Unintended Consequences of Lowering Disclosure Thresholds: Evidence from SFAS No. 5

Abstract:     
Investors have asserted that, too often, firms are not disclosing enough information for them to appropriately allocate their investment resources (e.g., Cheney 2008; FASB 2008; Desir et al. 2010). One approach would be for standard setters to lower a disclosure threshold for bad news in order to warn investors of more potential losses. Ordinarily, one would expect that adding more potential losses to a disclosure, would, if anything, add to investors’ perceptions of the risk of future loss. However, we examine two ways in which such a disclosure requirement can actually lower some investors’ risk assessments. The debate over the FASB’s recent proposal to lower the disclosure threshold for a firm’s litigation risk disclosures provides us with a timely setting to examine these two unintended consequences on different types of investors. First, lowering a disclosure threshold naturally means including additional potential losses in the disclosure that were previously thought too inconsequential to disclose. If some investors allow the low-probability losses to dilute, rather than add to, the more probable losses in their overall perceptions, then the requirement to disclose more bad news could actually lead to more favorable perceptions of litigation risk. Consistent with prior research on the dilution effect, we find that potential investors are the most susceptible to this effect. Second, since lowering the threshold likely changes the overall composition of the disclosure by adding low-probability losses, firms could adopt a “laundry list” strategy that characterizes the entire disclosure as unimportant, presenting the lowest risks most saliently, using compliance with the low threshold as a plausible reason for giving a lengthy disclosure of generally unimportant risks. Our experimental findings suggest that this strategy can be persuasive. Our findings have important implications for standard setters, investors, auditors, and researchers.

Number of Pages in PDF File: 45

Keywords: Accounting standards, disclosure thresholds, investor behavior

JEL Classification: C91, M40, M41, M49

working papers series