My research demonstrates that quarterly reporting creates all sorts of distortions in how managers allocate capital.
In 2013, long before Musk got his knuckles rapped, Dell Technologies went private in a $24 billion deal that was the biggest buyout since the 2008–09 financial crisis. The personal-computer maker’s motivation was that chairman and CEO Michael Dell couldn’t deliver good quarterly results, and the company was at a stage in which, if it wanted to innovate, it needed to go private. It returned to the public markets in 2018 in a much healthier position.
Probusiness conservatives typically view the idea of reducing the frequency of financial reporting as one way to lower how much companies pay for compliance—one of the exogenous costs of doing business.
But in fact, the frequency of reporting has little impact here. Once a company has had to comply with regulations, additional reporting increases its budgets only minimally. And compliance costs have been falling over time, and are likely to continue to do so.
However, there is good evidence behind the SEC’s concern that quarterly reporting fuels short-termism. Managers are frequently rewarded with restricted stocks and similar perks whose value depends on quarterly earnings.
Every MBA student learns that stock market prices are forward-looking. But they are only accurately priced if markets fully capture a company’s risks, which means insiders and outsiders need to have the same information.
Yet we live in a world of information asymmetry. Outsiders—including most shareholders and analysts—don’t fully understand the nature of risk-taking within a company, so all they see are the earnings numbers. Those numbers give only a partial picture, which effectively means that share prices don’t fully reflect all the risks that businesses are taking—or not taking.
Liberal-leaning observers fret about losing transparency and accountability if companies report less frequently. This is a legitimate concern, and an important trade-off to consider in any rule change. It seems fair to say that we want more transparency rather than less in corporate reporting, and that less timely reporting would likely result in less market discipline.
But because the markets have such a quarter-to-quarter focus, more market discipline is only one side of the coin. In economic terms, market discipline ensures price efficiency (prices consistent with risk). However, there is a catch: such price efficiency may come at the cost of economic efficiency (increasing the size of the pie).
The really important cost of quarterly reporting is that companies underinvest in innovation, reducing economic efficiency. If we force companies to disclose frequently, they worry about their next earnings numbers. And if they miss expectations, they’re punished by the market.
In the race to hit quarterly expectations, companies cut back on research and development, and fail to focus on projects that will return their investment only over the very long run. CFOs report that the first thing they do in response to market pressure is to slash R&D budgets, according to a 2005 study by Duke University’s John R. Graham and Campbell R. Harvey and Columbia’s Shiva Rajgopal. The CFOs know that doing so destroys value, but it’s hard to communicate that with outsiders.
My research demonstrates that quarterly reporting creates all sorts of distortions in how managers allocate capital. They tend to overinvest in the wrong types of projects—those that produce short-term returns. What gets underfunded? The big, bold, innovative value-creating projects that will make a bigger impact but only in the longer run.
Less-frequent reporting would also give companies less of an incentive to go private and more of an incentive to go public. This would enable them to share risk with a broader pool of investors, and not just with big institutions and hedge funds.
Changing the frequency of reporting also provides the opportunity to ask whether one size should fit all. The SEC wisely suggests that companies could be given flexibility over the frequency of their reporting. We have an opportunity to run a grand experiment in accounting. Some companies could continue to report quarterly, some could move to biannual reporting, and others to alternative time periods, such as every four months. This would enable us to truly measure the costs and benefits.
Semiannual reporting might not help big established companies, but it could help the most innovative companies in our economy by encouraging them to allocate more capital to risky, innovative projects. This could provide a big boost for the long-term health of the US economy.
Haresh Sapra is the Leon Carroll Marshall Professor of Accounting at Chicago Booth.
Frank Gigler, Chandra Kanodia, Haresh Sapra, and Raghu Venugopalan, “How Frequent Financial Reporting Causes Managerial Short-Termism: An Analysis of the Costs and Benefits of Reporting Frequency,” Working paper, April 2013.
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