose information so as to safeguard their reputation. A sustained reputation confers the legitimacy necessary to support their business model in the long term. This line of argument differs from capital markets and proprietary cost incentives where disclosure is based on the direct economic costs and benefits of disclosure. Chalmers et al’s (2004) theoretical framework, drawn from organizational theory, is based on a blend of institutional and legitimacy organisational theories. Legitimacy is defined as the generalised perception that the actions of an entity are desirable, proper or appropriate within some socially constructed system of norms, values, beliefs and definitions. Institutional organisational theory asserts that legitimacy is achieved by firms conforming to current conventional practices. Applying this framework to derivatives disclosure, Chalmers et al (2004), looking at Australia firms, find evidence that when confronted with societal pressures to make derivatives more transparent, managers responded in a manner that can be explained by legitimacy and institutional theories and the maintenance of the managers’ and their firms’ financial reporting reputations. They conduct their study over the 1992-1996 period and in their modelling of managerial reputation and legitimacy concerns; they use variables indicating whether a firm has a professional affiliation, was audited by the then Big 6 accounting firms, and is a member of the G 100. They find that concerns about firm reputation result in higher levels of disclosure.

Trueman (1986) affirms the legitimacy and firm reputation maintenance perspective, albeit focusing on individual manager reputation concerns. The author contends that there are incentives for talented managers to increase disclosure so as to differentiate themselves. Disclosure levels can influence investor perception of managers’ ability to anticipate and respond to future changes in the firms’ economic environment. Extending this reasoning to derivatives disclosures, I expect that managers will provide high quality disclosures so as to convey their sophistication and ability to effectively manage risk exposures. Hence, the talent signalling perspective would predict that more talented managers would disclosure more than

those who are less talented. For modelling purposes, I assume organisational legitimacy and managerial reputation to be closely related.

3.5.2

Managerial compensation

Executive compensation is another determinant of disclosure. Executive compensation can influence managers’ risk aversion and this can influence how managers disclose information. Chapter 2, sections 2.3.3 and 2.4.5.1, show that the agency costs arising from executive compensation, can influence corporate managers’ desire to smooth firm performance through either derivatives use or discretionary accruals. The same motivation can influence their disclosure of derivatives related information with a view of influencing the perceived riskiness of their firms. Along similar lines, Healy and Palepu, (2001) argue that compensation value maximisation can influence disclosure. Managers with significant levels of stock based compensation have incentives to disclose so as to bolster the liquidity and correct any perceived under-valuation of their stock portfolio. Managers can also be in a position where they do not want to be constrained by restrictive insider trading rules and therefore may disclose all potentially price sensitive private information that they hold prior to trading of their stock holding.

As described in earlier chapters, sections 2.3.3 and 2.4.5.1, managerial compensation typically comprises of stock based compensation and stock options in addition to cash compensation. The overall value of stock compensation and in-the- money stock options tends to be sensitive to price variation, namely the delta of compensation dominates. When delta dominates stock price and firm performance volatility become undesirable. On the other hand, out-of-the- money options can induce a desire for higher volatility as this increases the value of the stock options (Supanvanij and Strauss, 2006). In other words when vega dominates managers may welcome uncertainty and volatility of firm performance.

There is limited empirical evidence linking managerial compensation and derivatives disclosure. Aggarwal and Simkins (2004) find that firms where managers have higher proportions of stock options tend to have lower levels of derivatives disclosure. They infer that this is evidence of agency costs restraining disclosure. Although they do not explicitly measure vega and delta sensitivities, it is likely that vega dominated their sample or that the sample of stock options were largely out-of-the- money.

It is necessary to qualify that the described relationship between managerial compensation and derivatives disclosure is predicated on derivatives being used for risk management purposes. If a firm is engaging in speculative use of derivatives, enhanced disclosure will

only result in greater perceived riskiness. On the assumption that it is difficult to readily observe upfront, whether derivatives are used for hedging or speculation, it is hard to predict the direction of the relation between compensation and disclosure. Nevertheless, similar to other studies (Aggarwal and Simkins, 2004), managerial risk incentives are included as a determinant of disclosure.

3.5.3

Litigation cost

Disclosure of information can occur so as to avoid negative litigation consequences. Companies could disclose information due to the fear of legal sanctions should they provide either untimely or inadequate disclosures (Skinner, 1994). Unlike capital markets incentives, litigation cost concerns could deter the provision of forward looking information due to the risk of measurement error and low credibility of such information.

3.5.4

Corporate Governance

Chapter 2, section 2.4.6.1, discussed how corporate governance can influence earnings management reporting practices. The anticipated impact of an effective oversight role on firms reporting practices can be extended to risk disclosure. Stringent corporate governance structures can lead to higher levels and quality of disclosure. Another factor that could influence corporate governance and disclosure quality in the post-SFAS 133 period is the Sarbanes Oxley legislation. The Sarbanes Oxley Act (SOX) was enacted in 2002 in response to a number of high profile accounting related failures such as Enron and WorldCom. The legislation aimed to improve the corporate governance regime and internal control environment46, and consequently to improve the overall financial reporting quality (SEC 2003 and Leech, 2005). On corporate governance, the Act addresses board composition and responsibilities, auditor independence, auditor review of internal controls and CEO and CFO certification of financial statements. The improvement in disclosure involve reporting off- balance-sheet transactions and contractual obligations, communicating information that has a material impact in a timely fashion and assessing the adequacy of internal controls (Akhigbe, Martin and Newman, 2008).

Although SOX does not prescribe specific quantitative risk disclosure requirements, it can be inferred that the enhancement of financial reporting quality will include the provision of more and better risk disclosures. SOX could also induce firms to disclose negative information, in the context of derivatives use. This could include information on risk exposures and speculative use of derivatives. Akigbhe et al (2008) find evidence to the effect that SOX led

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Section 404 requires companies to include an assessment of the effectiveness of the internal control over financial reporting and an auditors’ attestation of the assessment in their annual reports. Section 302 requires a report on any changes in the internal control

to an increase in the perceived riskiness of firms by investors. This study controls for SOX through inclusion of the year dummy for when the change was enacted (i.e. 2002). Similar to Aggarwal and Simkins (2004), this study includes a proxy for corporate governance as a determinant of disclosure (i.e. the level of institutional ownership and corporate governance index). More discussion of this is included in 2.4.6.1.

3.5.5

Firm performance

Some theoretical models (Verrecchia, 1983) propose that good performance ought to result in increased disclosure, as firms tend to withhold negative news and disclose positive news. However other studies suggest that while performance is related to disclosure, the nature of the relation is unclear (Miller, 2002). Miller (2002) studies a set of disclosures and how these relate to earnings performance. He studies disclosure patterns as firms experience earnings increases, as earnings performance nears its end and when earnings are in decline. He finds unambiguous evidence that firms increase their disclosure levels as earnings increase. The trend is somewhat ambiguous when the earnings increase ends. During such a phase, firms with strong performance increase their long-term related disclosures while those with poor performance focusing on short-term oriented disclosures. At points of earning decline, there is a decrease in the level of disclosure.

Similar to Miller (2002), Leuz (2004) asserts that the relation between profitability and disclosure is complex and ambiguous, as it depends on the nature of the competitive landscape and the potential proprietary costs that could result. In a situation of high barriers to entry, firms are likely to disclose more than if there were lower entry barriers. Consistent with the above mentioned disclosure studies (Leuz, 2004); firm performance is included as a determinant of disclosure.

3.5.6

Firm size

Derivatives use and derivatives accounting require highly skilled personnel and sophisticated supporting technological platforms and internal processes. Leuz (2004) asserts that firm size is expected to be positively associated with disclosure levels. This is because size provides firms with economies of scale in relation to bearing the costs of disclosure i.e. costs of producing and disseminating information (Nikolaev and van Lent, 2005 and Leuz, 2004).

However,larger firms also typically have a larger institutional and analyst following and such investors are better placed to derive potential cost savings for private information acquisition. This can result in large firms being in a better position to hide their proprietary information

(Leuz, 2004). Therefore, the relation between firm size and observed disclosure is ambiguous. In addition, firm size can also be a proxy for both institutional legitimacy and reputation.

3.6

Conclusion

This chapter has outlined the theoretical framework of the impact of SFAS 133 on disclosure, alongside proposing testable hypotheses. The main contribution is the focus on the interaction between SFAS 133 fair value recognition and measurement, and disclosure requirements, combined with an analysis of the incentives that influence disclosure. This line of inquiry will illuminate whether SFAS 133 fair value requirements and increased complexity resulted in footnote disclosure becoming a complement or whether there is still a substitution effect. It builds on the work of Hamlen and Largay (2005) that focuses on the SFAS 133 impact of a small sample study (i.e. 30 Dow Jones companies) over a limited time period but does not factor in the interaction of incentives and disclosure levels. It is an enhancement of Aggarwal and Simkins (2004), where the focus is on incentives in the context of SFAS 107 which only required fair values to be disclosed through the footnotes. It also extends the work of Dunne, Helliar, Power, Mallin, Ow-Young and Moir47 (2004) who conducted a similar study in the UK context under FRS 13. However, FRS 13 did not have fair value recognition and measurement requirements.

On other derivatives footnote incentives, apart from the SFAS 133 recognition and measurement requirements, I primarily investigate the impact of capital markets and proprietary cost incentives as these incentives can be influenced by SFAS 133. The incentive postulations are premised on the increased information content under a regime that requires fair value disclosures and reduced proprietary nature of footnote disclosure information, after SFAS 133. I further control for other determinants such as managerial reputation, compensation based incentives, corporate governance (including SOX), firm performance and geographic diversification. The development of this chapter continues through chapters 6 (data, sample and research design) and 7 (empirical findings), where I also include discretionary accruals as one of the variables similar to other studies.

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