Annual reports in post-SOX era provide more disclosure about stock price risk

Vanderbilt study shows reduced information gap between executives and investors

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Vanderbilt University
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Apr 6, 2010

NASHVILLE, Tenn. – Corporate annual reports have become more informative since the passage of the 2002 Sarbanes-Oxley Act, thereby empowering investors with additional knowledge to forecast stock volatility, according to new research from the Vanderbilt Owen Graduate School of Management.
The study sheds light on the effectiveness of Management Discussions and Analysis sections, which have nearly doubled in size since the passage of SOX, but have been criticized for not providing increased information or transparency. MD&A sections have jumped from an average of roughly 5,000 words between 1996 and 2001 to more than 10,000 words between 2002 and 2006.

According to Jacob Sagi, associate professor of finance at Owen and the study’s co-author, the more robust MD&A sections have provided new information that has reduced the gap between what executives and investors know about company financial conditions.

“This is an important finding for investors, because it shows that the MD&A can now be used to better forecast stock price volatility,” he said. “Our research also showed that the post-SOX increase in informativeness was accompanied by an increase in stock liquidity. This appears to provide some validation for a reduction in the information gap between investors and executives.”

Sagi and his team unearthed these findings by examining nearly 26,000 reports from more than 8,000 publicly traded U.S. companies from 1996 to 2006. They developed an algorithm – not unlike what search engines use to make inferences when someone enters a question online – to predict stock volatility from MD&A textual content. The algorithm teaches that key qualitative words and phrases, such as “net loss,” “going concern,” “expenses” and “distributions,” are able to predict stock volatility as well or more accurately than a simple review of past performance or a strictly quantitative forecast.
Interestingly, the researchers found that the overall effectiveness of SOX in increasing MD&A disclosure remains somewhat unclear.

“Ironically, the highly traded, large capitalization firms that have the biggest impact on market volatility and which were squarely in the crosshairs of the SOX regulators are not the ones exhibiting the greatest increase in informativeness,” said Sagi.
Rather, the companies with the least onerous requirements under SOX – typically with market capitalization of less than $75 million – exhibit the greatest improvement in disclosure. Some of the detail these companies reported went beyond what is mandated by SOX. Researchers found that this development likely reflects fear among smaller companies of costly litigation in the post-SOX era where stiff penalties, including jail time, can be imposed for corporate executives and auditors who deliberately flout the law. Hence, the researchers hypothesize that these companies err on the side of too much rather than too little information.
The researchers also reason that these companies, in the new SOX environment, might be concerned that unchanged or lower levels of disclosure could signal to sophisticated investors that something is amiss in their financials.

“Although the disclosure landscape is uneven, one could say that the SOX effect we found is consistent with the ‘law of unintended consequences’ given that while it did not affect the intended target firms it nonetheless has had an impact on the market,” said Sagi.
Sagi’s co-authors include Shimon Kogan from the University of Texas at Austin, and Bryan Routledge and Noah Smith from Carnegie Mellon University. The study, “Information Content of Public Firm Disclosures and the Sarbanes-Oxley Act” is available here.

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