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How Stricter Financial-Reporting Enforcement Can Hurt Shareholders
- March 27, 2018
- CBR - Accounting
Financial crises in Europe and the United States have revived interest in what publicly traded companies are required to disclose. Supporters of strict public enforcement of disclosure rules argue that it increases the likelihood that companies will behave well, thereby boosting investor confidence in financial markets.
But Chicago Booth’s Hans B. Christensen and Mark G. Maffett and Booth PhD candidate Lisa Yao Liu examined how increased financial-reporting enforcement affects shareholders, and find the costs can outweigh the benefits.
The research takes advantage of a 1991 UK initiative that set up the Financial Reporting Review Panel to oversee companies’ financial reporting. Much the way the US Securities and Exchange Commission does, the FRRP began proactively reviewing financial reports in 2004, rather than only doing so in response to a complaint. From 2004 to 2011, it announced in advance which industries it planned to focus on in an upcoming year, giving companies a chance to preemptively improve their financial-reporting compliance. Sectors such as telecommunication, advertising, and insurance were selected only once during the seven years the FRRP announced its enforcement goals. Others were inspected more frequently; the retail sector was the most frequently targeted.
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Christensen, Liu, and Maffett looked at how companies responded, analyzing the reactions of the companies included in the FRRP’s targeted sectors. On average, a company’s annual report issued between 2004 and 2011 contained a financial-statement section that had 15,500 words. When the FRRP announced a targeted sector, the number of words in the financial-statement section grew 4 percent—and ended up 610 words longer than at companies in industries that weren’t targeted. The researchers also find that stock market liquidity increased by approximately 5 percent.
However, companies scrutinized by the FRRP also increased their spending on reporting systems. Using Thomson Reuters Worldscope database, Christensen, Liu, and Maffett parsed the data for audit fees paid by companies under the FRRP’s watch. The average company in the sample had $826 million in total assets and paid audit fees of $784,000 per year. Compared with companies not inspected, the targeted companies spent $32,000 more in audit fees—an increase of more than 4 percent. Importantly, the researchers note, audit fees are not the only costs likely to increase thanks to the increase in enforcement—but these other costs, such as management’s time and changes in corporate investment policies, are inherently difficult to measure.
Although the researchers find that focus-sector firms appear to have improved their disclosure, it’s not clear that the benefits associated with the additional oversight outweigh its costs. When the FRRP announced which industries it would target, stocks in those sectors reacted negatively, declining by as much as 1.5 percent.
“Despite the improvement in transparency, increasing proactive financial reporting enforcement intensity could have a net-negative effect on shareholder wealth,” write the researchers. Their findings suggest that enforcement had significant costs for both the companies being reviewed and the shareholders, who ostensibly stood to benefit from greater regulatory scrutiny.
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