Debt and Voluntary Disclosure

In attempting to understand voluntary corporate disclosure, many empirical studies have used leverage as an explanatory variable. One reason for an association between debt and disclosure relates to the agency costs of the shareholder-bondholder conflict. By voluntarily disclosing information, shareholders may be able to reduce this agency cost. We provide an additional reason why debt and disclosure may be positively related by focusing on the shareholder-manager relationship. Our explanation is driven by the optionlike feature of shareholder ownership in the presence of debt and the detrimental effect of diversification (reduced volatility) on option value. The diversification effect is introduced in our model when the shareholders use a "portfolio of managers" over the life of the firm. In attempting to understand voluntary corporate disclosure, many empirical studies have used leverage as an explanatory variable.1 One reason for an association between debt and disclosure relates to the shareholder-bondholder conflict. With debt, shareholders bear only one-sided risk. This provides them with ex post incentives to make decisions that are not in the bondholders' best interest. For example, shareholders may take on riskier projects, issue higher dividends, etc. (see, for example, Jensen and Meckling (1976) and Myers (1977)). Recognizing this possibility, bondholders demand a higher interest rate. By voluntarily disclosing information, shareholders may be able to reduce this agency cost. Presumably, the agency cost is higher for firms with higher levels of debt and, hence, such firms disclose more information. We provide an additional reason why debt and disclosure may be positively related by focusing on the shareholder-manager relationship. Our explanation is driven by the option-like feature of shareholder ownership in the presence of debt and the detrimental effect of diversification (reduced volatility) on option value. The diversification effect is introduced in our model when the shareholders use a "portfolio of managers" over the life of the firm. We study a two-period model in which an owner (shareholder) makes firing/retention decisions and a manager makes disclosure decisions. The analysis focuses on the effect of debt on these decisions. The firm's total cash flow (sum of period-one and period-two cash flows) is used to make a debt payment. We assume the firm's performance (cash flow) across periods is more likely to be similar if the same manager is retained than if a different manager is hired in each period. To capture this effect, we assume that, if the period-one manager is retained, cash flows across periods are perfectly 1 See, for example, Ahmed (1995), Botosan (1997), and Leftwich, Watts, and Zimmerman (1981). In a meta-analysis of the results of 23 separate studies, Ahmed (1995) documents a statistically significant positive relationship between disclosure level and firm size, exchange listing status, audit firm size, and leverage.