Voluntary Disclosure and the Internal Information Environment of the Firm

A manager’s voluntary disclosures are influenced by both his ability and incentive to disclose: does he have value-relevant information to share, and will disclosing it increase the stock price? Existing analytical literature has largely overlooked the firm’s internal information environment, typically assuming that the probability of a manager being informed is independent of the nature of the information. However, in practice, the flow of information to upper management often differs depending on whether the information is positive or negative. My new paper explores how the nature of a firm’s internal information environment—specifically the likelihood of the manager being informed about good versus bad news—affects the manager’s decision to disclose information voluntarily to investors.

In this paper, the internal information environment is categorized as either conservative or aggressive. A conservative environment is one where bad news is more likely to reach the manager, while an aggressive environment is one in which good news is more likely to reach the manager. This model reflects real-world scenarios where negative information may flow faster than positive information, or vice versa, within an organization. For example, certain CEOs foster environments that prioritize the rapid sharing of negative information so they can take corrective actions promptly. Conversely, some factors may lead to the preferential transmission of positive information, such as middle managers withholding bad news from senior leadership. As noted in one article in the Harvard Business Review, ‘At Kmart, for example, managers were reportedly reluctant to tell leadership team about problems in the business.’

The main message that emerges from this paper is that the internal information environment crucially affects the manager’s incentives to make voluntary disclosures to investors. First, a more conservative environment reduces voluntary disclosure. The intuition behind this result is that when the manager possesses negative information, but it is below a certain threshold, the manager has an incentive to withhold the information rather than disclose it, as revealing it would lead to a decrease in the firm's valuation. In the absence of disclosure, investors are left to infer whether the manager is uninformed or withholding negative information. When the internal environment is conservative, it is more likely that the manager is uninformed about positive developments, which increases investors' valuation of the firm when no disclosure occurs. Consequently, withholding information becomes more attractive to the informed manager, leading to reduced voluntary disclosure to investors.

Second, the paper analyzes how the interaction between the internal and external information environments affects voluntary disclosure. The external information environment refers to the investors' prior variance regarding the firm's value, which reflects the level of information asymmetry between the manager and the investors. The paper demonstrates that in conservative internal environments, an increase in investors' prior variance about the firm’s value leads to a reduction in voluntary disclosure, indicating that higher information asymmetry diminishes the incentives to disclose. Conversely, in aggressive internal environments, greater uncertainty about the firm’s value leads to more voluntary disclosure, implying that higher information asymmetry leads to more voluntary disclosure.

The intuition behind this result is as follows: An increase in investors’ prior variance of firm value creates conflicting effects. On the one hand, more dispersed beliefs about the firm’s value increase the probability of extreme negative firm value realizations that are not disclosed, prompting investors to lower their valuation of the firm when they see no disclosure. This motivates the manager to disclose more voluntarily. On the other hand, higher information asymmetry increases the probability that the manager is uninformed about exceptionally positive outcomes, which leads investors to raise their valuation of the firm in the absence of disclosure, reducing the manager’s incentives to disclose. Whether voluntary disclosure increases or decreases depends on which of these two effects dominates. The study shows that the first effect dominates when the internal information environment is aggressive, while the second effect prevails when the environment is conservative.

The paper’s findings offer a new explanation for why increased information asymmetry can lead to either more or less voluntary disclosure, depending on the context. Some empirical studies suggest that higher information asymmetry increases voluntary disclosure because investors’ demand for information rises as they become less informed. Other studies argue that lower information asymmetry results in more disclosure because reduced asymmetry attracts more investors, leading to greater demand for disclosures. This paper contributes to the debate by highlighting the importance of the firm’s internal information environment and its impact on voluntary disclosure, offering new predictions that can help reconcile the mixed results in the empirical literature. Considering the interplay between internal and external information environments, this study provides a more comprehensive understanding of how information asymmetry between a firm and its investors impacts disclosure decisions.

Joaquin Peris is a Ph.D. candidate in Accounting at Columbia University.

The full paper is available here.