There are several reasons why earnings may not fully reflect a firm's true value:

One: the conglomerate nature of most listed firms makes their operations much more diverse and complicated than those of the horizontally or vertically organized firms of earlier years. This means that even a basic understanding of a firm's value-generating ability requires a resource consuming search for and analysis of large amounts of information. Since organizational complexity also touches the administrative structure of the firm, it is increasingly hard for the managers themselves to fully comprehend the value-generating activities of the firm. Beyond that there is the added difficulty associated with the measurement of these activities.

Two: the degree of internationalization of firms is now much higher than it was in the 1960s and 1970s. This creates new challenges in reporting. It means, for example, that firms often must report their results via the use of more than one set of accounting standards. Equally difficult is the situation in which the firm may decide which of several accounting standards it wishes to use to divulge its operations. A further complication is that the reporting standards for some host stock exchanges are quite fluid. This is especially the case in emerging markets.

Three: the broader markets served by international firms make reputational factors increasingly important. Not only must a firm communicate its good citizenship to its stockholders, it must also do so to the governments and societies that host its overseas activity. Such things as protection of the environment, trade union relations, and management remuneration have a direct impact upon the firm's disclosure practices. This is especially important, because activities required in one country may be considered inappropriate in another. In addition, information released by the firm has some features that separate it from news about the firm originating from other sources. This distinction is due to the fact that firm-generated communication to outside interest groups comes from its management, the primary source of information about the firm. This makes the management reporting role relatively distinct from other sources of news generated about a particular firm.

Financial reporting can be employed to narrow the undesirable influences of information asymmetry. It also facilitates the disclosure of events and transactions in which managers behave in a manner that is not in the best interest of the owners. However, financial reporting, as currently constituted, is not the complete solution. There is a continuing misalignment of management and shareholder interests. Further, Healy & Palepu(1993) suggest that accounting rules and auditing practices are imperfect.

Record-keeping and control functions currently disclose insufficient information regarding the existence, value and use of resources. As long as this condition persists, the sources of capital available to firms will continue to be affected. Lack of information may, for example, dissuade capital market investors. This, in turn, may cause the shares of a firm to be undervalued due to the resulting lesser demand for its shares. If its shares are undervalued, a firm might turn to conventional loan finance, rather than to the capital markets. Gertler (1988) finds that lenders tend to require more adequate communication by the firm to its suppliers of capital than do equity holders. This information would tend to be privately held by lenders and less available to shareholders.

The value of reported earnings may be augmented by appropriate, additional disclosures. Such additional disclosures: (1) provide the market with more relevant valuation information and (2) may accelerate the process of absorption of that information into prices. Thus, the efficient production and use of information in the capital markets will benefit society at large. In order for this to be achieved, it is important for market participants to understand as much of the production and use of information as is possible. The purpose of this paper is to assist in the dissemination of this information.

Managers, shareholders, lenders and regulators benefit from this kind of summarization of research that attempts to determine the optimal set of disclosures. Researchers benefit from both: (1) the review of the historical developments of theoretical foundations, research methodology and empirical findings and (2) a statement of current thought about disclosure policy and its elements and objectives.

In this paper, the major developments of firm-to-outsider communication research are reviewed. It is designed to meet the needs of a wide variety of readers. There are so many perspectives possible that any attempt to list them would be futile. Worse, such an attempt might be counter-productive, because it would suggest that the only areas of interest and importance are the ones the authors of this article can imagine. For this reason, links are provided in this paper so that readers can jump to the section(s) of interest to them.

In general, the developments of disclosure literature follow a very logical path. Earlier studies can be classified into three major categories. First, there is the careful quantification of disclosed items in accounting reports, especially in annual financial statements. The attempt to identify value-determining variables, begun in 1961, continues. In the second phase, researchers attempt to construct theoretical underpinnings which explain the empirical findings. In the third phase, researchers attempt to combine theory and practice with a view to determining the optimal firm-to-outsider communication relationships that should exist.

Listed below are summaries of the subsequent sections of this paper. By clicking on the underlined title of the section, you can go to a given section.

Index Studies: The Search for Relationships Embodied in Financial Statements: This section of the review briefly introduces the works begun in the early 1960s. Many of the early works view disclosure from the perspective of the information producer. Therefore, the pioneer studies reflect the items that are actually disclosed in firms' business reports, usually in annual financial statements. However, these studies do not say much about how the disclosures match the users needs. Appendix 1 summarizes these seminal works from a U.S. perspective, while Appendix 2 summarizes the international confirmations.

Index Studies: The Expansion of the Search for Relationships to Include User Inputs: This section of the review is comprised the articles that take into account both producers' (managers) and users' (investors) views. Studies in this phase specifically investigate how the views of the two groups match with each other. Appendix 3 summarizes these works.The decision to classify an article into a given section of this paper is, in some cases, somewhat arbitrary. These groupings are, therefore, to be considered as indicative in their nature. Furthermore, the review is not intended to be an exhaustive one, rather the literature cited should delineate the major developments in research of this type.

Business Valuation and Communication Studies: The Search for the Reason for Relationships: This section of the review shows the shift in research towards the more integrated business communication issues begun by the Association for Investment Management and Research (1993). It brought about a transformation from traditional, Spartan financial statement analysis to a richer set of business valuation tools. This new direction of research also includes the: (1) business communication from the managers' point of view and (2) business valuation from investors' view. Appendix 4 summarizes the business valuation studies, while Appendix 5 summarizes the business communication studies. An essential facilitator for these new works is the increasing access to such databases as those provided by the Association for Investment Management and Research (AIMR) and Zacks Investment Research Data.

Summary and Conclusions: This being the concluding section, in it the work is summarized.

Index Studies: The Search for Relationships Embodied in Financial Statements

This section of the study focuses on the development of disclosure index literature. This is the first phase. In it, financial statements are studied, almost to the exclusion of anything else. Some problem areas related to this literature are identified. This is done in order to point out the need for improvements incorporated in the disclosure indices which follow in the second phase, which is described in a subsequent section of this paper entitled: Index studies: the expansion of the search for relationships to include user inputs. By specifically including user needs, multidimensional disclosure indices better account for a firm's overall disclosure strategy.

Early U.S. evidence

Beginning with the seminal work by Cerf (1961), the use of financial reports has been a continuous topic of investigation. Appendix 1 summarizes these studies. Cerf (1961) studies the annual reports of 258 NYSE listed firms, 113 firms listed on other exchanges, and 156 OTC firms over the period: July 1956-June 1957. Regression analyses are performed on 31 weighted items. He finds a positive relation between disclosure and: (1) asset size, (2) number of stockholders, and (3) profitability. A decade later, Singhvi & Desai (1971) follows the research design introduced by Cerf (1961) and reports similar results.

Besides studies that focus on the already listed firms, there are studies that concentrate on firms applying for a stock exchange listing. It may be that firms report large changes in expected sources of financing in their disclosures before the actual listing occurs. That action may help a firm attract an adequate number of interested investors for its shares. Copeland & Fredericks (1968) examine the listing applications of 200 firms seeking listing on the NYSE in 1964. Rank correlation analysis is performed on each of six specific indices--one for each of six particular purposes for listing a stock. A positive relation between materiality and disclosure is found to exist. This relation, however, is statistically insignificant.

Different stock exchanges usually have their own listing and disclosure requirements. Therefore, some studies apply similar indexes for different stock exchanges to see whether the host stock exchange has an influence on disclosure. Buzby (1974) analyses the annual reports of 44 NYSE and AMEX and 44 OTC firms, over the period: June 1970-June 1971. Rank correlations are used to investigate 38 weighted items. The correlation between the relative importance of the items and the extent of their disclosure is low. Stanga (1976) reportes that even the industrial sector to which the reporting firm belongs influences disclosure. Appendix 1 summarizes some of the prominent earlier U.S. disclosure index studies.

International confirmation

Besides the U.S. stock market disclosure indices, there is also international evidence. This is summarized in Appendix 2. Index studies in differential market settings indicate how disclosure reflects a firm's disclosure characteristics, worldwide. Some international studies are reviewed below, in order to show the similarities and differences obtained in different market settings. A subsequent section of this paper entitled, "Shortcomings and their consequences for the disclosure indes," summarizes these findings and shows that only a relatively small number of disclosure index items appear to be crucial ones. The rest of the items are more context-specific.

Choi (1973) investigates the annual reports of 72 firms that were Eurobond participants prior to 1971. He uses matched pairs to examine 36 unweighted and weighted items. He finds that entry to the European capital market is related to improvements in disclosure.

Barrett (1975) studies the annual reports of 103 firms, located in: France (15), Germany (15), Japan (15), Sweden (15), the Netherlands (13), the U.K. (15), and the U.S. (15), over the years: 1963-72. This study involves a comparison of disclosure indices and subindices. Seventeen unweighted and weighted items are examined. He finds that the overall extent and quality of American annual report disclosure is not better than that of British firms. He also finds that in specific disclosure areas, there are differences among countries. Results reported in Barrett (1976) further reinforce the view that the quality of disclosure and the degree of efficiency of national markets are related.

Amernic & Maiocco (1981) examine the annual reports of 60 Canadian firms during each of the years 1967, 1972 and 1977. Forty-two weighted items comprise the elements of disclosure in the model. These authors believe there are significant and consistent increases in the mean disclosure scores over the period they examine. There is a detectable industry effect related to disclosure in 1972. 1977 may also contain this relation. Canadian firms' cross-listing on a U.S. exchange is, they find, linked to improved disclosure.

Chow & Wong-Boren (1987) observe the annual reports of 52 firms listed on the Mexican Stock Exchange during 1982. Twenty four unweighted and weighted items are examined. They find that large firms voluntarly disclose more than do small firms.

Gray, Meek, & Roberts (1994, April) examine the annual reports of 116 U.S., 64 U.K., and 100 continental European, multinational firms in 1989. ANOVA is used to analyze 128 items. The results show that there are significant differences in financial reporting between internationally-listed and domestically-listed firms.

Statistical methods are used to identify similarities and differences among disclosure practices in various countries.

Spero (1979) examine the annual reports of 60 firms: in France (20), Sweden (20), and the U.K. (20). The years sampled are 1964, 1967, 1970, and 1972. Regression is performed on some previous indices adjusted for voluntary disclosure plus three of the author's own. He finds that the firm's need for capital explaines voluntary disclosure. Furthermore, disclosure increases in each sample country during the research period (1964-72).

Cooke (1989b) examines the annual reports of 90 firms: 38 unlisted, 33 listed on the Swedish Stock Exchange, and 19 listed on both the Swedish and at least one foreign stock exchange during the year 1985. Regression analysis is performed on 146 unweighted items. Listing status and size are found to be major explanatory variables for voluntary disclosure. In addition, firms categorized as trading disclose less voluntary information than do other industries.

Priebjrivat (1992) observes the annual reports of 63 firms operating in the Securities Exchange of Thailand in 1989. Regressions are performed on 27 unweighted and weighted items. Level of disclosure is found not to be related to capital costs as measured by beta and return variance. Voluntary disclosure is related to size, ownership structure, capital structure, and audit firm (domestic/international). Overall, the results with unweighted and weighted indices are the same.

Williams (1992) reviewes the latest annual reports of 316 firms in 13 countries in February 1990. Regressions are run on 43 weighted items. Size and profitability are significantly and positively related to disclosure. Results also indicate that nationality is an important determinant of disclosure.

Nair & Frank (1980) examine 233 accounting principles and reporting practices of 38 countries in 1973 and 264 principles and practices in 46 countries in 1975. Factor and discriminant analyses are performed on: (1) 6 classification categories for principles and practices in 1973 and (2) 7 classification categories for principles and practices in 1975. The groupings of countries by disclosure practices are different from groupings based on measurement practices. Also, the underlying environmental variables most closely associated with the practices are different. The results have implications about: (1) the comparability of financial statements and (2) accounting harmonization.

Tuominen (1991) reviewes the annual reports of 72 firms listed on the Helsinki Stock Exchange (HSE) and firms on the Finnish Broker's List during each of the years 1976, 1980, and 1984. Discriminant analysis, latent structure analysis, and principal component analysis are all used on 223 items. Over time, disclosure policy in Finland, he finds, has become more comprehensive and diversified.

One of the major purposes of disclosure in accounting reports is to inform shareholders about the firm's affairs. Therefore, it is natural that the market use of disclosed information is of interest. This investigation usually involves the relationship of disclosures and share prices.

Firth (1984) investigates the annual reports of 100 manufacturing firms (every 10th of The Times' 1,000 largest firms) during the year 1976. Regression analysis is conducted on 48 unweighted and weighted items. No significant association between the amount of disclosure and the level of stock market risk is found to exist.

Gray & Roberts (1989) send a questionnaire to 212 British multinational firms in 1984. Interviews are conducted and disclosure rankings are determined. The model consistes of 34 items contained in the questionnaire. Stock market pressures, it is found, appear to dominate political pressures in encouraging voluntary disclosures. Indirect costs of competitive disadvantage are important in the disclosure policy decisions.

Schadewitz & Blevins (1996a) survey the interim reports submitted to the HSE by 40 firms over the period 1986-89. APIs are constructed for positive and negative unexplained earnings portfolios. Unexpected disclosures are found to impact prices for a 10 day period, beginning with the announcement date for both permanent and for total earnings.

Because emerging markets may possess characteristics that differ from more mature markets, it is important that the more fluid, dynamic character of such smaller markets be assessed. The literature captures some of these. They are detailed below.

Susanto (1992) analyses the annual reports of 98 firms listed on the Jakarta Stock Exchange in 1990. Regression analysis is performed on 30 weighted items. Nationality (domestic/foreign) of a firm, new regulations and size are found to be related to disclosure.

Giner Inchausti (1993, April) analyzes 138 firms listed on the Valencia Stock Exchange over the period 1989-91. Regression and panel data analyses are executed on 50 unweighted items. Size, the auditing firm, and stock exchange listing are all found to be related to disclosure.

Raffournier (1994, April) reviewes the annual reports of 161 firms listed on the Swiss Stock Exchange in 1991. Regressions are performed on 30 items, based on EU directives. Disclosure is found to be related to the size and the degree of internationalization of a firm.

Schadewitz & Blevins (1996b) review 573 interim reports submitted to the HSE over the period 1985-93. Disclosure indices are developed. These are tested via regression analysis. A significant relationship is found to exist between the degree of disclosure and: (1) governance, (2) business risk, (3) growth, (4) growth potential, (5) size, and (6) regulation. The hypothesized relationships of: (1) financial risk, (2) capital structure, and (3) stock valuation are not evidenced. (In Appendix 2 there are reviews of some of the papers related to the user response research.)

Index Studies: The Expansion of the Search for Relationships to Include User Inputs

Index studies with user inputs

Financial reporting can serve many purposes. Therefore it is important for the producers of reports to be aware of the specific needs of the particular target groups for which the reports are designed. The studies reviewed here take into account the degree of coincidence between the supply of and the demand for disclosure. (These are summarized in Appendix 3.) Because of this, the findings reviewed below should be especially beneficial for those who design disclosures.

The research approach employed in these studies is normally the analysis of the same disclosure index that is submitted to several user groups. These different users groups are then assigned a weight for each individual item in the disclosure index. The assigned weights are then assumed to indicate the importance of different items for specific user groups. In general, the results show that the match between the producers and the users of disclosed information is often surprisingly low. This deficiency is discussed in more detail in a subsequent the section of this paper entitled, "Shortcomings and their consequences for the disclosure index literature."

Baker & Haslem (1973) send a questionnaire to 1,623 individual investors. Arithmetic means and standard deviations are computed for 33 items that are based on a pretested questionnaire. They conclude that individual investors use many items, simultaneously, in their development of expectations. Although there is evidence that individuals use many items, their results show that the actual disclosure is not always in line with the requirements that users are stating.

Chandra (1974) sends a questionnaire to 300 CPAs and 400 CFAs. A pairwise comparison of ratings is completed on 58 items. The items appearing in the questionnaire are based on the literature, annual reports, and inputs from professional accountants and professional analysts. The conclusion is that the valuation of information for equity investment decisions deviates between accountants and financial analysts.

Chenhall & Juchau (1977) sends a questionnaire to 1,025 active individual Australian investors in 1975. Disclosure scores in different investor populations are determined for 37 items selected on the basis of previous literature and documents from the Accounting Standards Steering Committee. It is learned that risk averse investors and those preferring high dividends value information on: (1) expected future dividend yields, (2) past dividend yield, and (3) ease of transfer of old shares. Investors accepting high risk and low dividends value information on: (1) leverage and (2) budgeted statements of performance and position.

The results obtained by Benjamin & Stanga (1977) indicate that there is controversy between producers and users of disclosure. They find that, in the case of 51 of the 79 items, commercial bank officers--who make term loan decisions-- and financial analysts--who make share investment decisions-- value information differently. In a similar vein, Firth (1978) observes differences in rankings for 75 items that are selected on the basis of the literature, recent annual reports, and discussions with users. Finance directors and auditors have somewhat similar views. Financial analysts and bank loan officers have somewhat similar views. However, users (analysts, officers) attach higher importance to directors' disclosures than do preparers (directors, auditors).

Kahl & Belkaoui (1981) investigate the annual reports of 70 commercial banks from 18 countries during 1975. Disclosure scores are computed and disclosure consensus is sought. Thirty weighted items based on the literature and the judgment of the author, professors and CFAs are observed. Differences are fund to exist in disclosure adequacy internationally. U.S. banks, it is learned, are leaders in the extent of disclosure. A positive correlation, they learn, exists between size and disclosure. There is a low consensus between producers and users of the ten disclosure items.

McNally, Eng, & Hasseldine (1982) analyze the annual reports of 103 firms listed on the New Zealand Stock Exchange in 1979. Differences in disclosure scores are examined using 41 weighted items that are based on literature, recent annual reports, and pilot-test by stockbrokers. They determine that stockbrokers and financial editors perceive the voluntary disclosure of a wide variety of items of information to be important. There is divergence between actual disclosure and that degree of disclosure that is perceived to be desirable by external users. Size is related to voluntary disclosure.

Firer & Meth (1986) examine the annual reports of 36 firms listed on the Johannesburg Stock Exchange over the years 1979-83. Differences in disclosure scores are examined on 49 weighted items selected on the basis of the literature, annual reports, and responses to a questionnaire sent to both investment analysts and financial directors. Investment analysts place: (1) a high level of emphasis on predictive information items, (2) low importance on inflation- related items, and (3) high importance on a statement of transactions in foreign currency. There is a low level of correlation between South African investment analysts and U.K. counterparts.

Wallace (1988) sends a questionnaire to 1,200 persons: 300 chartered accountants, 200 investors, 100 senior civil servants, 200 managers, 200 financial analysts, and 200 other professionals in 1986. Disclosure scores are used to determine consensus among different user groups. 109 items are assessed, based on the literature, regulation, and the degree of controversy surrounding any particular issue. The major finding of the study is the lack of consensus between accountants as a user-group and all other user-groups. (Appendix 3 summarizes the findings when the indices include both producers' inputs and users' perception of their worth.)

Shortcomings and their consequences for the disclosure index literature:

Both the producer's output and the user's perceived needs are specifically addressed. In addition, the degree to which these match is studied in the literature as is explained above. However, in the early phase of the disclosure index literature there are several shortcomings that can be assessed. This section addresses some of these. This discussion serves as a logical foundation for the subsection of this paper entitled,

Business valuation and communication studies: the search for the reason for relationships; a section in which the rationality behind certain business communication practices is discussed in more detail. Prior to 1976, the level of disclosure was interpreted by applying variables mainly based on a prima facie understanding of the use of disclosure.

Ball & Foster (1982, p. 199) point out the general lack of analysis of the benefits associated with voluntary disclosure policy by stating: "A heuristic framework of 'more disclosure is better' appears to guide many statements in this area." All of this activity is, in some ways, doomed to failure. The identification of indices that explain business communication is almost impossible. Among the reasons why this is true is that both the level and quality of investor ability varies widely across firms. Further, even the context and motivation underlying one disclosure may be greatly different from that associated with another. Finally, cross sectional and intertemporal differences exist among host country accounting rules and stock exchange reporting rules. Therefore, in order to gain further understanding, the next phase begins with the search for theoretical explanations of the empirical findings. For example, Leftwich, Watts, & Zimmerman (1981) provide evidence of incentives for managers to supply interim reports voluntarily. Their intention is to explain the existence of interim reports as a monitoring device. However, Schipper (1981) concludes that agency theory and team monitoring are not refined enough to allow unambiguous predictions on the basis of such detailed variables

Several conclusions can be drawn based on prior literature.

One: the emphasis in disclosure index studies, to date, is on annual reports. Although annual reports are very important in a firm's business communication, there are several other channels firms are employing in their communication. In order to better understand communication issues, the other tools should be studied, also.

Two: it appears that large firms disclose more information than do small ones. This unanimous finding is a natural outcome for several reasons. The business processes of large firms are more complex; therefore, they demand greater disclosure. The needs of the users of large firms' reports may also be more divergent than those of the users of small firms' reports.

Three: capital markets desire adequate levels of disclosure. Their great need for information is understandable in the context of constantly developing financial market tools. These tools offer a firm new possibilities to finance their operations and also modern techniques to protect themselves against financial risks. It is important for shareholders to be aware of a firm's practices in these matters. Furthermore, investors need precise information in order to properly manage the risk and return relations associated to their own security holdings.

Four: over time, the quality of disclosure seems to have improved. This reflects the trend towards more timely and efficient business communication. Improvements in disclosure cannot address solely the regulatory developments, for they must also address many other factors, such as the globalization of firms and capital markets through time that have accelerated this kind of improvement.

Five: risk measures, such as beta, seem not to be undisputedly related to disclosure. This outcome strongly supports the view that market risk, as measured by market model beta, is not related to the level of disclosure. It may indicate that beta is somewhat inefficient to capture the risk related information disclosures are providing.

Six: accountants and analysts have somewhat different views of the importance of various items. Although this is not a desired outcome in terms of maximum efficacy for the reports, it is understandable. Accountants are chiefly concerned about the accurate reporting of historical numbers, while analysts are interested of the future prospects of a firm. Furthermore, a firm's external auditors are mainly responsible for auditing a firm's past affairs; not its future prospects.

Seven: there exists a lack of communication between different interest groups. This seventh conclusion--one made on previous disclosure studies--is closely related to the sixth reason discussed above. It can be added that in both groups incentives are often constructed so that they encourage the current state of affairs, i.e. a relatively low level of communication between accountants and investors. On the other hand, the carefulness and restrictiveness of accountants in these relations advances the equality of investors. In other words, none of the outside investors have an access to privileged information.

Eight: the vast majority of the studies listed in the first three appendices have significantly different indices. This fact hinders a fair comparison between separate disclosure index studies.

The systematic comparison between studies is important, especially in order to separate fundamentally important items to be disclosed from the more context-specific items that have been disclosed.

Recognizing the widely prevailing differences in disclosure indices, Wallace (1988) searches for any consensus that might be concealed in the different disclosure studies. Accordingly, the author standardizes the disclosure indices used in nine previous studies. Standardization allows the importance of items in each separate study to be evaluated together. The items applied in previous studies are all categorized into dominance quartiles. The dominance of a quartile reveals the preference of different user groups for that item. Wallace finds 15 items in the most important dominance quartile that have a perception consistency of over 60 percent. There seems to be only a limited number of items with the highest importance. This indicates, among other things, that the differences in the determinants of the disclosure indices can be attributed, to a large extent, to context-specific factors, such as the country and legislative regime.

The best policy to follow in the construction of a disclosure index would be to make the number of items as small as possible without sacrificing important items. The American Institute of Certified Public Accountants recognize this in 1994 with the following [Recommendation No. 7, 124]: "Standard setters should search for and eliminate less relevant disclosures."

The weighting of individual elements of a disclosure index is very difficult. The ideal would be to obtain a set of disclosures that are important to stockholders and that have weights that are appropriate over the whole research period. The subjectivity associated with weighting is a danger that is recognized by Ashton (1974): "Generally, individuals overestimate the extent to which they utilize the less important cues and underestimate the extent to which they utilize the more important cues, i.e., subjective weights are much more evenly distributed across cues than are statistically-derived weights." This means that ex post assigned weights may not be reliable indicators of the actual use of information in interim reports.

The disclosure studies considered so far offer accumulated evidence that certain firm-specific and governance structure-specific characteristics are reflected in disclosures. However, the literature does not substantially add to the knowledge of how a firm should communicate in order to best reduce the information asymmetry between managers and investors.

In order to progress further towards a more complete understanding about disclosure matters, researchers began to focus on: (1) single items disclosed by a firm or (2) overall disclosure strategies. These developments are discussed in the next section.

Business Valuation and Communication Studies: The Search for the Reason for Relationships

Two somewhat different lines of thought have encouraged researchers to investigate firms' disclosure practices in more detail. Both approaches are born out of the fact that current earnings, alone, are insufficient to explain stock price behavior. Since Ball & Brown (1968), there is accumulating evidence that reported earnings contain information that is useful to stock markets. Yet, earnings are found to have only limited ability to explain market behavior. The inability of earnings to convey all useful valuation information is evidenced in two fundamentally different, ways: (1) the overall explanatory power of earnings is relatively low and (2) earnings information reflects into stock prices with a lag. Therefore, (1) not all information that is useful for share price valuation is provided by reported earnings and (2) even the information that is conveyed by reported earnings takes the market some time to assimilate.

Some related literature is reviewed below to emphasize these two deficiencies. The low earnings response coefficients (ERCs), as well as low explanatory power of the ERC models, indicate the low explanatory power of earnings for stock prices. The inability of reported earnings to convey all price relevant information is treated first. This is followed by a brief discussion of the failure of reported earnings to generate an immediate adjustment to the indicated price. All of this argues that the value of reported earnings may be augmented by appropriate additional disclosures. In addition to providing the market with more valuation-related information, such additional disclosures may also speed the process of absorption of price related information. As a result, the efficient production and use of information in the capital markets will benefit all market participants.

Lev (1989) reviews studies related to the earnings/returns association. He points out the limited understanding of the reasons for low earnings/returns associations. These findings have inspired researchers to explore reasons for the low explanatory power of earnings models. These research efforts can be further categorize in two, somewhat overlapping, classes of research: (1) that which focuses on extended financial statement analysis, summarized in Appendix 4 and (2) that which emphasizes the quality of overall business communication, summarized in Appendix 5.

Financial statement analysis: a rediscovered tool

Since the late 1980s, extended financial statement analysis began to attract broader academic attention. These studies are characteristically based solely on financial statement numbers and ratios, without taking into account managers' nonquantified analyses, which are disclosed in annual statements along with the reported accounting numbers. Ou & Penman(1989) exemplify. Such studies succeed in increasing the power of statistical models that explain cumulative abnormal returns (CARs). Lev & Thiagarajan (1993) extend this line of research by applying a guided search of fundamentals, rather than a solely statistical identification of the most prominent explanatory variables for stock returns. In the guided search of fundamentals, professional security analysts are asked to name the fundamentals that are the most important in their investment analysis work.

In the Finnish stock market, Martikainen (1990) investigates the economic determinants of stock returns and systematic risk. Four financial characteristics of a firm are analyzed: (1) financial leverage, (2) operating leverage, (3) corporate growth, and (4) profitability. All four characteristics are found to be long-term determinants of Finnish stock returns. However, the incremental significance of each characteristic is found to be low. Furthermore, Schadewitz (1996a)discovers that the low ERCs reported for annual earnings in other stock markets are also evidenced with interim earnings for HSE listed firms. (Appendix 4 provides a summary of the current work related to the analysis of the value of financial statements.)

Disclosure policy orientation

During the 1990s, applied disclosure indices became more user defined. These studies attempt to determine what disclosures are effective in business communication. (These studies are summarized in Appendix 5.) Lev(1992) reports that the recent focus has moved toward the integral type of disclosure strategy. Further, the Association for Investment Management and Research (1992) ratings are the focus of current study. Although AIMR indices are probably more user-oriented than those developed in prior studies, some deficiencies remain. Lang & Lundholm (1993), for example, notice that the AIMR indices are not necessarily based directly on original reports. In addition, the opinions that constitute the ranking of intertemporal studies probably change over time. This opinion drift would generate some biases and inconsistencies over time. Additional disclosures are found to provide the market with more valuation-related information. Hoskin, Hughes, & Ricks (1986) address the other-than-earnings disclosure deficiency. They find that qualitative comments by officers made concurrently with earnings appear to be important disclosures.

Two recent articles continue the examination of the influence of the degree of disclosure on the earnings/price relationship. Penno (1996) theorizes that disclosure precision can be forecast by the knowledge of the reporting firm's relative degree of success. Firms with a high degree of disclosure tend to be experiencing difficulties, while firms publishing less precise disclosures tend to generate more stable earnings. He calls disclosure with high precision back-to-the-wall policy, where initially unfavorable news is followed up by an extensive output of information. Disclosure with low precision is viewed as a don't-rock-the-boat policy, where good initial news is not followed by an extensive output of information. Frost & Kinney (1996) confirm this by discovering that, for foreign registrants, there is a significant variation in both earnings/price and the change in earnings/price by: (1) host country, (2) filing status, and (3) degree of disclosure. In addition, Healy, Palepu, & Sweeney (1995) argue that firms increase their overall disclosure, because they consider both short-term earnings and earnings growth to be insufficient indicators of the firm's prospects for long term economic performance. Lang & Lundholm (1993) find that disclosures are superior for: (1) firms that perform well, (2) larger firms, (3) firms with a weaker relation between annual stock returns and earnings, and (4) firms that issue securities. Schadewitz & Blevins (1996c) attack the question of the degree to which additional interim disclosures convey value related information to the markets. They confirm that the degree of disclosure does impact share prices.

Imhoff (1992) examines 185 firms identified in the 1982 Corporate Information Committee Report by the Financial Analysts Federation (FAF). Regression analysis is performed on the analysts' ratings, which are listed in the host document. Firms having relatively high (low) accounting quality are those with more (less) predictable earnings, more (less) accurate earnings forecasts, smaller (larger) annual earnings forecast revisions after first quarter results, lower (higher) likelihood of bad news in the annual earnings report, larger (smaller) size, and lower (higher) debt/equity ratios.

Lang & Lundholm (1993) review 751 firms rated at least once by the five FAF Reports, published over the years: 1985-89. Regressions are performed on existing analyst ratings of disclosure categories. Disclosure scores are higher for: (1) firms that perform well, (2) larger firms, (3) firms with a weaker relation between annual stock returns and earnings, and (4) firms that issue securities.

The current phase of this research attempts to reconcile theory and practice via the development of the optimal set of disclosures.

Price (1993) use COMPUSTAT and CRSP data to examine 2,533 firms over the years: 1984-91. Regression analyses are performed on variables derived from a set of simultaneous equations in which disclosure quality is first considered exogenous; then endogenous. Disclosure quality evaluations published by the AIMR are the elements used in the sources of the variables in the original simultaneous equations. He finds that management responds to higher levels of institutional ownership by providig higher quality disclosure.

Welker (1993) uses COMPUSTAT and CRSP data to examine 2,596 firms over the years: 1981-90, based on observations of quality evaluations published by the AIMR. Regression analysis is performed on variables derived from a set of simultaneous equations in which disclosure quality is first considered exogenous; then endogenous. Disclosure quality evaluations published by the AIMR are the elements used in the sources of the variables in the original simultaneous equations. Disclosure quality, he concluds, reduces information asymmetry. Hence, the cost of equity capital is reduced.

Gibbins, Richardson, & Waterhouse (1990) interview representatives from 11 disclosing firms and 9 external organizations over the period: 1985-86. An inventory of the results of the interviews is maintained on both the disclosure media and topics disclosed. A two-dimensional internal preference for managing disclosures is developed. The first dimension measures the degree of uncritical acceptance of rules and norms; the second dimension measures the propensity to seek firm-specific advantage vis-a-vis how disclosures are made and interpreted.

Sutley (1994) observes 116 winning and 123 nonwinning annual reports in the Financial Post annual report award program over the years: 1982-87. He performs regression and content analyses on disclosure quality evaluations published by the Financial Post Content analysis of Financial Post booklets that indicates that the concepts of disclosure, informativeness, and usefulness to investors are important in a judge's ranking over the period studied. Changes in winners' stock prices are less correlated with contemporaneous changes in earnings in the award year than are nonwinners. In addition, he finds that winners have larger increases in return variability during the annual report's announcement week than do nonwinners.

Healy, Palepu, & Sweeney (1995) identify 90 firms with sustained increases in the quality evaluation of the disclosure ratings published by the AIMR over the decade 1980-90. Regression analysis is performed, and control groups are established, using the disclosure quality evaluations published by the AIMR. Increased disclosure, they conclude, appears to be effective in helping investors to value short-term earnings growth. In addition, high level of disclosure creates additional consensus among investors leading to increased liquidity for the firms' stocks.

As the studies cited above indicate that many new and important aspects of a firm's business communication have been learned during the 1990s. The final section of this paper summarizes the major developments that have lead to the current stage of this literature. (Appendix 5 summarizes the current research in the overall business communication area.)

Summary and Conclusions

This paper reviews the firm-to-outsider communication in order to demonstrate the transformation that has taken place during the last 30 years. This transformation is identified as the progression of research from Spartan disclosure index studies to a rich set of business communication and valuation topics. Special care is taken to point out the important turning points appearing in the literature through the years. Although some of the classifications for the prior literature are somewhat arbitrary in their nature, the structure of this paper is designed to recognize the main developments through time in this arena of research. This review covers the period 1961-96. Over 200 variables are identified. Both listed and unlisted stocks are studied. Up to 39 host nations are examined. Annual and interim periods are inspected. In spite of this diversity, the development follows a very logical path.

First: in the early 1960s, there is a careful quantification of items disclosed in U.S. annual accounting reports. That research orientation gives a good view of the information actually disclosed in annual financial statements in the U.S. (These studies are summarized in Appendix 1.) Later, very similar findings are reported internationally. (These studies are summarized in Appendix 2.) One of the shortcomings during the early phase is its failure to explicitly match the information actually disclosed by producers (managers) with the perceived needs of the users (investors). Thus, the early works do not help managers craft their external financial reports such that they address user needs. Determining user needs is the next phase of this quest. The question of how well the information disclosed corresponds with the needs of users. (Studies asking the question of how well the information disclosed corresponds with the needs of users are summarized in Appendix 3.)

Second: in the second phase researchers attempt to construct theoretical underpinnings which explain the empirical findings. This phase takes place in the late 1970s and the early 1980s. However, agency theory and team monitoring are not refined enough to allow unambiguous predictions on the basis of the detailed variables suggested by some of the research at that time. Therefore, this line of thought does not have many followers in the 1990s.

During the second phase some studies compare several standardized indices prepared from previous studies. These provide evidence of a consensus among the different disclosure indices. It is found that there are 10 to 15 items that tend to be common. These few common elements cross international boundaries, varying regulatory regimes, reporting industries, and observation periods. This indicates that there are a limited number of items with the highest perceived importance. The rest of the disclosure index items are more context specific, such as those linked to the country and to the legislative regime. (These studies are summarized in Appendix 4.)

Third: in the third, current phase, researchers are attempting to combine theory and practice with a view to determining the optimal firm-to-outside communication relationships that should exist. In this phase the focus is to gain a finer understanding about the process of financial statement information dissemination to capital markets. In this, the current phase of research, it is explicitly recognized that the present theory can only partially explain: (1) the information production for the capital markets and (2) the use of that information.

Modern research seeks to discover tools for managers to establish disclosure policies that ensure that the value of the firm's activities will be fully reflected in a timely manner in its share prices. The direction of this research is toward the integration of business communication issues. It details the transformation from traditional, Spartan financial statement analysis to a richer set of business valuation tools. Both (1) a manager's business communication view and (2) an investor's business valuation view are taken into account in this phase of the work. (These studies are summarized in Appendix 5.)

The search continues! The focus is sharper now than in the past. The questions addressed are both more precise and enlightened. The objectives are more clearly delineated, but the end is not in sight.

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APPENDICES

Appendix 1. Annotated bibliography on pioneering disclosure index studies (Text subsection: Early U.S. evidence)

Appendix 2. Annotated bibliography on confirmatory disclosure index studies (Text subsection: International evidence)

Appendix 3. Annotated bibliography on disclosure index studies explicitly incorporating user inputs (Text subsection: Index studies with user inputs)

Appendix 4. Annotated bibliography on extended financial statement studies (Text subsection: Financial statement analysis: a rediscovered tool)

Appendix 5. Annotated bibliography on disclosure policy studies (Text subsection: Disclosure policy orientation)

END NOTE

The authors would like to acknowledge the skill, dedication and professionalism of following persons:

Ms. Petra Hiltunen, who helped in the detailing of the references in the early stages of the work,

Mrs. Maritta Griffin, who helped in the detailing of the references in the later stages of the work, and

Dr.Carole E. Scott, who formatted the work for electronic publication.

The authors are deeply appreciative of their boundless dedication and competence.

Any errors or omissions, however, are the sole responsibility of the authors.