Disclosure Versus Recognition: Inferences from Subsequent Events

• Date: 01 March 2017
• Author: JEREMY MICHELS
• DOI: http://doi.org/10.1111/1475-679X.12128
• Published date: 01 March 2017

DOI: 10.1111/1475-679X.12128

Journal of Accounting Research

Vol. 55 No. 1 March 2017

Printed in U.S.A.

Disclosure Versus Recognition:

Inferences from Subsequent Events

JEREMY MICHELS

∗

Received 24 April 2013; accepted 13 May 2016

ABSTRACT

Standard setters explicitly state that disclosure should not substitute for recog-

nition in financial reports. Consistent with this directive, prior research shows

that investors find recognized values more pertinent than disclosed values.

However, it remains unclear whether reporting items are recognized because

they are more relevant for investing decisions, or whether requiring recog-

nition itself prompts differing behavior on the part of firms and investors.

Using the setting of subsequent events, I identify the differential effect of re-

quiring disclosure versus recognition in a setting where the accounting treat-

ment of an item is exogenously determined. For comparable events, I find

a stronger initial market response for firms required to recognize relative to

firms that must disclose, although the large magnitude of the identified effect

∗University of Pennsylvania

Accepted by Christian Leuz. This paper is based on my dissertation, completed at the

University of Colorado Boulder (recipient of the 2014 FARS Best Dissertation Award). I

am indebted to the members of my committee for their insightful comments and contin-

ued guidance: Bjorn Jorgensen (chair), Yonca Ertimur, Alan Jagolinzer, Mattias Nilsson, and

Steve Rock. I also thank Brian Bushee, Paige Patrick, an anonymous reviewer, and semi-

nar participants at the 2013 Financial Accounting and Reporting Section Midyear Meeting

(especially Paul Zarowin, discussant), Arizona State University, Boston College, University

of Chicago, University of Colorado Boulder, Columbia University, Harvard University, Mas-

sachusetts Institute of Technology, University of Michigan, University of Minnesota, New York

University, Northwestern University,University of Pennsylvania, Pennsylvania State University,

University of Rochester, Stanford University, and University of Washington for their helpful

remarks. I gratefully acknowledge financial support from the Deloitte Foundation and re-

search assistance from Raghav Bhargava, John Dong, Mihir Jain, John Lin, Betsy Modayil,

Tanya Paul, and Aaron Zhang. An online appendix to this paper can be downloaded at

http://research.chicagobooth.edu/arc/journal-of-accounting-research/onlinesupplements

3

Copyright C, University of Chicago on behalf of the Accounting Research Center,2016

4J.MICHELS

calls into question whether this difference can be attributed to accounting

treatments alone. In examining various reasons for the stronger market re-

sponse to recognized values, I fail to find support for the hypothesis that this

difference is due to differential reliability of disclosed and recognized values.

I do find some evidence that investors underreact to disclosed events, con-

sistent with investors incurring higher processing costs when using disclosed

information.

JEL codes: G14; M41; M48

Keywords: mandatory disclosure; recognition; subsequent events

1. Introduction

Prior research indicates that investors typically find recognized values

more pertinent than disclosed values (Aboody [1996], David-Friday et al.

[1999], Ahmed, Kilic, and Lobo [2006]). These findings are consistent with

the concept that disclosure should not substitute for recognition (FASB

[1984]). Why investors find recognized values more relevant than disclosed

values remains an open question. Investors may rely more heavily on rec-

ognized values because of differences in the types of firms that choose to

recognize rather than disclose, because of differences in the characteristics

of transactions that are recognized rather than disclosed, or because of a

change in the perceived importance of a reporting item when regulators

require recognition of a previously disclosed item. When these differences

are held equal, however, it is unclear whether investors continue to value

recognition more than disclosure. That is, investors may not value recog-

nition per se, but rather characteristics of firms or transactions that are as-

sociated with recognition. Discerning whether requiring recognition alone

results in a stronger market reaction to an accounting item is difficult, as

accounting standards typically require similar transactions to be uniformly

recognized or disclosed (Bernard and Schipper [1994]). As a result, little

variation exists in the accounting treatment for similar transactions, either

across or within firms. What variation does exist is typically nonrandom,

precluding the establishment of causal inferences.

In this paper, I provide evidence on the differential effect of requiring

disclosure as opposed to recognition by exploiting the required accounting

treatment for subsequent events. A subsequent event is an event occurring

after a firm’s balance sheet date but before the firm issues its financial state-

ments. A firm must disclose a subsequent event if not disclosing the event

would cause the financial statements to be misleading. An example of a

subsequent event requiring disclosure is the loss of inventory or property,

plant, and equipment from a fire or natural disaster. However, a similar

event that occurred prior to the balance sheet date would require immedi-

ate recognition. Thus, in this setting, the timing of a natural disaster deter-

mines if a firm must disclose or immediately recognize an event’s financial

effect. As nature determines this timing, the setting of subsequent events

DISCLOSURE VERSUS RECOGNITION 5

can potentially yield causal inferences on the effect of mandated disclosure

relative to mandated recognition.

I conduct my analysis on a sample of firms experiencing natural disas-

ters. Firms that experience these disasters as subsequent events make up

the disclosing firms in my sample. I match each subsequent event firm to

a comparable firm that experienced a natural disaster prior to its quarter-

end, and thus must immediately recognize the event’s effect. I then com-

pare abnormal market returns following the event through the firms’ filing

of their financial statements across the disclosing and recognizing firms. I

find a stronger initial market reaction for recognizing firms relative to dis-

closing firms, consistent with investors relying more on recognition. The

magnitude of the difference in returns is quite large, however, which calls

into question whether this difference can be attributed to accounting treat-

ments alone. Recognizing firms experience abnormal returns in the initial

event window of −6.02%, compared to 0.95% for disclosing firms. These re-

turns relate to recognized and disclosed losses that are 0.37% and 0.53% of

assets, respectively. Returns between the two groups of firms converge over

time, consistent with the events being of comparable magnitudes. However,

returns between the two groups of firms remain statistically different until

the third quarterly filing date after the event.

While my research design is relatively well suited for identifying whether

investors react differently to disclosure versus recognition, I am less able

to distinguish between the multiple mechanisms through which this result

may attain. A variety of different causal mechanisms may exist. For example,

being assigned to recognition may cause a firm to measure an accounting

item with greater precision or less bias than a disclosed item, either be-

cause managers view recognized values as more important or because the

recognized values receive greater scrutiny from auditors. That is, requiring

different accounting treatments may drive differences in an item’s informa-

tional properties. Further, even if the informational attributes of disclosed

and recognized values are on average equal, investors may rely more on

recognized values if recognized values are more accessible or require less

effort to use. In additional analyses, I explore these alternative explana-

tions. I fail to find support for the hypothesis that differential reliability

causes investors to perceive recognized values and disclosed values differ-

ently. I do find some evidence of a delayed investor response to disclosed

items. These results suggest that investors may find disclosed information

relatively costly to use, and rely primarily on recognized numbers instead.

Some of the causal mechanisms outlined above rely on managers behav-

ing differently depending on whether they are required to disclose or rec-

ognize an event. This is possible because, while a firm has little choice over

whether it must disclose or recognize an item, the firm knows which ac-

counting treatment it has been assigned to and can alter its behavior ac-

cordingly. Thus, one may think of the effect I identify as the effect of the

assignment to a particular accounting treatment, as opposed to just the ef-

fect of the act of disclosure or recognition. While investors may respond