How reliable is financial statement information? Every day, banking and finance professionals make decisions about investing and lending based on a company’s financial statement. Therefore, how a manager reports information, and where, has far-reaching implications.
Shana Clor-Proell, assistant professor of accounting at the Neeley School of Business at TCU, and Laureen Maines of the Kelly School of Business at Indiana University, investigated whether and how recognition on the face of financial statements versus disclosure in the footnotes influences the amount that financial managers in public and private companies report for a contingent liability.
Their research confirmed that where the amount appears – recognized (face) vs. disclosed (footnote) – varies between public and private companies.
Importantly, CFOs for public companies expend more effort and demonstrate less strategic bias when contingent liability information is recognized on the face of the financial statements, rather than disclosed in footnotes. As a result, public company managers make more reliable estimates for recognized versus disclosed liabilities.
In contrast, CFOs of private companies exhibit no difference in how they establish estimates, regardless of whether the contingent liability is recognized or disclosed.
“Presumably these differences between public and private companies stem from the increased scrutiny that managers of public companies face from auditors and regulators as a result of their participation in the capital markets,” Clor-Proell said.
Stock market pressures play a primary role in both the amount of cognitive effort that preparers are willing to devote to the reporting task, and the extent to which preparers are willing to bias their financial estimates. This leads to the differential reliability of preparers’ recognized and disclosed estimates.
“For public companies, our results support users’ assumption that recognized numbers are more reliable than disclosed numbers,” Clor-Proell said. “Coupled with prior research, this result also indicates that the decisions of managers and auditors work in conjunction to exacerbate the differences between recognized and disclosed estimates.”
The results of this research have far-reaching implications for financial statement users who must make inferences about the reliability of financial statement estimates when making investing and lending decisions.
“The Impact of Recognition versus Disclosure on Financial Information: A Preparer’s Perspective,” appeared in Journal of Accounting Research
in June 2014.