The theoretical literature on disclosure offers a number of motivations for managers to provide information to parties external to the firm, including overcoming adverse selection, reducing private information acquisition costs, or reducing the cost of capital (see Verrecchia 2001). The empirical disclosure literature is similarly focused on examining managerial incentives for disclosure and finds evidence that capital markets transactions, corporate control contests, stock compensation, or litigation costs provide motivation for disclosure; this literature also shows that voluntary disclosure results in improved stock liquidity, reduced cost of capital, and increased information intermediation (see Healy and Palepu 2001).
However, far fewer studies examine firms’ motivations for withholding relevant information from interested parties, and much of this literature relies upon proprietary cost hypotheses. For example, Verrecchia (1983) argues that incentives to disclose information are a decreasing function of the potential proprietary costs associated with the disclosure, and Bens (2002) and Scott (1994) provide empirical evidence that the existence of proprietary costs is associated with lower disclosure levels and quality. Litigation cost arguments (see Hughes and Sankar 2000) also offer motives for nondisclosure of information, but evidence in support of this theory is mixed (see Skinner 1997; Francis, Philbrick, and Schipper 1994).
We extend the disclosure literature by examining the role of financial reporting bias as a disincentive for firms’ discretionary disclosure. Our analysis focuses on a sample of 60 firms that issued contingent convertible bonds between November 2000 and December 2002. Contingent convertibles, or “COCOs,” as they are more commonly known, are convertible bonds that cannot be converted into shares of common stock until a pre-specified stock price is reached; i.e., conversion is “contingent” upon reaching the price threshold. This convertible bond structure first appeared in late 2000 and is becoming increasingly popular, with more than 60% of 2003 and 80% of the year-to-date 2004 convertible debt issues structured as contingently convertible.
The popularity of COCOs stems mainly from their financial reporting effects on issuers’ diluted earnings per share (EPS) figures (see Marquardt and Wiedman 2004). Under Statement of Financial Accounting Standard (SFAS) No. 128, a contingency feature added to a traditional convertible bond often allows firms to exclude the effects of the bond when calculating diluted EPS, thereby creating an income increasing financial reporting bias for COCO issuers. Because managers may expect the revelation of the amount of this bias to be negatively interpreted by market participants, we argue that it represents a disclosure-related cost that will discourage some managers from full disclosure of COCO-related information. We consequently predict a negative relation between the quality of firms’ COCO-related annual report disclosure quality and the amount of bias that is present in diluted EPS.
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Financial Reporting Bias as a Disincentive for Discretionary Disclosure
