Endogenous Information Disclosure and Corporate Governance

We empirically study the endogeneity nature of disclosure quality and the effect of the regulatory reform at the beginning of this century under the Hermalin and Weisback (2009) theoretical framework. Our sample period encompasses two subperiods – the pre-reform subperiod of 1992 to 1999 and the post-reform subperiod of 2004 to 2007. We rank our sample firms into ten deciles based on their cash flow uncertainty (volatility) in the first subperiod. We find that higher cash flow uncertainty deciles have higher accruals and discretionary accruals (proxies for disclosure quality). Moreover, post regulatory reform, only the high cash flow uncertainty deciles experience decline in accruals and discretionary accruals – the higher the uncertainty decile rank, the larger the decline (i.e., the reform appears to be binding on the high cash flow uncertainty deciles). We also document that, post regulatory reform, only the high cash flow uncertainty deciles experience decline in R&D and advertisement expenses (proxy for myopic managerial behaviors) – again, the higher the decile, the larger the decline. Similarly, only the high uncertainty deciles experience reduction in firm valuation (measured by Tobin’s Q) – the higher the uncertainty decile, the larger the reduction. In terms of executive compensation, post reform, higher uncertainty deciles experience a higher degree of increase in CEO compensation ratio (i.e., compensation as a fraction of sales). These results are generally consistent with the predictions of HW (2009). The HW (2009) model also predicts that a regulatory reform aiming at improving disclosure quality will increase performance-based managerial turnover in reform-binding firms. However, similar to Kaplan and Minton (2008), although we find a general increase in CEO turnover in the second subperiod (i.e., the post-reform period), we find neither an increase in performance-based turnover nor an association between (cash flow) uncertainty decile ranks and turnover. However, it should be noted that the HW prediction of an (exogenous) increase in disclosure quality leads to higher managerial turnover is based on the relatively strong assumption of a pure strategy ‘signal jamming’ equilibrium. A simple generalization of the HW model shows that the effect of an increase in disclosure quality on managerial turnover can be positive, negative or zero.