Towards a Risk-Neutral Disclosure Policy: The Role of Compensation in Management Forecast Quality
51 Pages Posted: 28 Nov 2018 Last revised: 21 May 2019
Date Written: May 19, 2019
We investigate whether contracting with managers can serve as a mechanism to encourage them to reveal more of their private information to capital market participants. Under the assumption that managers have private knowledge of their firms’ future earnings performance, we use management forecast accuracy as a proxy for the extent to which managers reveal their private information and offer two main findings. First, both the amount of severance pay a manager receives and the convexity of a manager’s stock option portfolio (i.e., vega) are positively associated with that manager’s forecast accuracy. This result suggests that if shareholders compensate managers in ways that reduce concerns over firm volatility, managers are more forthcoming with their private information. Second, these contracting incentives are more strongly associated with managers’ forecast accuracy when short-term pressure to conceal private information is higher. Additional analysis suggests that (1) these results cannot be explained by earnings management activity subsequent to the forecast or by managers’ innate ability, (2) managers with these contracting incentives issue less optimistically biased forecasts, and (3) these contracts increase forecast accuracy of both good and bad news. Overall, our results suggest that shareholders can contract directly with managers to provide more accurate disclosures, a clear benefit to capital market participants.
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