entail mandatory disclosures for firms that, upon conclusion of the review, have been found to have prepared erroneous financial statements. Hence, the disclosure framework does not mandate any disclosure of ongoing reviews, nor of reviews that have been con-cluded without an error finding. As a result, only a small fraction of enforcement activities is observable. Figure 1 illustrates how this disclosure environment creates two potential points or periods in time where firms may decide to voluntarily disclose information on enforcement activities: while the review is under way or after conclusion of the review.
Distinguishing reviews which eventually resulted in observable enforcement action, as documented by the publication of an error finding, results in a total of four types of en-forcement-related disclosures (Figure 1). Note that only after the conclusion of a review that resulted in an error finding are firms mandated to divulge the fact that they have been subject to an enforcement review (type III in Figure 1). Yet, even in those cases, managers may decide to voluntarily report supplementary information via disclosure channels other
than the error announcement. For example, while the format of an error finding is man-dated by the securities regulator, a firm may decide to report on the error finding, for instance, in the annual report, and provide supplemental information, such as how the error has been addressed, or whether the firm agrees with the error finding.
Figure 2.1: Taxonomy of enforcement-related disclosures
Ongoing review Concluded review
Error finding I: Voluntary disclosure III: Mandatory disclosure
No error finding II: Voluntary disclosure IV: Voluntary disclosure
This figure identifies four principal cases of voluntary disclosures about enforcement reviews, by (1) differentiating disclosures about ongoing reviews from disclosures about concluded reviews, and (2) differentiating reviews that resulted in an error finding from those that did not.
In the remainder of this section, we briefly discuss potential disclosure incentives for the various classes of voluntary disclosures about enforcement reviews, pointing out potential firm-level perspectives on the “right not to remain silent”. First, we address incentives to divulge details on ongoing review activities (disclosure types I & II, Figure 1). Naturally, firm managers are not only informed of the ongoing review. The review is conducted as a communication between the enforcer and the firm, based mostly on written correspond-ence, and managers involved will typically have an idea of the quality of their financial statements and any potential errors they contain. Hence, as the review proceeds, the man-agers will form their own assessment of the likelihood that enforcers will eventually es-tablish errors. This is a piece of private information which is of potential relevance to firm outsiders such as investors, and managers may strategically decide whether and how to disclose it.
Disclosure theory suggests various incentives for firms to disclose or to withhold infor-mation about ongoing enforcement reviews. For one thing, managers may decide to in-form the market of an ongoing enforcement review, in an attempt to signal their commit-ment to transparency and hence their managecommit-ment quality (e.g., Hughes, 1986; Teoh and Hwang, 1991; Wang et al., 2008). Investors may value such a commitment, as increased
transparency reduces information risk, which is priced (R. Lambert et al., 2007). A related motive may be signalling (Trueman, 1986), that is, the attempt by managers to shape their disclosure in a way that credibly conveys their private assessment of a low risk of an adverse outcome of the enforcement review.
Managers may also have incentives to inform markets about ongoing enforcement re-views when the risk of getting censured by enforcement institutions is high. For one thing, managers may attempt to manage market expectations, that is, to prepare the market for a potential adverse outcome, in order to “soften” the market impact of an official error finding (Skinner, 1994). Also, managers may strategically time the disclosure of the pend-ing review (Acharya et al., 2011; Beyer et al., 2010), to minimise market impact. For instance, if annual earnings turn out to exceed market expectations, managers may decide to factor into the earnings announcement or annual report information on the enforcement review with the expectation of investors being distracted by the earnings surprise, or put-ting more weight on the positive news (DeAngelo, 1988).
Once an enforcement investigation has been concluded without an adverse ruling, the firm also has the choice to divulge that information (disclosure type IV, Figure 1). As the majority of errors established by the German enforcement bodies pertain to financial statements with a qualified audit opinion, the information that an enforcement review has yielded no error findings potentially conveys additional information on the high quality of a firm’s financial statements, and hence of its overall disclosures. Firms may hence decide to communicate that information in an attempt to reduce information asymmetry with investors.
Taken together, theoretical reasoning based on disclosure theory suggests that firms may decide to disclose information on ongoing enforcement reviews, or on a concluded inves-tigation, based on firm-specific trade-offs of the potential costs and benefits of these dis-closures. However, it is an open empirical question whether firms actually make such enforcement-related disclosures. We know of no prior literature investigating this ques-tion. Hence, in Section 2.4, we conduct an exploratory analysis using content analyses of annual reports to establish whether enforcement-related disclosures take place, to what extent, and in what shape. In additional analyses presented in Section 2.5, we then inves-tigate whether observable enforcement-related disclosure choices vary in a systematic way that is consistent with some of the disclosure motives we have outlined. To that end,
we first conduct a determinants analysis to infer characteristics of firms that opted to re-veal details of an ongoing enforcement review, relative to firms that embraced their “right to silent” (Section 2.5.1). In a second set of analyses (Section 2.5.2), we then include the market perspective, using event study methodology to investigate whether disclosures related to ongoing enforcement reviews potentially mitigate market reactions to the even-tual disclosure of error findings, consistent with the notion of walking down market ex-pectations.