This is potentially the most discussed attribute of disclosure quality in information content research conceivably due to the high accord regulatory bodies attach to the ascription. For example in the UK, ASB (1993; 2003; 2005; 2006) all agree that among other uses, narrative commentaries help members assess future prospects. Although the EU Accounts Modernisation Directive places less emphasis on forward-looking disclosure, an indication of future business developments is still required (Trucost 2006).
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Schleicher and Walker (1999) examined the information content of the OFR following first ever issuance of a guideline for narrative reporting by ASB (1993). The non-mandatory recommendations suggested that managers ought to discuss factors underlying operations and financial performance to provide a better understanding of the nature of the business, its environment and risks it faces. In the process of doing so, investors would be able to evaluate the future prospects of the company more accurately. In the study, forward-looking disclosures were specifically considered due to their capability in predicting future earnings changes. Through a dichotomously scored disclosure index, the variable values for future oriented disclosure were significantly associated with future earnings changes as well as market returns, confirming the hypothesis. Schleicher et al (2007) used computerised text-search to score UK annual report narratives and regression analysis to estimate disclosure level of forecast information and its information content, respectively. Still, even when an updated and bigger sample is applied compared to that in Schleicher and Walker (1999), future oriented information was useful to investors in instances of loss making firm. The prospective attributions confirmed to investors that loss making was not perpetual and the outlook of the business is good. The distinct feature in the study is that prospective disclosures in narratives of profit making firms were not relevant, implying that good profitability was confirmatory of the firm‟s future earnings potential.
In Australia, both impression management and incremental information have been applied to explain the relationship between returns and forward-looking disclosures. Boo and Simnett (2002) postulate two cost/benefit market scenarios that affect disclosure of forward looking information, the product market (competitive advantage) and financial market consideration (need for financing). When firms are financially distressed (loss making), the domination for financing requirements over competitiveness risks will compel firms to provide good prospective disclosures to attract investors. However, since the firms are loss making, there is a risk of management bias in providing forward-looking information. The fear for management reputation subdues this incitement because future oriented disclosures can be verified ex post (Hoskin et al. 1986). Boo and Simnett (2002) manually read annual reports of 140 loss-making Australian Stock Exchange listed firms and classified management
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prospective as optimistic or pessimistic. Similar to Schleicher et al (2007), results showed that financially distressed firms that disclosed opportunistic prospective narratives were most likely to succeed. Non-disclosing loss making firms were likely to fail, whilst the likelihood to fail was not different for firms having pessimistic or mixed prospective disclosures. The findings, justifying the reliability of good prospective disclosures, were attributed to presence of an audit opinion as well as potential litigation and reputation costs of misleading disclosures.
Lundholm and Myers (2002) use the AIMR scores for future oriented disclosures to estimate the extent to which prospective disclosures explain current share price returns. They argue that a firm can bring its future forward to the current period by revealing expected earnings changes. Both cross-sectional regression and time-series analyses confirmed the hypothesis where increased disclosure scores were associated with greater share price returns. To the contrary, Lang and Lundholm (2000) find mixed results for information content of changing disclosure patterns prior to equity offering firms on the NASDAQ exchange. A disclosure index method was used to code various information items to include information relating to short-term and long-term future narratives, among other information types and attributions. In the study, the contemplation was that firms use future oriented disclosures either as means of reducing information asymmetry or “hype the share”. Based on the disclosure culture of the company, firms that maintained a constant reporting pattern were characterised by significant returns prior to the offering and minor declines post the offer consistent with the hypothesis of reducing asymmetry. For significant disclosure increases prior to the offering, share prices considerably declined suggesting that there was an attempt to exaggerate the share value to which the market corrects itself by devaluation on issuance of the shares. Kasznik and Lev (1995), also consider two motivations for providing future oriented narratives. With the speculation that surprising investors with large unexpected future earnings may negatively influence share prices, managers weigh the risks to warn investors or not. Where the unexpected performance was bad news, firms occasionally warned with highly hard (quantified information) to instil investor confidence. Other variables that affect the propensity to provide more warnings were size of the surprise, existence of earlier prospective
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disclosures, membership to the high tech industry and firm size. For highly regulated firms, fewer warnings were provided. Because of the negative impact that the warning was expected to cause, management provided cautionary note in situations where bad news were to prevail for a long future period but for temporal bad news such warnings were not widespread. In turn, investors negatively and significantly reacted to the warnings due to doubt about the long-term competitiveness and economic viability of the firm. It was concluded in the study that the adverse investor reaction to future oriented disclosures of warnings explained the low levels of disclosures relating to future bad news despite risks such as increased investors‟
transaction costs and litigation.
Another dimension in Lev and Penman (1990) theorises that firms with good prospective news will disclose it to distinguish themselves from poorly performing firms. Such a tendency is explained by the signalling or screening theories. Although this is impression management, information content of such disclosures reflects that the information is verifiable, possibly ex-post in audited financial results. The alternative posit is that badly performing firms do not disclose to which investors interpret as a concealment of bad news hence react negatively. A test the theory, the researchers manually read annual earnings forecasts for firms listed on NYSE and AMEX and compared the impact of the disclosures on the cumulative abnormal returns. The results confirmed their hypothesis regarding intent for disclosure of forecast information but not nondisclosure, concluding that the strategy of not providing information does not necessarily mean concealment of bad news. Noticeably, the findings in Lev and Penman (1990), to a certain extent, differ from Schleicher et al (2007) in UK who suggested that forecast information for good performing firms has no relevance to share price returns as the current performance is sufficient to attract investors.
There are a number of other studies that find disclosures of future prospects informative. For example, Hoskin et al (1986), through a regression analysis using two-day excessive returns and a dichotomously scored disclosure profile for all announcements made around the earnings announcement in the period 1979 to 1981. The future attributions in narratives were regarded credible despite being voluntary. Perhaps, in fear of subduing reputation, officers are compelled to provide credible and useful information. Gelb and Zarowin (2002) used AIMR-
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FAF disclosure scores and annual share price changes but still find that greater disclosures are associated with positive returns. They suggest that primary objective of disclosures is to create certainty about future cash flows. Therefore, the evidence of information content in enhanced disclosures affirms that the narratives lead to better prediction of the future. Francis et al (2002) and Eiker et al (2000) subscribe to the ability of the forward-looking disclosures to inform on the future performance of the company. Similarly, market tests by Baginski et al (2000) showed that auxiliary narratives to management forecasts were significantly related to three-day cumulative abnormal returns. Investors considered the disclosures as credible conveyance of information from management thereby presenting a potentially useful extension of the financial reporting model. Atiase et al (2005) propose that the usefulness of prospective narratives depends on the investors‟ perception regarding the information‟s relevance and reliability. This value of prospective disclosures is deduced from its relationship with past performance as investors weigh it against the verifiable past information on performance.
Largely, the evidence above articulates that forward-looking disclosures are useful to investor although there are instances where the attribution is subjected to impression management. As an addendum to the credibility virtue in future-oriented disclosures Abrahamson and Amir (1996) argue that the attribution bridges the information gap by addressing the deviancy between the purpose of financial reporting (provide information to guide future investment decisions) and the kind of information financial statements contain (historical information).
The studies also recognise that impression management in the forward-looking attribute of narratives is constrained by the likelihood litigation and reputation risks; hence augmenting the usefulness of the disclosures.