The initial position is to consider ASB (2005; 2006) view which generally states that the narrative commentary provides information useful to investors in assessing the present and future performance of the business and the progress towards the achievement of future objectives. The regulatory guide also requires that the disclosures are a reflection of the view of managers about the business performance and future prospects and these views are presented in a manner that captures the relevant aspects to investors. This discourse reflects the discussion in chapter 5 where, under the entity concept of a firm, the agency concern created by separation of investors and management may lead to information asymmetry, thereby necessitating disclosures to aid investors make informed investment decisions.
In Abrahamson and Amir (1996), narrative commentaries were considered to alleviate the discrepancy between the objective of financial statements and the ability of the actual content of the statements to fulfil this function. Whilst financial statements are aimed at aiding investors in timing and valuing future cash flows and dividends, the information therein is purely historical. However, management posses the information that can be helpful in explaining current performance and forecasting but such data cannot be expressed within the financial statements. Therefore, narratives provide the platform for the disclosures. Another argument for narratives is the ability to reduce information asymmetry as explained by Barberis, et al (1998) with regard to causes of under and over reaction to earnings figures. In the case of under reaction, investors assume that figures have a large temporally component.
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The reason is that investors may depend on the earlier earnings that may be too low to justify current earnings. In the circumstance of over reaction, investors erroneously assume that past good performance is reflective of future good performance. In such cases, more information is required to justify current earnings.
To the contrary, although Ball and Brown (1968) recognised that other disclosures published with financial statements (for example, narratives) may have an influence on returns, they upheld that the income number captures nearly all information about the firm. Also, Kanto and Schadewitz (2000) argued that due to the agency relationship, managers can successfully use narratives to mislead investors. Further, some studies (e.g. Ali and Pope 1995; Ou and Penman 1989) conclude that financial statement figures arguably undermine the relevance of narratives. Other studies take an indecisive opinion (e.g. Healy et al. 1999; Lev and Penman 1990) and suggest that the association between abnormal returns and narrative disclosures reflects agency but explained as either a case of impression management or management‟s willingness to subdue information asymmetry.
From the above discussion, the insufficiency of financial statements to provide all information required by investors as well as the presence of agency may be the underlying reasons why investors need narratives. Given that investors need the information to make investment decisions, agency arguably creates two postures for providing the information. The first is the reduction agency problems by providing disclosures that reduce information asymmetry, thereby a state of incremental information. The second is a state of management impression where agency allows managers to increase information asymmetry. Interpreting this with reference to the theoretical framework, a mixed theoretical paradigm drawn from the MC and MI seems to explain share price returns due to narrative commentaries. The paradigm consists of efficient market hypothesis (EMH), uncertain information hypothesis (UIH), over reaction hypothesis (ORH) and incomplete revelation hypothesis (IRH). The other theories include market for lemons (ML), signalling and incomplete contracting.
Under EMH, when narratives are published, the market instantaneously reflects their value in share prices correctly to the level of market returns such that abnormal returns are nil. So, if
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the disclosures are bad, an accurate downward and immediate share price slump is observed.
Alternatively, an exact positive and instant valuation of shares is experienced for good news.
A nil effect will be realised immediately and rightly for narratives that are neither bad nor good. In all cases under EMH, the return that accrues to investors on publication of narratives is the market return or nil abnormal returns.
For UIH and ORH, the perfections that cause accurate share price reactions to narratives are relaxed. However, the right direction of movement is sustained but is only over or under reacted to and the right value of the information is achieved with time. This could imply that the disclosures have information content, however, full comprehension of the disclosures is realised with time. The delay may be argued be caused by either the degree of rationality in investors or extent to which the effect of the information in the narratives is easily understood.
The easiness in understanding disclosures could possibly be embedded in the level of attributions in narratives. This line of reasoning is drawn from disclosure extent studies (e.g.
Beattie et al. 2004; Beattie and Thomson 2007; Hooks et al. 2002a; Wallace and Nasser 1995) which suggest that the level of attributions enhances the quality and preciseness of information. To relate to UIH and ORH, therefore, it is inferable that the level of attributions in narratives enhances investors‟ understanding of disclosures.
Under IRH, the market is comprised of both irrational and rational investors. This possibly signifies that some investors can understand the impact of disclosures but others may not.
Therefore, narratives serve two roles, either impression management (to misled investors) and incremental information (to non-misled investors). As the rational investors rightfully interpret the narratives and correctly value them in the share prices, the misled investors fail to rightly value the disclosures. The rational investors later realise an opportunity to profit from the mispricing and take advantage of it to earn abnormal profits. A number of deductions could be made from this mechanism. Firstly, unlike UIH and ORH, share prices could move either direction, regardless of whether the information is good or bad due to the influence of irrational trading by some investors. Secondly, the theory recognises that the agency relationship and the presence of both rational and irrational investors may create an opportunity for both incremental information (reduction of uncertainty) and impression
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management (increase of uncertainty). The rebounding of rational investors to make abnormal returns from the decisions of irrational investors suggests that the true valuation for the narratives is not instantaneous but rather gradual.
The ML and signalling theories, as well incomplete contracts may be considered to suggest that the rhetoric or discourse and the selection of information provided in narratives may influence investors‟ decisions. For example, under ML, the main concern is selection of information where the concealment strategy is adopted. For signalling theory, managers may use the disclosures to either mislead or direct investors about the important aspects of performance. In incomplete contracts, attributions in disclosures play a key role to enhance the completeness of the contract between firm managers and investors with regard to information dissemination.