Financial statements are the media through which entities unveil various economic elements pertaining to their daily business. The concept of agency between managers and shareholders has helped in the development of arguments for disclosure. Management is solely responsible for the presentation of financial information and must conform to several stipulations. In addition, management must acknowledge that the shareholders and regulators are not the only party privy to the organization’s financial information. Other stakeholders such as creditors, debtors, vendors, potential investors, and consumers are also interested in such information to make informed decisions. Fundamentally, International Accounting Standard 1 (IAS) stipulates the procedure of disclosures by concisely outlining the elements to which preparers of financial statements should adhere. The increased value of relevant information has fueled the efforts to encourage entities to disclose substantial information, which usually entails extending disclosure aspects to even the information not stipulated by such standards. Voluntary disclosures are gaining recognition across all industries as the demand for meaningful information rises. Limitations such as the complexity of financial statements continue to encourage this course. The purpose of this paper is to elucidate the aspects of necessitating and issues affecting the voluntary disclosure of material information in entities’ financial statements.
Background of Voluntary Disclosure
IAS and other international accounting bodies have played a pivotal role in streamlining organizations to conform to meaningful disclosure of financial information. Given the dynamic nature of business environments across the globe, it is prudent to make disclosure standards as flexible as possible. Nonetheless, such provisions are limited to certain areas that may have negative implications for an entity and its establishment. More importantly, financial disclosures required by statute and IAS must not contradict the autonomy of organizations in providing the sensitive information to the public. Today, investors, for example, need more than the figures and amounts documented in annual reports to make sound financial decisions. The costs and benefits analysis of voluntary disclosure has helped in the argument for and against the practice. Partaking voluntary disclosure, on the one hand, benefits external stakeholders such as investors. Contrarily, such revelations are also linked to creating a competitive disadvantage to an organization (Xia, 2016). Thus, the balance of the pros and cons helps in explicating the worthiness of discretionary disclosures.
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Notably, numerous factors influence voluntary disclosure of financial statements. They include size of the firm, structure of ownership, leverage level, company age, profitability and the size of audit firm (Heinle & Smith, 2017). The size of a company determines how often the voluntary disclosure of financial data is done. Notably, large companies tend to disclose data often compared to the small ones. The assumption is always that, the proportion of the outside capital is higher for the bigger companies (Heinle & Smith, 2017). Ownership structure demands for disclosure of financial statements as a way of minimizing conflicts among owners (McMullin et al., 2019). The afore-mentioned is informed by the agency theory, which suggests that due to separation of ownership and control, there are chances that conflicts will erupt in a company (Heinle & Smith, 2017). For that reason, voluntary disclosure of financial statements is the only remedy. Firm’s leverage equally determines the rate at which voluntary disclosure takes place. In essence, in order to appeal to debt financiers, disclosure is more likely to happen. The exercise is also used to send positive information to debtors and investors (McMullin et al., 2019). Factually, audit firms influence the quality and level of corporate disclosure. The quality of external auditing tends to trigger corporate disclosure. Whenever a firm has higher financial perspectives, there is a high likelihood of disclosing financial information. By so doing, the firms manage to minimize information asymmetry between the managers and outsiders (McMullin et al., 2019). High profits serve as a motivation for managers to provide financial information in a bid to win investor’s confidence. In that sense, capital market and accounting performances are linked with higher chances of voluntary disclosure (McMullin et al., 2019). In terms of age, it is assumed that an older organization stands a higher chance of disclosing financial information. Essentially, an organization that has operated for years is likely to have a competitive edge in releasing, processing, and collecting information (McMullin et al., 2019).
Literature Review
Financial statements are inherently complex and pose interpretation risks to the users of such information. Risks of interpretation may take two forms: 1) overlooking specific economic indicators; and 2) failure to recognize vital relationships. Thus, the essence of voluntary disclosure is to eliminate such complexities, thereby making financial statements more comprehensible. Guay et al. (2016) find discretionary reporting as a useful tool in mitigating the rigidities associated with various types of financial statements. The study employs the number of forecasts as the determinative element of voluntary disclosure by an entity. It is worth mentioning that no stipulations (international or otherwise) require a company to present users of financial information with its economic prospects. Guay et al. (2016) argue that managers, as the agents to shareholders, seek for opportunities to report essential, yet non-mandatory information in annual reports. Such additions help in illuminating specific unclear or potentially controversial accounting aspects of an entity (Guay et al., 2016). In effect, discretionary reporting helps managers in mitigating risks associated with the complexity of financial statements.
Similarly, Noh et al. (2019) find an increase in the adoption of voluntary disclosure in public traded companies, despite the significant amendments made on the Securities and Exchange Commission’s (SEC) Form 8-K. In 2004, Congress passed the Sarbanes-Oxley Act, which required entities to use real-time disclosures for substantial financial changes. Correspondingly, the economic context of business information expanded considerably, which meant that companies were no compelled to make discretionary reports. Nonetheless, these changes also stipulated the inclusion of a particular set of economic events, most of which companies have found to be irrelevant. In consequence, entities have been in cross-purpose with the provisions of Form 8-K and have resolved to include additional relevant information for the users. Noh et al. (2019) explore key weaknesses of Form 8K in attaining the comprehensiveness of reports’ purpose, which then prompts firms to employ voluntary disclosure. Examples of such aspects include material contracts and codes of ethics. Accordingly, managers prefer the organization’s guidance to these stipulations as they fail to meet the goals of such disclosure sufficiently.
Further, Form 8-K is not flexible when reporting personal information about an enterprise’s undertakings. Noh et al. (2019) argue that one of the motivations behind voluntary disclosure of relevant information is to convey positive information, also dubbed as good news , to existing and potential investors, and other stakeholders. Unlike the rigid 8-K guidelines, managers have the discretion to reveal a wide range of favorable financial data, thus attracting investors and minimizing litigation risks (Noh et al., 2019). Therefore, entities seek discretional reporting in situations where the alternative means fail to enable them to create a desirable corporate image sufficiently. Such arguments that have made voluntary disclosure a substitute to Form 8-K, rather than a compliment.
Contrarily, Dyer et al. (2016) question the presupposition that complexity in financial disclosures is the most crucial determinant of discretionary reporting. The authors find that while Guay et al.’s (2016) revelations are critical in understanding the causality of such rigidity in voluntary disclosures, the effect of economic factors should not be underestimated. The dynamic nature of the corporate world today has partly led to the contextual changes in financial statements in particular and financial reporting as a whole. With the rise in computing power and investor knowledge, preparers of financial statements do not necessarily have to conform to the length of annual reports to ensure conciseness. Dyer et al. (2016) further argue that complexity is not as relevant as it used to be in the past two decades as it is today in determining whether to partake voluntary disclosure or not. Instead, the dynamic economic aspects surrounding enterprises today have necessitated the reporting of non-mandatory financial information to educate users of crucial financial elements.
Organizations exist to bring value to the consumer through external value creation. Internal value addition rewards companies with greater cash flows, which subsequently leads to increase in revenue for shareholders (Heinle & Smith, 2017). To sustain such success trajectories, companies must enhance financial disclosure to assess quality and performance. Performance measures identify whether organizations are committed to achieving preset goals and maximizing customer satisfaction. Notably, increased pressure from shareholders to deliver adequate returns on investments has led to more analysis of disclosure in the market (Heinle & Smith, 2017). Nowadays, shareholder’s interests in wealth maximization demand that companies account for every resource used in organizational development. Managers use the information obtained from financial statements to determine performance. Mandatory disclosure is no longer sufficient in meeting the needs of corporate information (Heinle & Smith, 2017). Increased demand for information in modern business environments makes voluntary disclosure a decisive element of determining organizational efficiency. Additionally, financial scandals have contributed to the decline of long-term companies. Therefore, shareholders require additional information to determine whether the organization performance aligns with pre-determined goals. Encouraging this level of transparency attracts investors, who analyze current and future market valuation of a company based on voluntary disclosure. Precise earning disclosure could result in higher investment from shareholders due to a lower perception of risk.
Further, risk disclosure has become integral after the 2007-2009 global financial crises. Concerns arose on the risk-taking in public companies. As indicated, most of the companies have eventually failed in the past decade due to their culture of non-disclosure. The FASB indicated that financial statements are necessary to determine an organization’s exposure to risks and their effects on decision making in capital allocation (Dey et al., 2018). In the past decade, disclosure has led to greater transparency and increased investor confidence in partaking business. Dey et al. (2018) state that the Dodd-Frank Act (DOF) enacted in 2010 requires that large corporations establish a board-level committee to assess disclosure of financial risks. Additionally, adopting enterprise risk management has discouraged management from risk-taking behavior (Dey et al., 2018). Such regulations have substantially improved accountability in financial reporting. Investors respond better to variance information, where the disclosure minimizes the uncertainty premium. Through voluntary discourse, companies can compare two data tests on share prices and narrow down the investors’ perception of variance. Reporting risk discourse informs investors on the amount of risk the company faces currently and in future.
Furthermore, financial reporting fraud has been a challenging issue in disclosure causing considerable risks to capital markets. Fraud refers to a misrepresentation or misreporting of facts. This action must be material and a result of reckless and negligent handling of information. Amiram et al. (2018) suggest that misconduct in financial disclosure undermines trust between companies, market participants, and shareholders. It affects appropriate allocation of resources leading to unprecedented losses and lack of interest from investors. Available evidence suggests that SEC applies an industry-specific approach in enforcing financial misconduct laws (Amiram et al., 2018). This approach has been inefficient in checking financial misconduct because corporations have identified workarounds through elusive legal strategies. The main concerns are on the stakeholder’s part. Amiram et al. (2018) find that despite managers being the most common perpetrators of financial misconduct, shareholders bear most of the effects since they make monetary payments. As such, shareholders incur heavy losses and reputation damage due to the misconduct itself. Overconfident managers are usually less inclined to share actual financial data in an attempt to cover up failures. Most managers apprehended by the SEC end up being replaced but few ever face jail time. Indeed, encouraging voluntary disclosure will require stringent policies in handling financial misconduct.
In addition, questions exist on reasons behind most non-disclosure and financial misconducts. Various capital market motivations motivate financial fraud. This set of motivations seeks to increase a company’s common stock (Amiram et al., 2018). Examples of common stock include preferred stocks that are at times restricted for top executives. Notably, these reserved stocks can be lucrative to an extent top executives prefer to alter the company’s stock to reflect higher figures to increase the restricted shares they receive. This behavior deters the progress of voluntary disclosure. Other instances of misreporting financial statements occur through companies offering restricted stock options to rank-and-file employees (Amiram et al., 2018). This is done as an incentive to lure the employees into misreporting and deter them from informing authorities. In addition, companies commit financial fraud as a means of gaining higher prices for equity and lowering interest rates for a loan (Amiram et al., 2018). This is a common case where companies conceal financial difficulties in the company. Risk disclosure in failing companies increases the risk premium thus lower external financing options. Financial misreporting also provides temporary boosts to failing companies. Voluntary disclosure that includes misleading information creates false faith in a failing company. Indeed, corporations might provide voluntary disclosure but the integrity of information presented matters most.
Consequentially, there are numerous benefits of more specific risk disclosure. SEC defines specificity as the practice of offering financial statements in specific number of words or phrases conveying specific information relevant to the firm (Hope et al., 2016). This means that companies should refrain from generic terms in their financial reports. For instance, the word “Apple” is more specific compared to the generic term “Firm”. Ambiguous statements leave room for multiple interpretations that can mislead shareholders. Specificity minimizes omission of important variables in the financial statement. SEC demands a 10-K report from public companies annually (Hope et al., 2016). This report is usually more comprehensive than normal reports and thus demands a high level of specificity. As indicated, investors find specific risk disclosure more reliable in assessing a firm’s accounting records when deciding on investment. With specific data, investors gain a vivid depiction of the company’s current state. Good governance emanates from transparency in voluntary disclosure. Shareholders and potential investors gain confidence in a company that willingly dispenses essential information on business performance. Hope et al. (2016) suggest that applying Named Entity Recognition (NER) technology can reduce the complexity of financial disclosure and provide near-human experiences.
Accordingly, the SEC has provided regulations on the necessities required in 8-K forms. This report ensures corporations inform shareholders and possible investors on major company events. Before this regulation, companies were only required to file reports at quarter-end. The intention was to provide firms with frequent information on the company’s performance. McMullin et al. (2019) contend that frequent disclosure ensures companies are more capable of the capital formation process. Increased mandated disclosure has been associated with higher price formation. Compelling companies to engage in frequent voluntary disclosure could elicit similar benefits. Changing from a semi-annual to a quarterly reporting schedule can reduce equity costs and interest rates. McMullin et al. (2019) suggest firms that voluntarily shifted to a quarterly schedule were likely to experience more productivity compared to those mandated to disclose information. The 8-K forms contain valuable information because it provides in-depth information on a shorter period compared to 10-K annual reporting. The SEC has prioritized ensuring 8-K forms are efficient to ensure that previously undisclosed information is assimilated into the company value (McMullin et al., 2019). Doing so ensures price formation is determined regularly giving a clear assessment of company stock price. With this information, investors can better decide which corporations are more likely to convert resources into profits. Findings suggest that voluntary disclosure is correlated with higher firm value.
Revealingly, the capital need theory is useful in explaining why some firms find voluntary disclosure an essential process. The theory argues that, managers in firms with intentions of making capital market transactions are heavily motivated to disclose information voluntarily (Hope et al., 2016). Notably, the liquidity in the stock market is enhanced by information disclosure, which leads to reduced cost of equity capital either through reduces cost of transaction or increased demand for the firm’s shares (McMullin et al., 2019). In that spirit, additional voluntary disclosure is preferable considering it helps to reduce the uncertainties surrounding the performance of a given company (McMullin et al., 2019). Based on this theory, whenever financial information is released voluntarily, investors are attracted and this helps in maintaining a healthy demand of the company’s shares (McMullin et al., 2019). Eventually, with higher level releasing financial information, the firm ends up gaining more on the stock prices.
Conclusion
The value of financial information cannot be overestimated. The complexity of financial statements has necessitated the adoption of mechanisms to offer supplementary information to users. Such rigidity is manifested in the inability of financial statements to conform to organizations’ goals, such as appealing to investors. Fundamentally, financial statements are limited to providing financial potion and performance of the reporting period. Information such as an entity’s prospects can only be revealed discretionally. In addition, existing reporting frameworks such as SEC’s Form 8K fail to provide a sufficient avenue for subjective reporting, this is crucial in promoting investment and growth. Further, the growing stakeholder knowledge has also prompted the extension of financial reporting, thereby demanding for discretionary disclosure. Further study is needed on the impacts of voluntary disclosure on an entity’s corporate image.
References
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