«Elizabeth Blankespoor University of Michigan Stephen M. Ross School of Business blankbe January 2012 Abstract This paper examines the ...»
The Impact of Investor Information Processing Costs
on Firm Disclosure Choice:
Evidence from the XBRL Mandate
University of Michigan
Stephen M. Ross School of Business
This paper examines the effect of investor information processing costs on firms’ disclosure choice.
Using the recent eXtensible Business Reporting Language (XBRL) regulation as an exogenous shock
to investors’ processing costs, but not to firms’ disclosure requirements, I find that firms increase their quantitative footnote disclosures after adoption of XBRL detailed tagging requirements designed to reduce investor processing costs. These results hold in a difference-in-difference design using non-adopting firms as the control group. To reinforce my finding that the disclosure increase is prompted by reduced investor processing costs, I examine cross-sectional settings where investor processing costs are likely to vary, showing that the disclosure increase is greater for firms where detailed information is more pertinent than summary measures (those with operations in multiple industries, more volatile earnings, and more disperse analyst forecasts), and smaller for firms with sophisticated investors. These findings suggest that investor processing costs can be significant enough to impact firms’ disclosure decisions.
I am grateful to my dissertation committee for their insightful comments and guidance: Gregory Miller (Chair), Raffi Indjejikian, Nejat Seyhun, Catherine Shakespeare, Jeffrey Smith, and Hal White. I thank Emmanuel De George, Merle Ederhof, Reuven Lehavy, Feng Li, Michael Minnis, Venky Nagar, Chris Williams, Gwen Yu, and workshop participants at the University of Michigan for helpful feedback. I thank Feng Li for programming advice and Nemit Shroff for the many conversations we have had about the paper. Finally, I gratefully acknowledge financial support from the Paton Accounting Fellowship and the Deloitte Doctoral Fellowship. All errors are my own.
1. Introduction Firm disclosures play a critical role in a well-functioning capital market. An important assumption of disclosure is that investors actually process the information disclosed. However, numerous studies show that information processing costs can reduce or impair investor processing of information.1 This paper examines whether firms consider investors’ information processing costs when choosing the amount of information to disclose. I predict and find that firms increase their disclosure when investor processing costs are reduced. Specifically, using a recent regulation that exogenously reduces investor processing costs for quantitative footnote disclosures, I find that firms increase these disclosures upon mandatory adoption of the regulation. I also show that the disclosure increase is larger for firms with information that is inherently more costly to process and smaller for firms with an investor base that has inherently lower processing costs. These findings are consistent with a reduction in investor processing costs increasing investor attention to disclosure, thus motivating firms to increase their disclosure.
I expect investor processing costs to affect firm disclosure because of their impact on firms’ disclosure benefits. The accounting literature characterizes firm disclosure choice as a cost-benefit tradeoff, with disclosure benefits such as reduced information asymmetry and improved market liquidity (Beyer, Cohen, Lys, and Walther 2010). These disclosure benefits are realized through investor processing of and response to firm disclosure choice. Thus, when processing costs prevent investors from fully responding to disclosure, the extent of disclosure benefits could be muted. If the impact on disclosure benefits is significant, firm disclosure choice could also be affected by investor processing costs.
Information processing can be separated into “information acquisition,” or the task of finding/reading information, and “information integration,” or the task of assessing the informational implications and arriving at a valuation decision (Maines and McDaniel 2000). Because XBRL has the potential to decrease both acquisition and integration costs (Hodge, Kennedy, and Maines 2004), I use the term “information processing costs” to refer to both information acquisition and integration costs. See Payne (1976), Casey (1980), Merton (1987), Bloomfield (2002), Hirshleifer and Teoh (2003), Plumlee (2003), You and Zhang (2009), Miller (2010), Bradshaw, Miller, and Serafeim (2011), and De Franco, Kothari, and Verdi (2011) for examples of studies that incorporate processing costs.
Although many studies examine the determinants of disclosure choice, the impact of investor processing costs on firm disclosure has not received much attention. This is perhaps because the two are jointly determined, making it difficult to infer causality, i.e. to separate the impact of investor processing costs on firm disclosure from disclosure’s effect on processing costs. The recent eXtensible Business Reporting Language (XBRL) mandate provides a unique setting to overcome this identification issue by exogenously decreasing investors’ processing costs without changing firms’ disclosure requirements. Specifically, this mandate requires a subset of firms to “tag,” or label, all quantitative disclosures in the financial statements and footnotes so the amounts are machinereadable, but the mandate does not require additional disclosure.2 The Securities and Exchange Commission (SEC) argues that XBRL reduces investor processing costs by eliminating the need for manual search and compilation of financial amounts, enabling easier comparison across time and firms, and highlighting contextual information about data items. Therefore, I use a firm’s mandatory adoption of XBRL as an exogenous reduction in investor processing costs for that firm.
To measure firm disclosure, I focus on quantitative disclosures in the notes to the financial statements (i.e. disclosures subject to XBRL’s “detailed tagging” requirements) because these details are valuable but costly to process. Information disclosed in the footnotes can provide investors with a rich context for understanding the firm beyond that provided by summary statistics (De Franco, Wong, and Zhou 2011, Li, Ramesh, and Shen 2011). For example, calculating a firm’s leverage ratio gives a sense of the financial structure of the firm, but examining the detailed listing of notes payable, interest rates, and maturity dates paints a much more nuanced picture of the firm’s current and future health. Although footnotes contain important information for firm valuation, they also impose high processing costs on investors because they include numerous pieces of information in a wide variety of formats, often with text and numbers interspersed. These high processing costs An additional strength of the XBRL setting is a staggered implementation that provides a benchmark group of nonadopting firms for comparison, allowing for a difference-in-difference design that controls for firm-specific and time-specific effects.
impair investor processing of the detailed footnotes (Casey 1980, Hodge, Kennedy, and Maines 2004).3 To the extent investors process less footnote information, firms have lower disclosure benefits and thus less incentive to provide the detailed information. As investors’ costs decrease, though, they are able to process more of the footnotes and increase their attention to detailed information.
Anticipating increased investor processing of detailed information and therefore more benefits to disclosure, firms have a stronger incentive to provide detailed information.4 To better understand this increased attention, it can be helpful to think about (1) who is scrutinizing and (2) how they are doing so in this setting. First, although the primary reason for implementing XBRL is “to make financial information easier for investors to analyze (emphasis added),” the SEC highlights that the benefits of XBRL extend to all market participants analyzing firm disclosures, including the SEC (SEC 2009). Essentially, lower processing costs can increase attention from investors or from any group acting on behalf of investors, such as analysts, media, or regulators.5 Second, a likely tool for increased scrutiny of firm disclosure is comparison to peer firm disclosures. Comparing disclosure across firms can lead to increased pressure on firms to provide information, as discussed in disclosure models and seen in practice (Milgrom and Roberts 1986, Dye and Sridhar 1995, Silverman 2002b). Peer firm disclosures are particularly relevant in the XBRL As evidence that the market finds it costly to fully impound footnote information into price, Li, Ramesh, and Shen (2011) find a market reaction to newswire filings alerts that contain highlights of footnote items, even though the SEC filings were available to investors prior to the alerts.
Alternately, this could be described in terms of the cost of non-disclosure. Without processing costs, theory predicts that when firms provide incomplete disclosure (i.e. non-disclosure), investors assume the worst case scenario and react negatively, imposing costs on firms. If investors process less information, they are less aware of non-disclosure and thus less likely to impose these costs of non-disclosure. With lower costs of non-disclosure, firms again have less incentive to provide the detailed information. As investor processing costs decrease, though, firms’ costs of non-disclosure increase, motivating them to provide more information. Effectively, investors (and other stakeholders) are less able to discipline firm disclosure choice when processing costs are high and more able to when costs are low.
As Supreme Court Justice Louis D. Brandeis said, “Sunlight is said to be the best of disinfectants; electric light the most efficient policeman.” (Paredes 2003). More recently, Congressman Darrell Issa used this analogy to highlight the significance of processing costs, saying, “Sunlight cannot serve as disinfectant if investors cannot easily understand or use the information they receive.” (Minority Staff Report 2010, p.27).
setting because XBRL’s standardized structure facilitates comparison across firms. This additional comparability increases the likelihood that stakeholders will use peer firm disclosures to set the expected level of disclosure and improve their disciplining of firm disclosure choice.
Accordingly, I predict that when firms adopt the detailed footnote tagging requirements of XBRL, they will increase the number of quantitative footnote disclosures in anticipation of increased investor attention to these disclosures. However, if firms do not believe XBRL will significantly impact investor processing costs or if they choose to delay adjusting disclosure until after investor attention increases, there would be no change in firm disclosure upon adoption of XBRL. In addition, firms may choose not to adjust their disclosure if the impact of investor processing costs on disclosure benefits is not significant. Thus, this is an interesting empirical question.
I find evidence supporting my prediction. In particular, I find that XBRL firms increase their quantitative footnote disclosures, consistent with firms anticipating increased investor processing of and demand for disclosures. I also find that the disclosure increase remains for XBRL firms after differencing out non-XBRL firms’ change in disclosure. These results are robust to controls for the qualitative information content of the filings, the presence of information intermediaries, firm characteristics, and firm and year fixed effects.
To reinforce my finding that the disclosure increase is prompted by anticipated reductions in investor processing costs, I examine cross-sectional settings where processing costs are either more likely or less likely to be a binding constraint on firms’ disclosure choice. First, I predict that the relation between investor processing costs and firm disclosure will be more pronounced for complicated firms, defined as those with information that is inherently more costly to process. Using firms operating in multiple industries, firms with volatile earnings, and firms with disperse analyst forecasts as proxies for complicated firms, I find that the disclosure increase for XBRL firms relative to non-XBRL firms is larger for complicated firms than for simple firms, consistent with the change in anticipated investor processing costs leading to a change in firm disclosure.
Second, I predict that the relation between investor processing costs and firm disclosure will be less pronounced for firms with more sophisticated stakeholders, i.e. those with inherently lower processing costs. Using the number of analysts and the percent of shares held by institutions as measures of the processing ability of the investor base, I find that the disclosure increase for XBRL firms relative to non-XBRL firms is smaller for firms with more sophisticated investors than for firms with less sophisticated investors. These results corroborate my hypothesis that investor processing costs affect firm disclosure.
My paper makes several contributions. First, I find empirical evidence of an important incentive that impacts firms’ disclosure choices. The disclosure literature includes numerous studies examining disclosure incentives, but the effect of investor processing costs on disclosure choice has been relatively difficult to capture empirically. Because my setting consists of an exogenous shock to investor processing costs, it allows me to identify the effect of investor processing costs distinct from other drivers of disclosure, such as firm-specific characteristics or firms’ incentives to signal the relevance of information. Several recent papers suggest that managers adjust their disclosure style based on investor processing costs (e.g. the complexity of annual reports (Li 2008) and the presentation of special items (Riedl and Srinivasan 2010)). I contribute to the literature by using a unique identification strategy to examine the impact of processing costs on firms’ fundamental disclosure choice of how much information to provide.