Journal of Accounting and Economics 34 (2003) 283–309

Discretionary disclosure and stock-basedincentives$

Venky Nagara, Dhananjay Nandab, Peter Wysockic,*aUniversity of Michigan, Ann Arbor, MI 48109, USA

bThe Fuqua School of Business, Duke University, Durham, NC 27708, USAcSloan School of Management, Massachusetts Institute of Technology, Cambridge, MA 02142, USA

Received 16 January 2001; received in revised form 2 May 2002

Abstract

We examine the relation between managers’ disclosure activities and their stock price-based

incentives. Managers are privy to information that investors demand and are reluctant to

publicly disseminate it unless provided appropriate incentives. We argue that stock price-based

incentives in the form of stock-based compensation and share ownership mitigate this

disclosure agency problem. Consistent with this prediction, we find that firms’ disclosures,

measured both by management earnings forecast frequency and analysts’ subjective ratings of

disclosure practice, are positively related to the proportion of CEO compensation affected by

stock price and the value of shares held by the CEO.

r 2002 Elsevier Science B.V. All rights reserved.

JEL classification: D21; J33; M41

Keywords: Discretionary disclosure; Incentive; Share ownership; Stock compensation

$We would like to thank First Call and IBES for providing data on management forecasts and analyst

following. We gratefully acknowledge comments and suggestions from seminar participants at the 2001

JAE Conference, 1999 Financial Economics and Accounting Conference, 2000 EIASM Workshop on

Accounting and Economics, 2000 European Accounting Association Conference, University of Chicago,

Georgetown University, University of Iowa, MIT, University of Michigan, Tilburg University, The

Wharton School, and from Stan Baiman, Steve Buchheit, Dan Collins, Ron Dye, Raffi Indjejikian, Bill

Lanen, Christian Leuz, Chris Noe, Madhav Rajan, Phillip Stocken, Ro Verrecchia, Jerry Zimmerman,

and especially S.P. Kothari (editor), an anonymous referee, and Mary Barth (discussant).

*Corresponding author. Tel.: +1-617-253-6623; fax: +1-617-253-0603.

E-mail address: wysockip@mit.edu (P. Wysocki).

0165-4101/03/$ - see front matter r 2002 Elsevier Science B.V. All rights reserved.

PII: S 0 1 6 5 - 4 1 0 1 ( 0 2 ) 0 0 0 7 5 - 7

1. Introduction

The role of incentives in mitigating managerial agency problems is a central themein accounting research. In this paper, we focus on stock price-based incentives’ rolein mitigating the managerial disclosure agency problem. We argue and provideevidence that stock price-based incentives reduce managerial reluctance to discloseprivate information. Specifically, we find that firm disclosures, measured both by thefrequency of management earnings forecasts and analyst ratings of firm disclosures,increase in both the proportion of CEO compensation tied to the stock price and thevalue of CEO stockholdings.Prior accounting literature largely assumes that managers’ and investors’

disclosure preferences are congruent and argues that factors such as proprietarycosts preclude disclosure (e.g., Verrecchia, 2001).1 In contrast, we argue thatmanagers avoid disclosing private information because such disclosure reduces theirprivate control benefits. For instance, a lack of information disclosure limits theability of capital and labor markets to effectively monitor and discipline managers(Shleifer and Vishny, 1989). The disclosure agency problem can thus be regarded asthe fundamental agency problem underlying other agency problems. Practitionersalso echo the view that managers exhibit an inherent tendency to withholdinformation from investors, even in the ‘‘high disclosure’’ environment of US capitalmarkets. A panelist at the recent Stern Stewart Executive Roundtable states, ‘‘yallthings equal, the managers of most companies would rather not disclose things ifthey don’t have to. They don’t want you to see exactly what they’re doing; to see thelittle bets they are taking’’ (Stern Stewart, 2001, p. 37).2

This managerial disclosure agency problem is an important concern for investors,especially given disclosure’s key role in capital market allocation and corporategovernance decisions (see, e.g., Verrecchia, 2001; Bushman and Smith, 2001). Onepossible approach to mitigate this agency problem is to link manager compensationdirectly to their disclosure activity. However, such a compensation contract wouldhave to specify in advance the appropriate disclosures for all future contingencies.Stiglitz (2000) argues that, since future contingencies are innumerable andunverifiable, such a contract would be incomplete and potentially ineffective.We posit an alternative solution to the disclosure agency problem using stock

price-based incentives. Stock prices impound the relevant information in managerialdisclosures in light of the current contingencies. As a result, stock price-basedincentives elicit both good news and bad news disclosures from managers. Managershave incentives to release good news because it boosts the stock price. On the otherhand, the potential negative investor interpretation of silence (Verrecchia, 1983;Milgrom, 1981), and litigation costs (which reduce the value of the managers’

1Watts and Zimmerman (1986, p. 159) argue that managers disclose their private information only if it

increases firm value. This argument assumes that manager and shareholder interests are congruent.2Mandated disclosures exist in part to alleviate this agency problem, but several accounting observers

believe that mandated disclosures are becoming increasingly irrelevant, as they do not force managers to

reveal pertinent information (see Francis and Schipper, 1999; Lev and Zarowin, 1999; FASB, 1996, 1999).

V. Nagar et al. / Journal of Accounting and Economics 34 (2003) 283–309284

ownership interest) are incentives to release bad news. Therefore, we argue thatmanagerial stock price-based incentives, both as periodic compensation andaggregate shareholdings, help align long-run managerial and investor disclosurepreferences and mitigate the managerial disclosure agency problem.To test our hypothesis that stock price-based incentives encourage disclosure, we

use multiple measures of disclosure. The first measure is the frequency ofmanagement earnings forecasts. Although earnings forecasts may be contractible,such disclosures coincide with detailed qualitative disclosures (Hutton et al., 2000).These qualitative disclosures and the unverifiable contingencies that necessitate themare unlikely to be contractible. Therefore, we view management earnings forecasts asa disclosure measure that captures both hard forecasts of future earnings and, more

importantly, the qualitative and contextual information surrounding these forecasts.Because of the diversity and qualitative nature of disclosure activities, any singledisclosure measure may not provide a full picture of disclosure activity. Accordingly,we use a second disclosure measure to capture investor perception of managerialdisclosure. This second qualitative measure is based on the Association forInvestment Management and Research (AIMR) survey of analyst ratings of overall

disclosure quality and has been used in prior disclosure research (e.g., Lang andLundholm, 1993).Using the above measures of disclosure, we test our hypothesis in a multiple

regression setting that controls for factors, identified in prior research, that affectboth disclosure activities and the use of stock-based incentives. Consistent with ourhypothesis, we find that earnings forecast frequency is positively related to theproportion of CEO compensation and wealth tied to the firm’s share price. Similarly,we find that AIMR analyst ratings of firm disclosure activities are positivelyassociated with stock price-based incentives. These combined findings suggest thatour results reflect an underlying relation between disclosure and stock price-basedincentives, and not idiosyncratic properties of earnings forecasts or analystdisclosure ratings.We recognize that disclosure and incentive contract choices are potentially

endogenous corporate policies. To directly address the potential endogeneity, weexamine changes in management-forecast frequency surrounding the SecuritiesLitigation Reform Act of 1995. This act is an exogenous shock that increased the netdisclosure benefits to firms by reducing the firm-borne legal liability costs of forward-looking discretionary disclosures. The enactment of the legislation should have astronger effect on the disclosure activities of managers with greater wealth tied to thefirm’s share price. Consistent with this prediction, we find that firms with greater pre-

enactment CEO stock price-based incentives show a larger increase in the number ofmanagement-forecasts post-enactment. Therefore, our results appear to be robust toendogeneity concerns.Our basic premise is that stock price-based incentives are contractual mechanisms

that help align managerial disclosure preferences with those of shareholders.However, theory suggests that contracting costs lead to incomplete contracts andpreclude the complete elimination of agency conflicts (Jensen and Meckling, 1976).For example, Aboody and Kasznik (2000) find that managers with stock-based

V. Nagar et al. / Journal of Accounting and Economics 34 (2003) 283–309 285

incentives mislead investors by accelerating ‘‘bad news’’ disclosures to maximize thevalue of upcoming scheduled stock option grants. However, such opportunisticdisclosure activity is unlikely to persist because rational investors will recognize thisopportunistic timing of disclosures (Aboody and Kasznik, 2000, p. 97). Our findingson the positive relation between analysts’ long-run perceptions of disclosurepractices and firms’ long-run use of stock price-based incentives suggest that that,in the long run, these incentives mitigate disclosure agency problems instead ofexacerbating them.Our findings also speak to prior compensation studies, which argue that firms use

stock price-based incentives when prices are informative about managerial actions(e.g., Lambert and Larcker, 1987). However, this argument abstracts away the priceformation process through which prices become informative about managerialactions. Our results suggest that stock price-based compensation itself plays a role inthis process by providing managers with an incentive to improve price informative-ness through disclosure.The rest of the paper is organized as follows. Section 2 develops our primary

research hypothesis and discusses several competing hypotheses that generatealternative predictions. Section 3 describes our sample and disclosure measures.Section 4 outlines empirical tests and summarizes the results. Section 5 concludes.

2. Disclosure, agency conflict, and compensation

2.1. Hypothesis development

Managers acquire private information about the firm’s future expected cash flowsand risk through their proximity to operating activities. Current investors wantprivately informed managers to reveal this information for several reasons. First, byreducing information asymmetry, disclosure increases stock liquidity and lowers thefirm’s cost of capital (e.g., Glosten and Milgrom, 1985; Diamond and Verrecchia,1991). Recent studies document that firms with higher analyst ratings of theirdisclosure practices have lower bid–ask spreads (Welker, 1995), lower cost of equity(Botosan, 1997), and lower cost of debt (Sengupta, 1998). Second, disclosureimproves corporate governance and asset stewardship, thus reducing shareholder–manager agency problems such as shirking and perquisite consumption (Bushmanand Smith, 2001).Despite this investor demand, self-interested managers are reluctant to reveal their

private information. Poor disclosures weaken investors’ ability to disciplinemanagers. Consequently, managers become entrenched, reducing the chance ofreplacement (Shleifer and Vishny, 1989). Indeed, rent-seeking managers haveincentives to exacerbate information asymmetry by selecting projects that obfuscatefirm performance (Edlin and Stiglitz, 1995). Moreover, disclosures can cause thelabor market to reassess managerial talent and ability. Thus, unless suitablycompensated, risk-averse managers are reluctant to disclose if they are uncertainhow such disclosures reflect on them (Nagar, 1999).

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Prior accounting research has largely ignored this disclosure agency problem. Itassumes that managerial disclosure preferences are congruent with those of investorsand uses factors such as proprietary costs to explain non-disclosure (see, e.g.,Verrecchia, 2001). Skinner (1994 and 1997) argues that managers and shareholdersface different legal costs of disclosure, but does not examine the divergence betweenshareholder demand for information and managerial disclosure incentives. Noe(1999) examines the association between insider trading and voluntary disclosure,but does not analyze how the competing interests of managers and shareholdersaffect disclosure.Encouraging managers to disclose is important, yet not easy to achieve. Giving

managers a flat wage is unlikely to induce disclosure, especially when managersderive private benefits from control. The fact that flat wages are unaffected bydisclosure does not imply that managers are indifferent to disclosure. Non-disclosureincreases the owners’ cost of intervention and allows managers to continueextracting rents from their employment. Therefore, managers receiving a flat wageare reluctant to reveal their private information, and investors must considerincentive mechanisms to elicit disclosure.Owners can mitigate the disclosure agency problem with incentive contracts based

on performance measures that are informative about managerial disclosure activity.One possibility is a direct contract on disclosure activities, but the subjective natureof disclosure makes writing an ex ante complete contract difficult. Becausemanagers’ private information is both unforeseeable and unverifiable (Tirole,1999), investors cannot ex ante specify all possible future contingencies and theinformation they desire in each circumstance. Consequently, managers can ‘‘game’’the incomplete contract by disclosing a large amount of useless information.3

Alternatively, investors can award discretionary bonuses after evaluating disclosurequality. However, investor commitment to make such discretionary bonuses may notbe ex ante credible to managers.By contrast, we argue that stock price-based incentive contracts effectively

encourage disclosure, for several reasons. First, unlike accounting measures such asearnings, stock price is a timely performance measure because investors canimmediately react to disclosures by trading in the firm’s shares. Second, if investorsperceive disclosed information to be irrelevant to the current contingency, the stockprice will not change. That is, the price formation process takes into account boththe quality and the quantity of information disclosed. Third, stock price-basedincentives encourage both good news and bad news disclosures. Stock priceappreciation is a natural incentive for managers to release good news. The case forbad news disclosure is less obvious. The important insight is that investors with

3If disclosure can be measured, one may question why it cannot be contracted. Theoretical

compensation research has repeatedly emphasized that measurability and contractibility are two entirely

different properties of performance measures, and the availability of ex post measures does not imply that

good ex ante contracts can be written on these measures (Baker, 2000). For example, a contract on the

number of forecasts will cause a manager to issue many uninformative forecasts and, in all likelihood,

reduce accompanying qualitative disclosures for which he receives no reward (in particular, see

Holmstrom and Milgrom, 1991).

V. Nagar et al. / Journal of Accounting and Economics 34 (2003) 283–309 287

rational expectations respond not only to disclosure but also to non-disclosure,which they rationally perceive as ‘‘worse’’ news (Verrecchia, 1983; Milgrom, 1981).Consequently, it is beneficial for managers compensated on stock price to disclosebad news to investors rather than remain silent. On the other hand, silence can alsomean that the manager does not have private information. Dye (1985) shows thatinvestors react negatively to non-disclosure only when they expect the manager tohave private information. This property of the stock price reduces the risk imposedon managers and leads to a more efficient contract. Finally, withholding bad newscan lead to costly litigation that reduces the value of managerial shareholdings.Consequently, potential litigation costs are an institutional force that helps elicit badnews disclosure from managers who have stock price-based incentives.We focus on the role of stock-based incentives in inducing disclosure. However,

shareholders give managers incentives to motivate a multitude of managerial tasks,not all of which are best motivated by stock price-based incentives (Bushman andIndjejikian, 1993). Since we argue that the disclosure task is better motivated withstock price-based incentives, our primary hypothesis is that disclosure is positivelyrelated to the use of stock price-based managerial incentives.4

To measure stock price-based incentives, we consider the amount of both themanagerial wealth tied to stock price (a ‘‘stock’’ or holdings measure) and theperiodic managerial compensation tied to stock price (a ‘‘flow’’ measure). Stockholdings capture the extent to which stock price directly affects managerial wealth. Ifthe market rewards better disclosure policies, then managers with greater share-holdings will derive greater benefits from their disclosures. Periodic stock price-basedcompensation captures the extent to which managers are periodic traders in thefirm’s equity. Periodic stock or option grants effectively make managers ‘‘buyers,’’while periodic option expirations make them ‘‘sellers’’ of the firm’s stock. Priordisclosure studies argue that such trader-managers are concerned about the impactof disclosure on stock price because of the immediate wealth consequences (e.g.,Bushman and Indjejikian, 1995).

2.2. Competing models

Prior research offers several competing hypotheses between disclosure and stockprice-based compensation. First, Aboody and Kasznik (2000) argue that managerswho receive scheduled stock option awards preemptively release unfavorable firmnews in anticipation of the awards to increase the value of grants made ‘‘at-the-money.’’ This opportunistic behavior is consistent with contracting theory, whichstates that contracting costs prevent the complete elimination of agency problems(Jensen and Meckling, 1976). However, Aboody and Kasznik (2000, p. 97) note that

4In this regard, this study’s focus in not on the optimality of stock-based incentives, but on the

equilibrium disclosure choices made by managers in response to their incentives. Our study is therefore

similar to prior studies (e.g., Larcker, 1983) that conjecture that owners use compensation to motivate

certain managerial actions (e.g., long-term capital expenditures), and focus on whether managers make the

hypothesized action choices.

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rational investors will eventually recognize such opportunistic disclosures. Therefore,if such managerial behavior persists, rational analysts will recognize it and rate thedisclosures as low quality. In effect, this competing ‘‘opportunistic disclosure’’behavior predicts a negative association between disclosure quality and stock price-based incentives and is thus a testable alternative hypothesis.Second, our primary hypothesis assumes that the agency problem manifests itself

in the managers’ intrinsic reluctance to disclose. If managers are intrinsicallyoverzealous disclosures, then shareholders, who fear the revelation of costlyproprietary information, may want to inhibit managers’ overzealous disclosureswith stock price-based incentives. This reasoning also predicts a negative associationbetween disclosure and stock price-based incentives.Third, ownership structure also affects investor demand for disclosure. For

example, the demand for disclosure, and consequently, the incentive to disclose, areboth absent when a manager owns all the shares in the firm. Leland and Pyle (1977)demonstrate that a firm’s adverse selection problem in the capital market, a keydeterminant of disclosure demand, decreases with the proportion of the shares ownedby the manager. Thus, manager stock price-based wealth and the proportion ofinsider ownership are opposing forces that affect managers’ disclosure incentives.The confounding issue is that the two measures are likely correlated. Therefore,ignoring the ‘‘majority ownership effect’’ of manager shareholdings can lead to acorrelated omitted variable bias in an empirical investigation of disclosure and stockprice-based incentives. Therefore, we explicitly control for the proportion of insidershareholdings in our research design to parse out the effect of stock price-basedwealth on manager disclosure choices.

3. Empirical measures, sample selection, and descriptive statistics

3.1. Main variables

Any single disclosure measure is unlikely to capture the breadth and thequalitative nature of firms’ discretionary disclosure activities. Therefore, we use twomeasures to study the long-run relation between discretionary disclosure and CEOs’stock price-based incentives. The first measure is the frequency of managementearnings forecast activity. Previous empirical studies use management earningsforecasts to capture manager disclosure activities (see, for example, King et al., 1990;Frankel et al., 1995). We view management earnings forecasts as a disclosuremeasure that captures both hard forecasts of future earnings and the qualitative andcontextual information surrounding these forecasts. For example, the qualitativeinformation and contextual disclosures accompanying earnings forecasts oftenaddress why the firm’s prospects have changed (i.e., a change in consumer demand, adecrease in supplier costs, an increase in competition, etc.). Hutton et al. (2000)provide detailed evidence on the prevalence of the qualitative disclosuresaccompanying management earnings forecast announcements. Consequently, even

V. Nagar et al. / Journal of Accounting and Economics 34 (2003) 283–309 289

though the forecasts per se could potentially be contractible, the importantaccompanying qualitative disclosures are unlikely to be.Our second disclosure measure attempts to measure the quality of disclosures

directly. We use data from the AIMR survey of analyst ratings of overall disclosurequality. Prior accounting disclosure research uses this measure to capture a range ofdisclosure activities (e.g., Lang and Lundholm, 1993).We also use two measures of the managerial incentives tied to stock price, stock

price-based compensation and stock price-based wealth. Our first measure is the exante proportion of CEO compensation related to their firms’ share price, whichcaptures firms’ explicit policy choice to link managers’ on-going compensation toshare price. Using Execucomp data, we compute the ratio of the average annual exante stock price-based compensation (the sum of total value of stock option grantsplus the value of restricted stock grants) to total direct CEO compensation.5 Thevalue of the stock option grants is based on Standard and Poor’s modified Black–Scholes options valuation methodology. This variable, Comp, controls for cross-sectional differences in the level of CEO compensation.In addition to Comp, the ‘‘flow’’ measure, we also define a ‘‘stock’’ measure of

price-based incentives. This measure is the dollar value of the CEO’s shareholdings,Wlth. We use the Execucomp database to calculate this measure. Ideally, one wouldprefer a measure of the manager’s stock price-based wealth as a proportion of histotal wealth. However, since data on total CEO wealth is unavailable, we use thenatural logarithm of the average value of CEO shareholdings in the firm over thesample period. This proxy implicitly assumes that the proportion of CEO wealth tiedto share price is increasing in the value of shareholdings.The discussion in Section 2 argues for a steady-state relation between disclosure

and stock price-based incentives. Therefore, our main empirical tests examine theassociation between disclosure, compensation, and wealth over long windows. Allvariables are computed as multi-year averages to smooth out year-to-year variationsunrelated to systematic disclosure incentives.

3.2. Control variables

Prior studies indicate that firm characteristics such as accounting quality, size,growth, and financing needs influence investor demand for, and thus the equilibriumlevel of, disclosure (Bamber and Cheon, 1998; Lang and Lundholm, 1993; Frankelet al., 1995). Because stock price-based incentives are also correlated with these firmcharacteristics (Lambert and Larcker, 1987), we control for these characteristics in

5Total direct CEO compensation includes bonus, salary, other annual cash awards, value of restricted

stock grants, net value of stock options grants, long-term incentive payout, and all other compensation in

a year. We define stock price-based compensation as total value of restricted stock granted, plus the net

value of stock options granted. Our measure differs from prior studies such as Lambert and Larcker (1987)

who use the ex post price sensitivity of compensation to characterize managerial compensation contracts.

Certain components of our non-stock price-based compensation measure contain ex post components (i.e.,

an earnings bonus). Therefore, we use the average total compensation over a long window to capture the

ex ante level of these non-stock price-based components of compensation.

V. Nagar et al. / Journal of Accounting and Economics 34 (2003) 283–309290

our regressions to alleviate correlated omitted variable problems. We now turn to adiscussion of our control variables.

3.2.1. Proportion of inside ownership

The proportion of inside ownership affects outside investor demand for disclosureand consequently the need to provide disclosure incentives. For instance, if themanagers own 100 percent of the firm, outside demand for information is absent.Our measure of inside ownership is the average fraction of total shares outstandingheld by corporate insiders over the sample period. This information is tabulated inthe Spectrum database. Due to the measure’s skewness, we use decile ranks of insideownership as a control variable in the regressions. The inclusion of this variable inthe regression analysis alleviates potential correlated omitted variable biases becausethis variable is liked correlated with CEO wealth.

3.2.2. Firm size

Firm-specific factors affecting disclosure include proprietary costs and informa-tion asymmetry between management and investors (see, for example, Verrecchia,1990). Following Bamber and Cheon (1998), we measure proprietary costs using firmsize and its market-to-book ratio (see below). Firm size, MV, is measured as theaverage beginning-of-year equity market value over the sample period. We use thenatural logarithm of MV in our analysis because the variable is highly skewed. Thelogarithm also captures any decreasing marginal effect of size on disclosures.

3.2.3. Market-to-book ratio

The ratio of market value to book value of equity proxies for several factors. It iscommonly used to measure the investment opportunity set, and the associatedfinancing considerations, which partly determine disclosure costs. The market-to-book ratio also proxies for the information asymmetry between management andinvestors, an important determinant of the disclosure choice (Verrecchia, 1990). Theratio, MB, is calculated as the Compustat values of average market value of equitydivided by the book value of equity over the sample period for firms with positivebook value of equity.

3.2.4. Analyst following

Prior studies show that analyst following is positively related to managementforecasts (e.g., Soffer et al., 2000) and disclosure quality (e.g., Lang and Lundholm,1993). Analyst following can also proxy for firm-level information production/disclosures tendencies and outside pressure to meet analysts’ information demands.We obtain analyst following data from the 1997 version of the IBES database. If afirm is not in the IBES database, we assume that its analyst following is zero (ourresults are robust to this assumption). Because analyst following is highly skewed, weuse its natural logarithm, Log(NAnalysts+1). This measure also captures anydecreasing marginal effect of analyst following on disclosure incentives.

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3.2.5. Firm performance

Lang and Lundholm (1993) find a strong positive relation between analystdisclosure ratings, the level of firm performance, and the variability of firmperformance. We control for the level of firm performance by using averagecalendar-year CRSP stock returns, Return, for each firm over the sample period. Wemeasure the variability of firm performance and firm news (StdReturn) using the 6-year standard deviation of annual CRSP stock returns prior to the sample period foreach firm. The standard deviation of annual stock returns is highly correlated withthe R2 of annual return-earnings regressions (e.g., Kothari, 1992). Therefore, thevariability of annual stock returns also can capture ‘‘earnings quality.’’ Additionally,failure to disclose poor performance in a timely manner can lead to lawsuits byinvestors, which is costly to both the firm and its managers (Skinner, 1994). Weintroduce a dummy variable, BadNews, to identify firms that experience a negativeannual CRSP stock return in any year over the sample period.

3.2.6. Financing

Frankel et al. (1995) document a positive association between external financingtransactions and disclosure activity, arguing that firms raising external funds haveincentives to make voluntary disclosures. We control for the firms’ financingtransaction motives using an equity-financing dummy variable, Issue, which equals 1if the firm sold common or preferred shares in excess of 20 percent of its marketvalue in any of the sample years, and zero otherwise.

3.2.7. Firm complexity

Investors may find it difficult to analyze firms with multiple lines of business.Therefore, there are likely benefits to increased disclosure for firms with multipleproduct lines and subsidiaries. The number of business segments as reported in 1997version of the Compustat Business Information Tapes, NSeg, controls for firmcomplexity.

3.2.8. Industry dummies

The relation between disclosure and stock price-based incentives is likely to differacross industries. These differences are driven by a variety of industry-specificfactors, such as ‘‘accounting quality’’ and proprietary costs, that affect the demandfor and the supply of information. We control for these differences with a fixed-effects regression analysis that uses industry dummy variables. Industries areidentified using standard Compustat 2-digit SIC groupings.

3.3. Description of the management-forecast sample

In the management-forecasts sample, we construct the dependent variable,management-forecast frequency, from the 1998 version of the First Call database.This database contains information on the announcement dates of managementforecasts of quarterly and annual earnings and has wide coverage starting in 1995.We gather firm financial variables and analyst following from the 1997 versions of

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the Compustat and IBES databases, respectively. Stock price-based incentive datacome from the 1997 version of Execucomp. We maximize the number of years in oursample by merging overlapping data from four publicly available databases.Therefore, the final management-forecast sample covers the years 1995–1997.Table 1, Panel A outlines the sample selection criteria for the first dataset. The

final management-forecast sample consists of 1,109 firm observations. Table 1, PanelB indicates that the management-forecast sample represents 21 major industrygroups. The number of firms in each industry group ranges from 11 in theProfessional Services industry to 140 in the Retail Sales industry. Table 2, Panel A

Table 1

Panel A—Sample criteria for management forecast sample

Number of firms with complete CEO compensation and shareholdings data available

from Execucomp for 1995, 1996 and 1997

1,217

Number of firms failing to meet following criteria: 108

Stock price (D199) and share outstanding (D25) available at beginning of 1995–1997

Positive book value of equity (D60) and total assets (D6) at beginning of 1995–1997

Operating income after depreciation (D178) available for 1995–1997

Market to book ratio greater than zero at beginning of 1995–1997

Complete annual stock return data to from CRSP for each year 1989–1997

CEO share holdings in 1995–1997

Final sample (firms in Execucomp, Compustat, IBES, CRSP, and First Call data) 1,109

Panel B—Industry affiliation of firms in management forecast sample

Industry acronym 2-digit SIC categories Number

of firms

Automobiles 37 40

Chemicals 28–29 107

Clothing 22–23 26

Consumer goods 15–16 13

Electrical 36,38 122

Equipment 35 71

Financial 60–69 78

Food 1–7,20–21 44

Healthcare 80, 82 17

Material 32–33 37

Media 27,48 52

Metallurgy 34 26

Mining 10,14 15

Misc. manufacturing 39 10

Oil 13,46 26

Professional service 87 11

Retail sales 50–59 140

Transport 40–45,47 35

Utilities 49 101

Wood products 24–26 47

Services 70–79 91

Total 1,109

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presents descriptive statistics for this sample. The earnings forecasts frequency,NForecast, over the 3-year period ranges from 0 to 17 forecasts. Because managersmay learn information early in a fiscal quarter and issue an earnings forecast thatreflects this private information, it does not preclude them from issuing anotherrevised forecast later in the same quarter (as observed in several observations in oursample). The mean (median) number of management earnings forecasts is 2.21(2.00). Approximately 30 percent of the firms do not make any forecasts during thesample period. The descriptive results are consistent with other studies that use morerecent data on management earnings forecasts (e.g., Kile et al., 1998).

Table 2

Panel A—Descriptive statistics for management forecast sample

The sample consists of 1,109 firms. Variables are averaged over 1995–1997

Variable Description Mean Median Max Min Std.

dev.

NForecast # of earnings forecasts

during 1995–1997

2.22 2.00 17.00 0.00 2.61

Comp Ratio of stock based to total

compensation (3-year average)

0.33 0.32 1.00 0.00 0.22

Wlth Value shares held by CEO

(3-year average, $M)

37.28 4.35 5500.00 0.00 250.00

InsiderOwn Fraction of total shares held by

Insiders (3-year average)

0.17 0.02 0.92 0.00 0.18

BadNews Dummy variable if annual

CRSP stock return was negative

in either 1995, 1996 or 1997

0.51 1.00 1.00 0.00 0.43

Return Annual CRSP stock return

(3-year average)

0.19 0.16 1.17 �0.27 0.16

StdReturn Standard deviation of annual CRSP

stock return (1989–1994 average)

0.21 0.17 0.40 0.05 0.06

MB Beginning of year market-to-book

ratio (3-year average)

3.89 2.82 46.08 0.24 2.58

NAnalyst Analyst following in 1997 12.28 10.00 42.00 0.00 8.32

NSeg Average number of business segments 1.99 1.00 10.00 1.00 1.40

MV Market value of equity

(3-year average, $ billions)

4.41 0.91 172.80 0.03 7.77

Issue Dummy variable if firm issued

common shares exceeding 20%

of market value in 1995–1997

0.07 0.00 1.00 0.00 0.26

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The mean (median) value for the proportion of stock price based to totalcompensation, Comp, is 0.33 (0.32). This variable also exhibits substantial cross-sectional variation with firm observations ranging from no stock price-basedcompensation to 100% stock price-based compensation. The control variables,Return, BadNews, MB, NAnalyst, and MV, also show large cross-sectional variation.Finally, 7 percent of the firms in the sample have significant equity-financingtransactions over the sample period.

4. Empirical tests and results

This section outlines the empirical tests of our research hypothesis. In particular,we test the relation between firm disclosure and the CEO stock price-based incentivesconditional on factors that affect both. We first examine the cross-sectional relationbetween management earnings forecast activity and stock price-based incentives. Wethen examine changes in management-forecast activity before and after the SecuritiesLitigation Reform Act of 1995. Finally, we present our results using analyst ratingsof firm disclosures as an alternative disclosure measure.

Table 2 (continued)

Panel B—Correlation table for management forecast sample

Sample consists of 1,109 firm observations. #Forecast is the number of management earnings forecasts

during 1995–1997, Comp is the 4-year average ratio of CEO stock price-based compensation to total com-

pensation, Wlth is the average value ($M) of shares held by the CEO in 1995–1997, InsideOwn is the decile

rank of the fraction of firm’s shares held by insiders in 1995–97, BadNews is a dummy variable which equals

1 if annual CRSP stock return was negative in either 1995, 1996 or 1997, Return is the 3-year average ann-

ual calendar CRSP stock in 1995–1997, StdReturn is the standard deviation of CRSP annual stock return

between 1989 and 1994, MB is a 3-year average beginning-of-year market-to-book ratio, NAnalyst is the

number of analysts following the firm in 1997, MV is a 3-year average market value of equity ($ millions),

NSeg is the average number of business segments reported between 1995 and 1997, and Issue is a dummy

variable that equals one if the firm issued common shares exceeding 20% of market value in 1995–1997.

# Fore-

cast

Comp Log

(Wlth)

Inside-

Own

Bad-

News

Ret Std-

Ret

MB Log

(MV)

NSeg Issue

Comp 0.18

Log(Wlth) 0.06 �0.08

InsideOwn �0.02 �0.25 0.13

BadNews �0.10 �0.06 �0.04 �0.03Return 0.21 �0.04 0.12 0.10 �0.37

StdReturn 0.08 0.15 0.04 0.05 0.15 �0.12

MB 0.13 0.17 0.09 0.03 �0.23 0.43 0.18

Log(MV) 0.22 0.28 0.16 �0.38 �0.19 0.28 �0.23 0.23

NSeg �0.06 0.01 0.05 �0.15 0.01 �0.03 �0.12 �0.10 0.30

Issue �0.04 0.07 0.06 �0.01 �0.05 0.13 0.05 �0.04 �0.10 �0.05Log(#

Analyst+1)

0.23 0.26 �0.04 �0.32 �0.03 �0.08 �0.18 0.09 0.70 0.07 �0.03

Bold numbers indicate significance at the 5% two-tailed level.

V. Nagar et al. / Journal of Accounting and Economics 34 (2003) 283–309 295

4.1. Frequency of management earnings forecasts and CEO incentives

For descriptive purposes, we begin by examining the unconditional relationbetween NForecast, the number of quarterly earnings forecasts, Comp, the ratiostock price-based to total CEO compensation, and Log(Wlth), the natural logarithmof the value of CEO shareholdings. Consistent with our prediction, the simplecorrelations in Table 2, Panel B indicate a significantly positive relation betweendisclosure and compensation tied to share price. On the other hand, we find that thesimple correlation between disclosure and the natural logarithm of the value of CEOshareholdings is insignificant. However, one should interpret this simple correlationwith caution because the level of CEO wealth tied to share price may also capture thefraction of shares held by insiders, which is presumed to have a negative effect ondisclosure. In fact, the simple correlations in Table 2—Panel B show a significantpositive correlation between CEO wealth to share price and insider ownership. Inaddition, the correlations indicate that other firm characteristics are associated withboth CEO stock price-based incentives and management forecasts. We thereforeperform a multiple regression analysis to control for these factors.We estimate the following multiple regression model to test the relation between

management earnings forecast activity and CEO stock price-based incentives(Section 3 defines the variables):

NForecast ¼ aþ b1Comp þ b2 LogðWlthÞ þ b3InsiderOwn þ b4BadNews

þ b5Return þ b6StdReturn þ b7MB þ b8 LogðMV Þ

þ b9NSeg þ b10 LogðNAnalyst þ 1Þ þ b11Issue þ e: ð1Þ

Because CEO compensation, CEO share ownership, disclosure, accounting qualityand proprietary costs are likely to vary significantly across industries in the sample,we use an industry fixed-effects specification to rule out the possibility that theresults are driven by cross-industry differences in stock price-based incentivesand disclosure. Column 1 of Table 3 presents the regression results. Consistent withour prediction, the sign on the CEO compensation variable is significantly positiveafter controlling for CEO wealth, inside ownership, and other disclosuredeterminants. In particular, an increase in CEO stock compensation from 25% to75% of total compensation is associated with 0.48 more management forecasts overthe 3-year period. This is a relatively large effect given that the mean and mediannumber of management forecasts is approximately 2. The positive coefficient onCEO stock compensation also rejects the ‘‘overzealous manager’’ alternativehypotheses in Section 2.2, which predict a negative association.Also consistent with our prediction, the coefficient on Log(Wlth) is significantly

positive. In particular, a doubling in CEO stock price-based wealth is associated with 0.17more management earnings forecasts. Given the large variation in CEO wealth tied toshare price, this relation appears to be economically significant. Finally, the coefficient onInsideOwn is negative and significant. This finding is consistent with the view that greaterinsider control leads to lower disclosure activity (Leland and Pyle, 1977). In Section 4.2,we further explore the effect of insider ownership on disclosure activity.

V. Nagar et al. / Journal of Accounting and Economics 34 (2003) 283–309296

Table 3

Effect of compensation on management forecast frequency

Sample consists of 1,109 firm observations. NForecast is the # of management earnings forecasts during

1995–1997, Comp is the 3-year average ratio of CEO stock price-based compensation to total compensa-

tion, Wlth is the average value ($M) of shares held by the CEO in 1995–1997, InsideOwn is the decile rank

of the fraction of shares held by insiders in 1995–1997, BadNews is a dummy variable which equals 1 if

annual CRSP stock return was negative in an year 1995–1997, Return is the 3-year average annual calen-

dar stock over 1995–1997, StdReturn is the standard deviation of annual stock returns between 1989 and

94, MB is the 3-year average beginning-of-year market-to-book ratio, NAnalyst is the # of analysts follow-

ing the firm in 1997, MV is the 3-year average market value of equity ($M), NSeg is the average # of busi-

ness segments reported between 1995 and 1997, and Issue is a dummy variable that equals 1 if the firm

issued common shares exceeding 20% of market value in 1995–1997.

NForecast ¼ aþ b1Comp þ b2 LogðWlthÞ þ b3InsiderOwn þ b4BadNews þ b5Return þ b6StdReturn

þ b7MB þ b8 LogðMVÞ þ b9NSeg þ b10 LogðNAnalyst þ 1Þ þ b11Issue þ e

Coefficient (predicted sign) Full sample

(Nobs=1,109)

Forecaster sub-

sample:

NForecast>0

(Nobs=764)

Full sample: Probit

w/categorical

dependent variable

(Nobs=1,109)

Estimate (t-stat) Estimate (t-stat) Estimate (t-stat)

Comp (+) 0.977 1.131 0.304

(2.61) (2.51) (2.93)

Log(Wlth) (+) 0.171 0.210 0.062

(2.02) (1.97) (1.83)

InsideOwn (�) �0.832 �0.442 �0.121(�1.82) (�1.38) (1.99)

BadNews (+) 0.278 0512 0.182

(1.77) (2.11) (1.50)

Return (+) 2.223 2.445 1.227

(2.57) (2.31) (4.09)

StdReturn (+) �6.142 �0.105 �3.130(�0.91) (�0.58) (2.03)

MB (+) 0.021 �0.009 0.021

(0.86) (�0.10) (0.67)

Log(MV) (+) 0.157 0.289 �0.036(2.03) (2.65) (1.25)

NSeg (+) �1.57 �0.203 �0.040(�2.74) (�2.68) (0.32)

Log(NAnalyst+1) (+) 0.505 0.412 0.314

(3.61) (2.28) (4.89)

Issue (+) �0.111 �0.188 �0.015(�0.40) (�0.26) (�0.03)

Industry dummies Included Included Included

Adj R2/pseudo R2 15% 13% 17%

V. Nagar et al. / Journal of Accounting and Economics 34 (2003) 283–309 297

The estimated coefficients on the control variables in regression model (1) areconsistent with findings from previous studies. As in Lang and Lundholm (1993), wefind that firm performance, as measured by Return, is positively related to disclosure.With respect to analyst following, the results indicate that doubling the number ofanalysts is associated with 0.50 more forecasts over the sample period. In this regression,we also find a marginally significant negative association between insider shareownership and management-forecast activity. This negative relation is consistent withour prediction that greater insider control leads to lower outside demand for disclosure.Firm size and the number of segments are also significant determinants of forecastfrequency. However, the coefficient on the number of segments is opposite to thepredicted sign. This may be attributable to the fact that more diversified multi-segmentfirms have fewer surprise earnings events that might require preemptive managementforecasts. The effect of equity financing on disclosure is statistically insignificant.We conduct robustness checks on the sample to address concerns that

approximately 30 percent of the firms in the main sample make no managementforecasts in the sample period. Our data selection criteria classify firms as having nomanagement forecasts if they do not appear in the First Call database over thesample period. First, to rule out the possibility that these null observations drive theresults, we estimate Eq. (1) on a sub-sample of firms with non-zero managementforecasts. The results of this test are reported in column 2 of Table 3. The regressionresults are essentially unchanged. Second, there may be a meaningful distinctionbetween a manager’s choice of (a) no forecasts versus forecasts, and (b) someforecasts versus many forecasts. Therefore, we re-estimate Eq. (1) for the full sampleusing a Probit specification (dependent variable equals 1 if the number of forecasts>0, and 0 otherwise). The results, reported in column 3 of Table 3, indicate thatstock price-based incentives remain a significant determinant of the managementchoice to issue discretionary earnings forecasts.

4.2. Alternate measures of CEO shareholdings and insider ownership

To further investigate the role of equity ownership on the results, we re-estimateregression model (1) using a modified definition of CEO wealth tied to share price.This alternate specification includes not only the value of actual shares held, but alsothe value of options held by the CEO. The regression results using this modifieddefinition of CEO wealth are similar to those presented in Table 3 with thecoefficients on both Comp and the modified Log(Wlth) remaining positive andsignificant. The main empirical results are essentially unchanged for both decileranks and logarithmic transformations of all ownership variables.We also test for possible non-linearities in the relation between insider ownership

and disclosure activity by using an approach similar to Morck et al. (1988). We re-estimate Eq. (1) using a piece-wise linear transformation of insider ownership basedon the cut-offs of Morck et al. (1988):

InsiderOwn.0to5 =insider ownership if insider ownership o0.25=0.05 if insider ownership X0.05

V. Nagar et al. / Journal of Accounting and Economics 34 (2003) 283–309298

InsiderOwn.5to25 =0 if insider ownership if insider ownership o0.05=insider ownership minus 0.05 if 0.05 pinsider ownershipo0.25=0.20 if insider ownership X0.25

InsiderOwn.over25 =0 if insider ownership o0.25=insider ownership minus 0.25 if insider ownership X0.25

Regression results indicate that the coefficient on the CEO stock price-basedcompensation and wealth variables remain significantly positive with values of 0.933and 0.182. The coefficients on the three insider ownership variables are:InsiderOwn.0to5 is positive but not significant, InsiderOwn.5to25 is negative andsignificant at the 5% level, and InsiderOwn.over5 is negative and insignificant.Therefore, after controlling for CEO stock price-based compensation and wealth,insider share ownership generally has a negative influence on disclosure activity,except at very low levels of insider ownership. The significantly lower disclosureactivity in the InsiderOwn.5to25 range is also consistent with greater observedmanagerial expropriation in the InsiderOwn.5to25 range (Morck et al., 1988).Finally, we perform a robustness check to address the possible interacting effects

of changes in ownership and current stock compensation awards. In thisspecification, we re-define our compensation variable as the sum of the Black–Scholes value of stock option grants, the value of restricted stock grants, and thechange in the value of prior stock grants. Using this new compensation variable, weestimate the regression specification outlined in Model (1). Again, we find a positiveand significant association between the frequency of managerial disclosure activityand both compensation (and change in the value of shareholdings) and CEO wealthtied to share price.

4.3. The securities litigation reform act of 1995

Despite the inclusion of several firm-specific factors as controls, a possiblepitfall of the prior association analysis is that stock price-based incentives anddisclosure are both endogenous to some other underlying factor that drives theresults. To address this concern, we estimate the disclosure–incentive relation aroundan event that exogenously changed the environment with respect to one of thevariables.The enactment of the 1995 Securities Litigation Reform Act reduced firms’

potential litigation costs related to voluntary disclosures of forward-lookinginformation (e.g., Johnson et al., 2001). Lower litigation costs increase the netvalue of disclosure to the firm, and thus a manager with more stock price-basedincentives has more to gain from increasing his disclosure activities. In contrast, amanager with no stock price-based interest in the firm faces no change in disclosurecosts and benefits, and thus has no incentive to change his disclosure activities. Weperform tests similar to Johnson et al. (2001) and examine whether changes in thefrequency of management earnings forecast disclosures surrounding the passage ofthe Act are positively related to the manager’s ex ante stock price-based incentives.

V. Nagar et al. / Journal of Accounting and Economics 34 (2003) 283–309 299

Similar to Johnson et al. (2001), we assume that the Act’s enactment wasunanticipated and that firms did not systematically adjust CEO stock price-basedincentives in anticipation or in reaction to the Act. We apply the following regressionmodel to test the relation between the changes in management earnings forecastsbefore and after the Act and the ex ante CEO stock price-based incentives:

DNForecast ¼ aþ b1Comp þ b2 LogðWlthÞ

þ b3InsiderOwn þ b4BadNews þ b5Return

þ b6StdReturn þ b7MB þ b8 LogðMV Þ

þ b9NSeg þ b10 LogðNAnalyst þ 1Þ þ b11Issue þ e ð2Þ

DNForecast is the change in the number of earnings forecasts made by a firmbetween 1995 and 1996. Comp is the value of stock and option grants as a fraction oftotal CEO compensation in the pre-event year (1995) to capture the ex-ante com-pensation policy. Log(Wlth) is the natural logarithm of the value of shares held bythe CEO in the in the pre-event year (1995). The control variables are the same asthose defined in Eq. (1). We estimate both an industry fixed-effects specification anda specification with a high-tech dummy to control for the possibility of a differentialimpact of the act on disclosure activities of industries. The sample consists of 1,109firm observations.The industry fixed-effects regression results for the pre- and post-event periods are

presented in column 1 of Table 4. Consistent with our predictions, we find thatchanges in disclosure frequencies surrounding the passage of the Securities LitigationReform Act are significantly positively related to the ex-ante fraction of CEOcompensation tied to share price. On the other hand, we find a positive, butinsignificant relation between changes in the disclosure frequencies and Log(Wlth).As a specification check, we estimate model (2) by substituting changes in disclosurefrequency between 1996 and 1997 (a period strictly after the passage of the Act).Given that this period does not span the event period, we predict no relation betweenchanges in disclosure between 1996 and 1997 and compensation policy in 1996. Theresults of this test are presented in column 2 of Table 4. Consistent with thisprediction, we find no relation between year-to-year changes in managementforecasts in the non-event period and CEO stock price-based incentives (both Comp

and Log(Wlth)). A caveat to the interpretation of this result is if existing stock price-based incentives also proxy for changes in the firm’s litigation risk in 1995–1996,which are not captured by the control variables. Then caution should be exercised ininterpreting our finding of a larger increase in disclosure among firms with higherstock price-based incentives as attributable to these incentives.

4.4. Disclosure quality and stock price-based incentives

The preceding empirical tests rely on management-forecast frequency as a measureof disclosure activity. In this section, we examine another disclosure measure, namelyanalyst ratings of firm disclosures. We use data from the AIMR survey of analystratings of overall disclosure quality.

V. Nagar et al. / Journal of Accounting and Economics 34 (2003) 283–309300

Table 4

Regression results for changes in management forecasts following the enactment of the securities litigation

reform act of 1995

Sample consists of 1,109 firm observations. DNForecast is the change in the # of management earnings fore-

casts. Comp is the ratio of CEO stock based compensation to total compensation, Wlth is the value ($M)

of shares held by the CEO, and InsideOwn is the decile rank of the fraction of shares held by insiders, all

measured in the pre-event year. BadNews is a dummy variable which equals 1 if annual CRSP stock return

was negative in an year 1995–1997, Return is the 3-year average annual calendar stock over 1995–1997,

StdReturn is the standard deviation of annual stock returns between 1989–1994, MB is the 3-year average

beginning-of-year market-to-book ratio, NAnalyst is the # of analysts following the firm in 1997, MV is

the 3-year average market value of equity ($M), NSeg is the average # of business segments reported bet-

ween 1995 and 1997, and Issue is a dummy variable that equals 1 if the firm issued common shares exceed-

ing 20% of market value in 1995–1997.

DNForecast ¼ aþ b1Comp þ b2 LogðWlthÞ þ b3InsiderOwn þ b4BadNews þ b5Return

þ b6StdReturn þ b7MB þ b8 LogðMVÞ þ b9NSeg þ b10 LogðNAnalyst þ 1Þ þ b11Issue þ e

Coefficient Predicted sign Change in forecasts Between

1995 and 1996 (obs=1,109)

Change in forecasts between

1996 and 1997 (obs=1,109)

Estimate (t-stat) Estimate (t-stat)

Comp (+) 0.404 �0.050(2.97) (�0.39)

Log(Wlth) (+) 0.131 0.038

(1.82) (0.80)

InsiderOwn (–) �0.064 �0.035(�0.24) (�0.21)

BadNews (+) 0.149 0.111

(1.71) (1.66)

Return (+) 1.128 0.692

(1.75) (1.94)

StdReturn (+) �1.466 �0.737(�1.08) (�0.78)

MB (+) 0.019 0.008

(0.43) (0.55)

Log(MV) (+) 0.094 0.017

(1.20) (0.16)

Nseg (+) �0.211 �0.088(�1.42) (�0.59)

Log(NAnalyst+1) (+) 0.068 �0.014(0.85) (�0.48)

Issue (+) �0.083 0.042

(�0.37) (0.16)

Industry dummies Included Included

Adj R2 3% 2%

V. Nagar et al. / Journal of Accounting and Economics 34 (2003) 283–309 301

We collect the analyst ratings data of firm disclosures from the annual Evaluations

of Corporate Financial Reporting, published by the AIMR from 1992 to 1995 (4years).6 Analyst subcommittees prepared evaluation reports for each industry in thesurvey. The subcommittees evaluated firms’ relative disclosures contained in variouscategories including annual reports, quarterly reports, and other forms of investorrelations including conference calls, press releases and informal communicationswith analysts and investors. These evaluations include subjective assessments ofquality and relevance of firms’ disclosures. Each industry subcommittee evaluated aset of firms and provided relative disclosure scores in each category as well as anoverall score for each firm in their industry. We focus our analysis on the firms’overall disclosure quality.Again, we use the 1997 versions of the Execucomp and Compustat

databases as our sources of information for CEO compensation, shareholdings,and firm financial data. The selection procedure for the final sample of 289 firms issummarized in Table 5—Panel A. We use the actual overall AIMR disclosure score,DScore, in our analysis. This variable is defined to have a maximal value of 100 totalpoints.7 Over the 4-year period, disclosure scores range from a 13.2 to 96.0, with amean of 71.9. As in the management-forecast sample, there is substantial variation inboth the CEO compensation, Comp, and the CEO wealth tied to share price, Wlth.The descriptive statistics in Table 6—Panel A indicate that stock price-basedcompensation varies from 0% to 100% of total annual compensation. The mean ratioof stock price-based to total compensation is 0.30. In addition, there is wide variationaround the mean (median) value of CEO shareholdings of $57 million ($9 million).For descriptive purposes, we begin by examining the unconditional relations

between Dscore, Comp, and Log(Wlth). As indicated in Table 6—Panel B, the simplecorrelation between DScore and Comp is 0.17, and is statistically significant (DScore

is industry-adjusted in Table 6—Panel B). On the other hand, the simple correlationbetween Dscore and Log(Wlth) is insignificant. Since other firm factors caninfluence both CEO compensation and shareholdings, and the managementdisclosure choice, we exercise caution in interpreting this simple correlation andundertake a multiple regression analysis to control for these factors. Similar to ourprior analysis, we include InsideOwn as an additional independent variable tocontrol for the impact of high inside ownership on the relation between voluntarydisclosure and stock price-based incentives. We apply the following multipleregression model to examine the relation between the overall disclosure quality andCEO stock price-based incentives:

DScore ¼ aþ b1Comp þ b2 LogðWlthÞ þ b3InsideOwn

þ b4BadNews þ b5Return þ b6StdReturn

þ b7MB þ b8 LogðMV Þ þ b9Nseg

þ b10 LogðNanalyst þ 1Þ þ b11Issue þ e: ð3Þ

6The AIMR discontinued publishing the annual surveys after 1995.7The actual reported AIMR scores have different maximum point totals in certain industries. Scores for

these industries are re-scaled to be out of 100 total points.

V. Nagar et al. / Journal of Accounting and Economics 34 (2003) 283–309302

DScore is the raw overall AIMR disclosure score for each firm averagedover 1992–1995. The other variables are the same as those described in Section 3and are calculated over the sample period 1992–1995. The regression includesindustry fixed effects to control for the cross-industry differences in disclosureratings, differences in compensation policy, and other differences that might affectthe relation between these two variables. The sample consists of 289 firmobservations.Table 7 presents the estimation results for a fixed-effects regression model.

Consistent with our prediction, the sign on the CEO compensation variable and the

Table 5

Panel A—Selection criteria for AIMR disclosure score sample

Number of firms with CEO compensation and stock holding data available from 292

Execucomp for 1992–1995 and have AIMR disclosure rankings from 1992 to 1995

Number of firms failing to meet following criteria 3

Stock price (D199) & shares outstanding (D25) available for 1992–1995

Positive book value of equity (D60) & total assets (D6) available for 1992–1995

Operating Income after depreciation (D178) available for 1992–1995

Complete data to calculate ROA for each year 1989–1994

Final sample (firms in Execucomp, Compustat, IBES, CRSP, and AIMR survey) 289

Panel B—Industry affiliation of firms in AIMR disclosure score sample

Industry acronym Number

of firms

Airline 7

Automobiles 11

Chemicals 13

Clothing 8

Electrical 11

Environmental 7

Financial 9

Savings and loan 2

Food 27

Healthcare 15

Homebuilding 7

Insurance 23

Machinery 17

Media 15

Metallurgy 10

Oil and gas 29

Pharmaceutical 1

Retail sales 19

Railroad 7

Software 5

Specialty chemicals 11

Telecommunications 3

Textiles 14

Wood products 18

Total 289

V. Nagar et al. / Journal of Accounting and Economics 34 (2003) 283–309 303

CEO wealth variable are positive and statistically significant. In other words, analystperception of a firm’s overall disclosure practice is increasing in the proportion ofCEO stock price-based compensation and CEO stock price-based wealth. Theeconomic interpretation of the regression coefficient on Comp is as follows: if thefraction of the CEO compensation tied to stock-prices increases from 0% to 100% oftotal compensation, then the average analyst disclosure rating is approximately 6.6points higher. This is a large fraction of the standard deviation of AIMR disclosurescores, which have a mean (standard deviation) of 72 points (14 points). Theeconomic interpretation of the estimated coefficient on Log(Wlth) is that a doublingin the CEO wealth tied to share price is associated with a 2.3 point higher average

Table 6

Panel A—Descriptive statistics for analyst score sample

The sample consists of 289 firms. Variables are averaged over 1992–1995

Variable Description Mean Median Max Min Std.

dev.

DScore The raw AIMR disclosure score for

each firm averaged over 1992–1995

71.90 73.70 96.00 13.20 14.20

Comp Ratio of stock based to total compensation

(4-year average)

0.30 0.29 1.00 0.00 0.20

Wlth Value of shares held by CEO (4-year

average, $M)

57.22 9.10 5195.00 0.00 241.00

InsideOwn Fraction of shares held by insiders

(4-year average)

0.13 0.02 0.68 0.00 0.15

BadNews Dummy variable if annual CRSP stock

return was negative in any year 1992–1995

0.53 1.00 1.00 0.00 0.42

Return Annual CRSP stock return (4-year average) 0.18 0.15 1.03 �0.21 0.19

StdReturn Standard deviation of annual CRSP stock

return (1989–1994 average)

0.19 0.16 0.32 0.04 0.04

MB Beginning of year market-to-book ratio

(4-year average)

3.12 2.29 52.45 0.68 4.22

NAnalyst Analyst following in 1995 19.36 18.00 46.00 0.00 8.75

NSeg Average number of business segments 2.53 2.00 10.00 1.00 1.62

MV Market value of equity (4-year average) 8.62 1.67 91.13 0.19 4.43

Issue Dummy variable if firm issued common

shares exceeding 20% of market value

in 1992–1995

0.08 0.00 1.00 0.00 0.26

V. Nagar et al. / Journal of Accounting and Economics 34 (2003) 283–309304

disclosure rating.8 The positive coefficients on the stock price-based incentivemeasures reject the ‘‘misleading disclosure’’ alternative hypothesis described inSection 2.2, which predicts that, in the long run, rational analysts will assign lowerratings to disclosures made by CEOs with stock-based incentives. Importantly,the consistency of our results across both analyst ratings and earnings forecastssuggests that our results reflect an underlying relation between disclosure and stock

Table 6 (continued)

Panel B—Correlation table for analyst score sample

DScore is the raw AIMR disclosure score for each firm averaged over 1992–1995, Comp is the 4-year ave-

rage ratio of CEO stock based compensation to total compensation, Wlth is the average value ($M) of shares

held by the CEO in 1992–1995, InsideOwn is the decile rank of the fraction of firm’s shares held by insiders

in 1992–1995, BadNews is a dummy variable which equals 1 if annual CRSP stock return was negative in

any year 1992–1995, Return is the 4-year average annual calendar CRSP stock in 1992–1995, StdReturn

is the standard deviation of CRSP annual stock return between 1989 and 1992, MB is the 4-year average

beginning-of-year market-to-book ratio, NAnalyst is the number of analysts following the firm in 1995,

MV is the four year average market value of equity ($ millions), NSeg is the average number of business

segments reported over the sample period, and Issue is a dummy variable that equals one if the firm issued

common shares exceeding 20% of market value in 1992–1995. The sample contains 289 observations.

Industry

Adjusted

DScore

Comp Log

(Wlth)

Inside-

Own

Bad-

News

Ret Std-

Ret

MB Log

(MV)

NSeg Issue

Comp 0.17

Log(Wlth) 0.03 �0.10

InsideOwn �0.02 �0.22 0.15

BadNews �0.05 �0.02 0.03 �0.05Return 0.10 �0.06 0.14 0.09 �0.39

StdReturn �0.07 0.02 0.05 0.05 0.18 0.07

MB 0.03 �0.06 0.09 �0.04 �0.11 0.41 0.04

Log(MV) 0.23 0.16 0.14 �0.30 �0.28 0.38 �0.19 0.18

NSeg 0.04 0.02 �0.01 �0.09 0.03 �0.12 �0.13 �0.03 0.22

Issue 0.00 0.09 0.04 �0.02 0.07 �0.07 �0.06 �0.08 �0.16 �0.02Log(#

Analyst+1)

0.32 0.15 �0.01 �0.26 �0.10 0.25 �0.10 0.10 0.68 0.08 �0.12

Bold numbers indicate significance at the 5% two-tailed level.

8We use actual analyst disclosure scores (re-scaled to be out of a total of 100 points) to avoid losing

information in the variance of analyst ratings. The results are robust to the use of ranked disclosure scores

(results are available from the authors). We argue, however, that the common use of ranked AIMR scores

has its drawbacks. Consider two firms that receive absolute disclosure scores of 0.9 and 0.7 out of

maximum score of 1.0 in their industry group. In other words, analysts decide there is only a ‘‘20% actual

difference’’ in the firms’ disclosures. If these are the only two firms in the industry, the ranking technique

used by Bushee and Noe (2000) would assign the first firm a rank score of 0.75 and the second firm a rank

score of 0.25 (a 50% difference in disclosures). On the other hand, if same two firms were the high and low

disclosures in an industry group of 10 firms, the same ranking technique would assign the first firm a rank

score of 0.95 and the second firm a rank score of 0.05 (a 90% difference in disclosures). Therefore, the use

of ranks actually distorts disclosure scores and diminishes, rather than improves, comparability across

industries.

V. Nagar et al. / Journal of Accounting and Economics 34 (2003) 283–309 305

Table 7

Regression results for analyst disclosure scores

DScore is the raw AIMR disclosure score for each firm averaged over 1992–1995, Comp is the four-year

average ratio of CEO stock based compensation to total compensation, Wlth is the average value ($M) of

shares held by the CEO in 1992–1995, InsideOwn is the decile rank of the fraction of firm’s shares held by

insiders in 1992–1995, BadNews is a dummy variable which equals 1 if annual CRSP stock return was

negative in any year 1992–1995, Reurn is the four-year average annual calendar CRSP stock in 1992–1995,

StdReturn is the standard deviation of CRSP annual stock return between 1989 and 1992, MB is the four-

year average beginning-of-year market-to-book ratio, NAnalyst is the number of analysts following the

firm in 1995, MV is the 4-year average market value of equity ($ millions), NSeg is the average number of

business segments reported over the sample period, and Issue is a dummy variable that equals one if the

firm issued common shares exceeding 20% of market value in 1992–1995. The sample contains 289

observations.

DScore ¼ aþ b1Comp þ b2 LogðWlthÞ þ b3InsideOwn þ b4BadNews þ b5Return þ b6StdReturn

þ b7MB þ b8 LogðMVÞ þ b9Nseg þ b10 LogðNanalyst þ 1Þ þ b11Issue þ e

Coefficient Predicted sign DScore: overall disclosure

Estimate (t-stat)

Comp (+) 6.589

(1.89)

Log(Wlth) (+) 2.310

(1.77)

InsideOwn (�) �0.052(�0.73)

BadNews (+) �1.084(�0.88)

Ret (+) 6.534

(2.02)

StdReturn (+) �1.873(�0.98)

MB (+) 0.021

(0.42)

Log(MV) (+) 0.927

(1.65)

NSeg (+) �1.321(�1.20)

Log(NAnalyst+1) (+) 6.104

(3.83)

Issue (+) 2.873

(1.36)

Industry dummies Included

Adj R2 64%

V. Nagar et al. / Journal of Accounting and Economics 34 (2003) 283–309306

price-based incentives, and not idiosyncratic properties of earnings forecasts oranalyst disclosure ratings.The estimated coefficients on the control variables are consistent with prior

studies. Consistent with Lang and Lundholm (1993), analyst following is asignificant determinant of perceived disclosure quality. In particular, a doubling ofthe analyst following is, on average, associated with a 6.1 point increase in analystdisclosure rating. As in the management-forecast tests, we include the proportion ofinsider share ownership in the regression analysis. However, we find no significantrelation between insider share ownership and analyst evaluations of disclosurepractices.

5. Conclusion

The accounting literature extensively examines the role of incentives in mitigatingagency problems. This paper studies the role of stock price-based incentives inmitigating the managerial disclosure agency problem. The demand for disclosurearises because investors wish to assess the risks and returns of their claims to thefirm’s assets, as well as monitor managers. Because of their close proximity to thefirm’s operating activities, managers are privy to this information. However,managers are inherently unwilling to disseminate their private information becausedisclosure potentially reveals shirking and perquisite consumption, or leads to labor-market reassessments of managerial ability. This mismatch in disclosure incentivescreates investor-manager agency concerns. We hypothesize that stock price-basedincentives mitigate this agency problem. Consistent with our prediction, we find apositive long-run relation between disclosure and stock price-based incentives. Therelation holds for multiple measures of disclosure and is robust to alternativespecifications and endogeneity tests.A possible competing explanation for our empirical findings is that firms with low

earnings quality use more periodic stock price-based compensation and, indepen-dently, have high disclosure activity because earnings are uninformative. These twoindependent outcomes could potentially result in a spurious correlation between theperiodic stock price-based compensation and disclosure activity. However, oursupplemental findings on the positive relation between disclosure and long-termmanagerial wealth tied to share price, as well as the presence of several firm-specificcontrols in our regressions, mitigate concerns that the compensation findings arespurious. Moreover, we argue that this competing explanation merely reinforces ourhypothesis regarding incentives and managerial disclosure. In particular, thecompeting explanation (1) fails to recognize the existence of the managerialdisclosure agency problem, and (2) is silent on the mechanisms through whichmanagers are motivated to disclose information. In contrast, we argue that stockprice-based incentives are a potential mechanism that shareholders use to elicitdisclosure from managers.Our findings make three contributions to prior literature. First, prior empirical

literature associates disclosure choice with firm characteristics, largely ignoring

V. Nagar et al. / Journal of Accounting and Economics 34 (2003) 283–309 307

managerial incentives to disclose. We highlight the impact of contracts betweenowners and managers on managerial disclosure. Second, we provide an ex antecontracting explanation for the association between stock price-based incentives anddisclosure, as opposed to an ex post managerial opportunism explanation (see, forexample, Aboody and Kasznik, 2000). Finally, and perhaps most importantly, ourresults provide a new perspective on the use of stock price-based incentives. Priorcompensation studies argue that firms use stock price-based incentives because pricesare informative about managerial actions (e.g., Lambert and Larcker, 1987). But thisargument abstracts away the price formation process through which prices becomeinformative about managerial actions. Our results suggest that managerial incentivestied to price play a role in this process by motivating managers to improve priceinformativeness through disclosure.

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