Do Managers Issue More Voluntary Disclosure When GAAP Limits Their Reporting Discretion in Financial Statements?

• Published date: 01 March 2022
• Author: PAUL HRIBAR,RICHARD MERGENTHALER,AARON ROESCHLEY,SPENCER YOUNG,CHRIS X. ZHAO
• Date: 01 March 2022
• DOI: http://doi.org/10.1111/1475-679X.12401

DOI: 10.1111/1475-679X.12401

Journal of Accounting Research

Vol. 60 No. 1 March 2022

Printed in U.S.A.

Do Managers Issue More Voluntary

Disclosure When GAAP Limits

Their Reporting Discretion in

Financial Statements?

PAUL HRIBAR,∗RICHARD MERGENTHALER ,†

AARON ROESCHLEY ,‡SPENCER YOUNG ,§

AND CHRIS X. ZHAO 

Received 20 December 2018; accepted 30 July 2021

ABSTRACT

We examine whether managers provide more voluntary disclosure when

GAAP limits their reporting discretion in financial statements. We find man-

agers are more likely to disclose non-GAAP earnings, issue more management

forecasts, and provide longer yet more readable management discussion and

analysis (MD&A) disclosures when GAAP limits their discretion. These ef-

fects are stronger when there is greater demand for information and bet-

ter monitoring. In contrast, these effects are weaker when managers have in-

centives to manage earnings. Difference-in-differences analyses around stan-

dard changes provide further evidence that managers make more non-GAAP

adjustments and are more likely to discuss the standard and its underlying

transaction in the MD&A when a new standard limits their discretion more

than its predecessor. Collectively, our results suggest managers use voluntar y

∗University of Iowa; †Penn State University; ‡University of Kentucky; §Arizona State

University; Hong Kong Baptist University

Accepted by Douglas Skinner. We appreciate helpful comments and suggestions from

an anonymous referee, Max Hewitt, Roger White, Dain Donelson, and workshop partici-

pants at the University of Houston, University of Iowa, the University of Arizona, Lancaster

University, Queen’s University, and the 2018 AAA Western Regional Doctoral Student Fac-

ulty Interchange. An online appendix to this paper can be downloaded at http://research.

chicagobooth.edu/arc/journal-of-accounting- research/online-supplements.

299

© 2021 The Chookaszian Accounting Research Center at the University of Chicago Booth School of

Business

300 hribar et al.

disclosure channels to convey information when GAAP limits their ability to

recognize such information in financial statements.

JEL codes: M40, M41, M48, M49

Keywords: managerial discretion; mandatory financial reporting; voluntary

disclosure; quality of accounting information

In our view the proposed amendment [to the Derivatives and Hedging

standard (topic 815)] that would require physical settlement of the contract

accounted for as a derivative to be probable is overly restrictive and would

result in financial reporting that is inconsistent with an entity’s risk management

activities.

Ernst and Young LLP, Comment Letter dated January 13, 2020 (emphasis

added).

1. Introduction

Accounting standards outline the rules managers must comply with when

recognizing information in GAAP financial statements.1There is consid-

erable debate, however, about how much discretion accounting standards

should afford managers. When discretion is limited, so is the range of

economic information managers may communicate through the financial

statements. This matters because narrowing the range of information rec-

ognized in financial statements limits their informativeness, increases in-

formation uncertainty, and has economic consequences (Holthausen and

Leftwich [1983], Christensen, Nikolaev, and Wittenberg-Moerman [2016],

Guay, Samuels, and Taylor [2016]). In this paper, we examine whether

managers are more likely to convey information via voluntary disclosure

channels (e.g., management forecasts, management discussion and analysis

[MD&A], and non-GAAP earnings) when GAAP limits their reporting dis-

cretion and thereby the information they can recognize in financial state-

ments.

Understanding whether managers issue more voluntary disclosure when

GAAP limits managers’ discretion is important for several reasons. First,

voluntary disclosures are often unaudited, difficult to monitor, and expose

firms to litigation risk (e.g., Donelson, McInnis, and Mergenthaler [2012]).

Second, managers can choose to withhold voluntary disclosures, potentially

limiting the production of information that investors and other stakehold-

ers desire. Finally, standard setters are interested in the totality of informa-

tion conveyed to investors (FASB [2010]). Together, these factors suggest

1Following Statement of Financial Accounting Concepts No. 5, we define recognition as

“the process of formally incorporating an item in the financial statements of an entity as an

asset, liability,revenue, expense, or the like. A recognized item is depicted in both words and numbers,

with the amount included in the statement totals” [p. 24].

the effect of limiting managers’ reporting discretion on voluntary disclosure

301

that investors, standard setters, and regulators care whether information is

conveyed through voluntary or mandatory channels. Our research informs

standard setters and policy makers about how the discretion afforded to

managers by GAAP affects the channel through which managers convey

information.

Toexamineourresearchquestion,wecreateanewmeasurethatcap-

tures the extent to which GAAP limits managers’ reporting discretion in

financial statements. The conceptual underpinnings of our measure are

borrowed from the legal literature that identifies modal verbs as a subset of

verbs implying necessity, restriction, or obligation (e.g., Trosborg [1995],

Federal Plain Language Action and Information Network [2018]). Our

measure quantifies the number of times the modal verbs “shall,” “should,”

and “must” occur in each accounting standard, adjusted for transaction

complexity and standard length. We use this measure as a proxy for the

extent to which each accounting standard limits managers’ reporting dis-

cretion in financial statements. We then weight our standard-level measure

by the relative importance of each accounting standard to the firm (e.g.,

Folsom et al. [2016]) to obtain a firm-year measure of the extent to which

GAAP limits managers’ reporting discretion in financial statements.

In our first set of analyses, we use this measure to examine whether

managers provide additional voluntary disclosure when GAAP limits their

reporting discretion in financial statements. We find evidence consis-

tent with increased voluntary disclosures when managers’ discretion is

limited. In terms of economic significance, firms in the highest decile

of our measure (i.e., instances where GAAP limits managers’ discre-

tion most) issue 0.50 additional management forecasts per year and

are 16.6% more likely to provide a non-GAAP earnings number than

firms in the lowest decile of our measure.2In addition, the MD&A

is longer but more readable, and managers are more likely to use

multiple voluntary disclosure channels when GAAP limits managers’

discretion.

We next perform cross-sectional tests examining variation in the relation

between limiting managers’ reporting discretion in financial statements

and voluntary disclosure. We examine how this relation is affected by (1)

monitoring intensity, (2) information demands, and (3) managerial incen-

tives. We find the relation is stronger when firms have better monitoring

and when there is a greater demand for information. The relation is weaker

when executives have incentives to manage earnings.

Our last set of tests uses a difference-in-differences design around ac-

counting standard changes. This design alleviates concerns that attributes

2Because we examine disclosure channels that managers use when GAAP limits discretion,

our tests examine forecasts other than GAAP earnings forecasts. Analyses discussed later and

tabulated in the online appendix provide evidence that our results are concentrated in fore-

casts other than forecasts of GAAP earnings.