Firm Disclosure Policy and the Choice Between

Firm Disclosure Policy and the Choice Between
Private and Public Debt*
DAN S.DHALIWAL,University of Arizona and University of Korea INDER K.KHURANA,University of Missouri
RAYNOLDE PEREIRA,University of Missouri
1.Introduction
This paper examines the relation between afirm’s disclosure policy and its debt placement decision.In particular,we examine whether low-disclo-surefirms exhibit a greater propensity to raise funds in private debt mar-kets.Two theoretical views motivate our inquiry.One view argues that private lenders,who are largelyfinancial intermediaries in the form of banks and insurance companies,have an advantage in evaluating borrow-ers with information problems(Boyd and Prescott1986).For example, private lenders are better able to access nonpublic proprietary informa-tion.They also enjoy economies of scale in screening information-prob-lematicfirms(Ramakrishnan and Thakor1984).Similarly,Diamond (1984)viewsfinancial intermediaries as‘‘delegated monitors’’who over-come the free rider problems that may impede information collection and monitoring.The implication is that afirm with a poor information envi-ronment willfind it advantageous to raise funds in private debt markets because it faces lower adverse selection costs.Consistent with this predic-tion,prior studiesfind a greater reliance on private debt among borrow-ers with a poor information environment due to low accounting quality (Bharath,Sunder,and Sunder2008).Separately,prior research has also found low disclosure policy to have a detrimental impact on afirm’s information environment(Lang and Lundholm1996;Bamber and Cheon *Accepted by Michael Welker.We thank Michael Welker(associate editor),two anony-mous reviewers,Chris Barry,Jere Francis,Sun Kim,Mark Lang,Vassil Mihov,Ken Shaw,Terry Shevlin,Robert Trezevant,and workshop participants at Boston University⁄Charles River Associates,Columbia University,University of Kansas,MIT,New York University,University of Missouri-Columbia,University of North Carolina,University of North Texas,Texas Christian University,University of Texas at Austin,and Wharton for helpful comments.We also thank Shawn X.Huang and Xiumin Martin for excellent research assistance.
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doi:10.1111/j.1911-3846.2010.01039.x
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1998).Given this impact,theory predicts that low-disclosurefirms will obtainfinancing from private lenders.
In contrast to this focus on adverse selection costs,a second view,based on recent theoretical research,emphasizes the role of disclosure-related costs in the debt placement decision.Theoretical models highlight the‘‘two-audi-ence signaling problem’’encountered in obtaining funds from public capital markets(Bhattacharya,Boot,and Thakor2004;Yosha1995).The crux of the argument here is that information disclosed to afirm’s investors in a public market setting can also be observed by afirm’s competitors.Such ‘‘information leakages’’can create negative spillover effects which adversely affect a borrower’s competitive position and hence its future profitability (Yosha1995;Bhattacharya and Chiesa1995).Recent chieffinancial officer (CFO)survey evidence supports this argument.Specifically,Graham, Harvey,and Rajgopal(2005,p.62)find‘‘nearly three-fifths of survey respondents agree or strongly agree that giving away company secrets is an important barrier’’that affects afirm’s disclosure policy.In light of these public disclosure costs which discourage disclosure offirm-specific informa-tion,the choice of market through whichfirms raise externalfinancing becomes an important consideration(Bhattacharya et al.2004;Yosha 1995).A resulting implication from this line of inquiry is thatfirms which adopt a low-public-disclosure policy are more likely to turn to private debt markets for theirfinancing needs:firms can benefit from providingfirm-spe-cific information without being subjected to the attendant public disclosure costs.In contrast to public debt,privately placed debt is viewed as inside debt because of the close relationship between the borrower and lender (Bhattacharya and Chiesa1995;Campbell1979;Rajan1992).In light of this relationship,theory predicts that borrowers will turn to private debt markets when the costs associated with publicly revealing information is substantial.James and Wier(1988,p.49)is illustrative of this point: Companies may not wish to reveal to the public the information that
lenders require.For example,suppose afirm is raising capital for an
investment that involves a new marketing strategy,the value of which
would be reduced if competitors learn of it prior to its introduction.
Borrowing from insiders permits thefirm to keep its strategy secret.
In summary,both views predict low-disclosurefirms will turn to private debt markets to raise funds.While thefirst view highlights the advantage of private debt markets in the form of adverse selection cost savings,the sec-ond view points to the net benefitfirms obtain from conveyingfirm-specific information without incurring the cost associated with public disclosure.In this paper,we empirically evaluate this relation between disclosure policy and the choice between private and public debt.Two points are worth noting as to why we focus onfirm disclosure policy.First,disclosure repre-sents an important mechanism through whichfirm-specific information is CAR Vol.28No.1(Spring2011)
Firm Disclosure Policy295 conveyed to afirm’s outside investors.Prior literature provides ample evi-dence documenting the impact of disclosure on afirm’s information envi-ronment(e.g.,Lang and Lundholm1996;Welker1995).Second,we focus onfirm disclosure policy,as opposed to the information conveyed at the time of debt offering,because investors are very much concerned about the flow offirm-specific information during the life of the debt.1Leuz and Wysocki(2006)argue thatfirms can‘‘withhold or manipulate information in certain situations,e.g.,when performance is poor’’in the absence of an expanded disclosure policy.
In evaluating the impact of afirm’s disclosure on the debt placement decision,we also consider the influence of afirm’s accounting quality in this setting.2There are two reasons for this consideration.First,recent research notes that accounting quality has a bearing on afirm’s informa-tion environment and hence is relevant in the debt placement decision (Bharath et al.2008).As such,it is important to examine whether the disclosure–debt placement decision relation holds after controlling for a firm’s accounting quality.Second,Francis,Nanda,and Olsson(2008)find the impact of disclosure on ex ante cost of equity capital is attenuated when accounting quality is controlled for.One explanation for thisfinding is that disclosure and accounting share a complementary relation:higher accounting qualityfirms also exhibit an expanded disclosure policy.This positive relation is consistent with the argument that disclosure is more credible in the presence of high-quality accounting(Francis et al.2008).As such,the impact of disclosure cannot be clearly discerned without control-ling for accounting quality.It is also worth examining whether disclosure plays a more prominent role of conveyingfirm-specific information when the underlying accounting quality is poor.The upshot here is that the impact of disclosure policy may not be uniform acrossfirms and in fact it may be manifested in afirm’s accounting quality.Our empirical analyses explore these issues.
1.There are significant differences in disclosure requirements,at the time of offering,
between public and private debt.For example,public debt issues require a Securities and Exchange Commission(SEC)registration that calls for a detailed disclosure of the intended use of the funds raised.Given the due diligence obligations of the many parties involved in a public offering,such as lawyers and accountants,the borrowingfirm will be pressured to provide as much forward-looking information as possible(Steinberg 2001).Furthermore,borrowers have incentives to providefirm-specific information that is not required by regulation but that is valuable in assessing thefirm’s future economic performance.Borrowers will want to reveal this type of information because it may lower the estimated default risk and thus the cost of their debt.
2.In evaluating the quality of afirm’sfinancial statements,prior research has used the
terms accrual as well as earnings quality.While we generally use the term accounting quality,we also use the terms accruals quality or earnings quality when it serves to improve the exposition of our discussion.The construction of the accounting quality variable follows prior literature and serves to capture‘‘the precision of the earnings sig-nal emanating from thefirm’sfinancial reporting system’’(Francis et al.2008,p.54).
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We empirically evaluate the theoretical predictions about the relation between afirm’s disclosure policy and its debt placement decision at two levels.3First,we study the borrowingfirm’s incrementalfinancing choice between the issuance of publicly offered debt and privately placed debt.4 Here we also examine the association between switches in the private⁄public debt placement decision and changes in disclosure policy.Second,we exam-ine the relation betweenfirm disclosure policy and debt placement decision at a more aggregated level.Principally,theory suggests that private debt financing is advantageous forfirms that adopt a low public disclosure policy.To evaluate this proposition,we examine the impact of afirm’s dis-closure policy on our samplefirms’balance sheet mix of private and public debt outstanding.This analysis complements our incremental choice analy-sis by investigating whether the relation betweenfirm disclosure policy and the aggregation of debt placement decisions over time is consistent with our theoretical predictions.Furthermore,it also serves to address the concern of whether ourfindings on the incremental debt placement decision simply reflect the informationflow at the time of issuance.Prior research has noted thatfirms alter their disclosure in the period surrounding equity issuances (Lang and Lundholm2000).By focusing on the mix of afirm’s private–public debt issuances outstanding,we are able to examine the robustness of the impact of disclosure policy on afirm’s debt placement decision.
Our analysis uses two measures offirm disclosure policy.Thefirst measure is based on management earnings forecasts(MEFs).Following Baginski and Rakow2008,this disclosure measure combines three attributes of MEFs:the presence of a MEF,the frequency of MEFs,and the average precision of the MEFs.Our second disclosure measure is based on analyst evaluations offirm disclosure policy as reported in the Association of Investment Management and Research’s Annual Reviews of Corporate Reporting Practices(AIMR reports).This disclosure measure reflects a com-prehensive evaluation of both the hard information and the soft informa-tion disclosed by thefirms and has been used in prior disclosure research
(e.g.,Lang and Lundholm1993,among others).
3.We focus on debt rather than equity markets for several reasons.Debtfinancing is the
dominant source of capital for U.S.businesses.Bolton and Scharfstein(1996)report that debt issues accounted for85percent of all externalfinancing and equity accounted for only7percent during the time period1946through1987.Moreover,the market for private equity is a fraction of the size of the market for private debt.Carey,Prowse, Rea,and Udell(1993)note that the quantity of funds raised through private equity has dropped since1989.For these reasons,the debt market is a better setting for examining the role of costly public disclosure in the placement decision.
4.The benefit of the incrementalfinancing approach is that it allows us to link the bor-
rowing decision to factors measured immediately prior to the borrowing decision(Denis and Mihov2003).The discrete choice analysis associated with incrementalfinancing assumes thatfirms minimize the cost offinancing by selecting the debt market that pro-vides funds at the lowest cost(MacKie-Mason1991).
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Firm Disclosure Policy297 Our management forecast sample covers2,235publicly issued corporate bonds and private debt placements issued over a10-year period from1997 to2006and our AIMR sample consists of637publicly issued corporate bonds and private debt placements issued over the14-year period from Jan-uary1,1982through December31,1995.Consistent with the theoretical predictions,wefindfirms with poor disclosure policy in place are more likely to issue private debt.This result holds even after accounting for the endogeneity offirm disclosure policy.Consistent with Bharath et al.2008, wefind a negative association between accounting quality and the issuance of private debt.The statistical significance of our disclosure variables sug-gests that disclosure has an incremental impact on the debt placement deci-sion over and above afirm’s accounting quality.We next examine whether the impact of disclosure is uniform acrossfirms with varying accounting quality.Here,wefind the impact offirm disclosure on debt placement deci-sions is more pronounced for the subsample of borrowers with lower accounting quality.This evidence suggests thatfirm disclosure policy signifi-cantly impacts the debt placement decision in the presence of poor account-ing quality.
Turning to our analysis on the mix of private and public debt on a firm’s balance sheet,wefind that low-disclosurefirms rely more on private debtfinancing as a proportion of total long-term debt outstanding.How-ever,unlike the incrementalfinancing choice analysis,we are unable to detect a statistically significant difference in the coefficient estimates of the disclosure variable across two subsamples sorted on accounting quality. Thisfinding,while inconsistent with our second prediction,suggests that aggregatedfinancing choices over time may not allow us to carefully iden-tify the interrelation betweenfirm disclosure and accounting quality on a firm’s debt placement decision.
To highlight the contribution of our study,it is useful to juxtapose it with prior research on the effects of disclosure.Much of the empirical research has been directed at examining whether disclosure improves afirm’s information environment.For instance,Lang and Lundholm(1996)find disclosure improves analyst forecast error and dispersion.In contrast to these analyst-based measures,subsequent research,focusing on market-based measures,finds an expanded disclosure policy improves stock liquidity (Welker1995)and contributes to a lower cost of equity and debtfinancing (Botosan1997;Sengupta1998).In contrast to prior research,we examine how disclosure can impact nonprice elements of debt contracting.Princi-pally,we show the impact of disclosure on the debt placement decision.
More recent research has also reexamined the impact of disclosure conditional onfirm accounting quality.The evidence here is mixed.For example,Francis et al.(2008)find that,while earnings quality has afirst-order effect on cost of equity capital,voluntary disclosure fails to exhibit a significant and distinct effect on the cost of equity capital.In contrast, Baginski and Rakow(2008)findfirm disclosure policy,as measured by the
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properties of afirm’s MEFs,is negatively associated with the cost of equity capital,after controlling for afirm’s accounting quality.Given the comple-mentary relation between disclosure and accounting quality,we also exam-ine the effects offirm disclosure policy conditional on afirm’s accounting quality.
Our paper is related to Bharath et al.2008,who examine how account-ing quality affects borrowers’choice of private versus public debt market. Theyfind poor accounting quality borrowers are likely to borrow from pri-vate lenders.Our study differs from their study in two important ways.First, we focus on disclosure policy and examine whether it is a significant factor after controlling for afirm’s accounting quality.We also examine whether the impact of disclosure varies with afirm’s accounting quality.Second,we also examine whether disclosure and accounting quality impact the mix of private and public debt used by afirm.Overall,our study points to the sig-nificance offirm disclosure policy in the debt placement decision.We further find that disclosure plays a more prominent role in the incremental debt placement decision when afirm’s accounting quality is poor.Overall,our results document how disclosure policy and accounting quality affect non-price elements of debt contracting such as the debt placement decision.
The remainder of this paper is organized as follows.In the next section, we elaborate on the factors which shape afirm’s disclosure policy.We then discuss the resulting impact of afirm’s disclosure policy on its choice between issuing either private debt or public debt and how the debt place-ment–disclosure relation is affected by afirm’s accounting quality.In sec-tion3,we describe our measures of afirm’s disclosure policy.Section4 describes our data and methodology.Section5presents our empiricalfind-ings,and section6concludes the paper.
2.Development of testable hypotheses
Disclosure policies of public corporations have received considerable scru-tiny(see,e.g.,Healy and Palepu2001).An important empiricalfinding from this line of inquiry is the considerable cross-sectional variation in disclosure policy(Lang and Lundholm1993).How is this possible if the disclosure policies of public corporations are regulated?To be sure,public corpora-tions are subject to disclosure policies specified in securities laws and in the rules and regulations of the SEC.However,extant laws and regulations provide considerable latitude in the extent offirm-specific information that is disclosed publicly byfirms(Steinberg2001).For example,existing regula-tions merely serve to encourage,as opposed to require,financial projections in registration statements,annual reports,and other documentsfiled with the SEC.5
5.Such disclosures of forward-looking information are backed by‘‘safe harbor’’provisions
which protect the disclosingfirm from liability.These protections are provided on the condition that thefirm disclosure is reasonable and made in good faith.
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Firm Disclosure Policy299 Given this latitude,considerable research has been directed at under-standing the forces that shape afirm’s disclosure policy(Verrecchia1983; Lang and Lundholm1993).Extant research contends that public disclo-sure offirm-specific information reduces information asymmetry between afirm and its outside investors and lenders and this in turn contributes to a lower cost of capital(Verrecchia2001;Easley and O’Hara2004). Supportive of this argument,prior empirical studies(e.g.,Botosan1997; Botosan and Plumlee2002;Sengupta1998)have documented a negative relation between afirms’level of public disclosure and its cost of capital. While much of the attention has been focused on the impact of disclosure on the cost of funds raised in public capital markets,Mazumdar and Sengupta(2005)find superior disclosure also contributes to a lower cost of private debtfinancing.
Despite the benefits of an expansive disclosure policy,extant theory points to the existence of an interior optimal level of disclosure.The argument is that disclosure involves costs and hencefirms will decide on an appropriate disclosure level by weighing both the costs and benefits associated with an expansive disclosure policy(Verrechia1983).The consideration of disclosure costs is highlighted in Graham et al.’s2005 survey of CFOs.Theyfind a majority of managers consider disclosure costs to be a significant barrier to an expanded disclosure policy.They note that‘‘CFOs do not want to explicitly reveal sensitive proprietary information‘on a platter’to competitors,even if such information could be partially inferred by competitors from other sources,such as trade journals or trade conferences’’(p.63).Given these concerns,it is not surprising that there is considerable variation infirm disclosure policy (Lang and Lundholm1993).Given this variation in adoptedfirm disclo-sure policy,it raises questions about whether it would in turn affectfirm financing decisions.We explore this issue by examining the relation betweenfirm disclosure and the debt placement decision involving private and public debt.
In part,our inquiry is motivated by prior theoretical studies on this issue.For instance,Campbell(1979)modeled the relationship between cor-porate disclosure and the choice between raising capital in the private or public securities markets.In his model,a manager has private information about an investment that will generate monopoly profits for thefirm. However,the manager is reluctant to publicly disclose this private infor-mation because such a disclosure will reduce the project cashflows.In this setting,keeping information confidential enhancesfirm value.Similarly, Bhattacharya and Chiesa(1995)and Yosha(1995)argue that technological and strategic marketing information,if disclosed,may diminishfirm value. To the extent that private debt provides a channel in which information can be transmitted confidentially to the investor,theory indicates that it is cost efficient to issue private debt when the cost of public disclosure is substantial.
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The argument that private debt is optimal when public disclosure is costly rests on the assumption thatfirms can conveyfirm-specific informa-tion directly to private lenders without fear of subsequent information leak-age,especially to afirm’s competitors.Yosha(1995)argues that proprietary information is less likely to be leaked in bilateral as opposed to multilateral financing arrangements.A private placement is similar to a bilateral arrangement,because the debt is typically placed with a limited number of financial intermediaries.With a small number of lenders,the exposure from the failure of a borrower to each lender is considerable,and hence lenders have an incentive to prevent leakage of proprietary information that can affect the competitive position of their borrowers.Additionally,Emerick and White(1992)point out that a borrower has‘‘greater opportunity and freedom to share more speculative information about strategies,business conditions,and competitors’’in private debt markets.Borrowers can make forward-looking disclosure in private debt markets without fearing potential litigation.6Furthermore,private debt avoids the disclosures that are required for a public offering.In particular,private placements are exempt from registration with the SEC.These registration requirements notwith-standing,investors in public capital markets are more concerned about the futureflow offirm-specific information.Therefore,they willfind afirm with low public disclosure to be unappealing and hence may impose a higher cost on the borrower(Sengupta1998).Taken together,these arguments imply low-disclosurefirms will exhibit a higher likelihood of relying on private debtfinancing.
It is worth pointing out that,while private debt allowsfirms to benefit from conveyingfirm-specific information without bearing the attendant costs associated with public disclosure,it is not entirely without costs. Specifically,Diamond(1994)argues that a private lender‘‘incurs operating costs and corporate taxes of its own’’and will transfer these costs to bor-rowers.For example,U.S.banks are subject to reserve requirements and Federal Deposit Insurance Corporation premiums.These requirements do not apply to lenders in the public debt markets(Diamond1994).More-over,these bank requirements will serve to increase the costs of obtaining funds from thesefinancial institutions(Diamond1994;Fama1985).Sepa-rately,Rajan(1992)argues that overreliance onfinancial intermediaries may be problematic in that the private information gathered by these 6.Carey et al.(1993)note that,while existing regulations do not explicitly prohibit disclo-
sure of forward,looking information,this type of disclosure exposes afirm to potential litigation if subsequentfirm performance does not match investor expectations based on the forward-looking information.Carey et al.(1993,p.5,footnote12)note that,‘‘[a]lthough law and regulation do not prohibit dissemination of such information,the pattern of court rulings regarding legal liability of issuers encourages issuers when mak-ing a public offering to disseminate only information for which the historical foundation is clearly demonstrable.’’
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Firm Disclosure Policy301 lending institutions can be used to extract rents from borrowingfirms. In light of these costs,afirm’s debt placement decisions involve the criti-cal assessment of the cost–benefit trade-offs involved.Following prior the-ory,we argue disclosure represents an important consideration in afirm’s debt placement decision.The testable hypothesis involved can be stated as follows:
H YPOTHESIS 1.Low-disclosurefirms are more likely to issue private debt
as opposed to public debt,ceteris paribus.
It is important to note that disclosure is not the only mechanism through whichfirm-specific information is conveyed to afirm’s outside investors. Financial statements also play a significant role.However,the underlying accounting quality is not uniform acrossfirms and hence it can impede the effectiveness offinancial statements in conveyingfirm-specific information.7 Given that both disclosure andfinancial statements affect afirm’s informa-tion environment,recent research has begun to examine whether accounting quality impacts the effectiveness offirm disclosure.One reason for this inquiry is the conflicting views on the relation between disclosure and accounting quality.
There are two competing views on the relation betweenfirm disclo-sure policy and accounting quality.One view posits a substitutive rela-tion between disclosure and accounting quality(Grossman and Hart 1980;Milgrom1981;Verrecchia1983).The argument here is that the demand for disclosure results from the information asymmetry between a firm and its outside investors.To the extent that poor accounting quality adversely impacts afirm’s information environment,it creates greater demand for disclosure.An alternative view predicts a positive(comple-mentary)relation between accounting quality and disclosure(Verrecchia 1990).The argument here is thatfirms with high accounting quality will disclose more because the information conveyed is viewed as more credible.
Given these differing views,the relation between accounting quality and disclosure is an empirical issue.Nonetheless,it has two implications for our study.First,given that both disclosure and accounting quality affect a firm’s information environment,simply relating disclosure to afirm’s debt placement decision without considering accounting quality can overstate the impact offirm disclosure policy in this setting.Indeed,Bharath et al.(2008) argue and present empirical evidence that poor-accounting-qualityfirms are more likely to opt for private debt than public debt.As such,we need to control for accounting quality in our empirical model to ensure that we 7.A number of recent studies(e.g.,Francis,LaFond,Olsson,and Schipper2004)have
pointed out the influence of afirm’s accounting quality on its information environment.
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examine the incremental effect of disclosure over and above the effect of the accounting quality variable.
Second,an important question arises as to whether the magnitude of the influence of disclosure on afirm’s decision to use public or private debt varies with the accounting quality of afirm.In other words,is the effect of disclosure on the choice of public versus private debt more pronounced for firms with poor accounting quality than forfirms with good accounting quality?To the extent that poor accounting quality plays a limited role in ameliorating,or even exacerbating,the information asymmetry between a firm and its outside investors,firm disclosure can have a more significant bearing on afirm’s information environment.However,if poor-accounting-qualityfirms also uniformly display low disclosure,consistent with the com-plementary view of the disclosure–accounting quality relation discussed above,then such a prediction may not hold.In light of the conflicting views,we empirically evaluate whether the impact of disclosure on the debt placement decisions varies with afirm’s accounting quality.The testable hypothesis can be stated as follows:
H YPOTHESIS2.The relation between low disclosure and private debt issu-
ance is more pronounced forfirms with low accounting quality than
forfirms with high accounting quality,ceteris paribus.
3.Measurement offirm disclosure policy
The focus of this study is the relation between afirm’s disclosure policy and its debt placement decision.Following prior research,we use two proxies to measurefirm disclosure policy.Ourfirst measure is based on MEF data.It serves to capture afirm’s commitment to disclose private,firm-specific information publicly(King,Pownall,and Waymire1990).Our second dis-closure measure is based on analyst disclosure scores published in the AIMR reports.It serves as an evaluation of afirm’s overall disclosure pol-icy(Lang and Lundholm1996;Healy,Hutton,and Palepu1999).We explain each of these measures in detail next.
Disclosure measure based on MEFs
Ourfirst measure is based on MEFs,which coincide with detailed quali-tative disclosures(Hutton,Miller,and Skinner2003).Several prior stud-ies have shown that MEFs are informative not only to stockholders (Patell1976;Penman1980;Pownall and Waymire1989;Pownall,Wasley, and Waymire1993)but also tofinancial analysts(Jennings1987;Cotter, Tuna,and Wysocki2006).Like Nagar,Nanda,and Wysocki2003,we assume MEFs capture both hard forecasts of future earnings and the contextual information surrounding these forecasts.This interpretation is consistent with prior research which suggests that MEFs increase the transparency of afirm’s earnings process and provide value-relevant information.
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