Is There Such a Thing As Too Much Financial Reporting?

Wednesday, December 17, 2014

Is more frequent disclosure about a company’s financial results always better? It must be, because greater transparency is always preferable, right? Not so fast. In “How Frequent Financial Reporting Can Cause Managerial Short-Termism: An Analysis of the Costs and Benefits of Increasing Reporting Frequency” (Journal of Accounting Research 2014), Professors Frank Gigler and Chandra Kanodia question this bit of conventional wisdom. 

Chandra Kanodia
Frank Gigler

“The prevailing view in requiring more frequent disclosure was that the primary impediment is the cost of compliance; such as anything from the direct costs of compiling and disseminating the information to more indirect costs like those of auditing, potential legal liability, and even costs of putting firms at a strategic disadvantage to their competitors,” Gigler says. “Technological advancements over the past 80 years have dramatically reduced the direct costs of compliance, so, to the extent that these are the major impediments to disclosure, it would stand to reason that it would now be beneficial to increase the frequency of required reporting.”

Gigler, Kanodia, and coauthors Haresh Sapra, ’00 PhD, and Raghu Venugopalan, ’01 PhD, studied reporting frequency from a “real effects” perspective and developed a cost-benefit tradeoff that provides new insights into how desirable a greater frequency in reporting actually is. “Many firms argue that requiring more frequent reporting would create ‘managerial short-termism,’” says Kanodia. “That is, management would make decisions with a view of achieving quick bottom-line results at the expense of long-run value creation.”

The pressure to obtain fast, bottom-line results disappears when financial reporting frequencies decrease. “Infrequent reports could provide better incentives for project selection decisions even though they provide less information to the capital market,” says Gigler.

Under ideal conditions, the forward- looking nature of markets would adequately punish firms that destroy long-term value by making myopic decisions. “Even if every market participant is individually short-term focused, the market would collectively price the firm based on long-run value creation,” says Kanodia. “This is because every successive generation of buyers is concerned about the price they can sell the firm to the next generation. However, the ability of markets to discipline management breaks down when managers are better informed than investors in capital markets. Given this information asymmetry, investors are forced to make inferences from the reports they receive and such inferences could favor short-termism. The surprise in our findings is that even small and plausible information asymmetries between managers and investors will precipitate the short-termism that is associated with frequent financial reports.”

Thus, a good way to preserve efficiency is for managers to better communicate their information. “Even though the paper is written to provide direction to accounting regulators, there is an underlying and important message to business managers as well,” says Gigler. “Because the breakdown of the disciplining role of forward-looking markets is the result of an information asymmetry between mangers and investors, any actions managers can take to credibly communicate the reason they have chosen particular actions will restore efficiency and eliminate market-induced short-termism.”