Mandated Financial Disclosure Leads to Fewer Innovative Companies

Corporate disclosure and reporting mandates help capital markets work better, or so goes the typical argument in favor of them. Proponents of such mandates argue that they promote innovation while also protecting investors and other stakeholders. In the United States, some have asked whether some of the reporting requirements that apply to public companies should be expanded to include private companies, as well.

But disclosure can backfire by driving small companies to stop innovating, suggests research by Columbia’s Matthias Breuer, Chicago Booth’s Christian Leuz, and Erasmus University’s Steven Vanhaverbeke. Analyzing the effects of the European Union’s accounting directives, they find that financial reporting reduced the number of companies innovating in an industry. It discouraged smaller companies and redistributed their activities, “thereby concentrating innovation spending among a few large firms,” write the researchers.

Corporate information can be valuable—and sensitive. A business’s profit margin can indicate its competitive position, while gross margin data can reveal advantages in production processes and sourcing—information that can be useful to not only competitors but also customers and suppliers. Its balance sheet provides a view into the company’s financial resources as well as a look at tangible and intangible assets such as patents, copyrights, and trademarks. And an extensive narrative disclosure about key products, services, research and development, and strategy can educate competitors. These spillovers of information to other companies could benefit aggregate innovation in the economy as a whole, even when they hurt the incentives of innovative companies. Thus, the aggregate effects are not clear.

To gauge this, the researchers exploited a feature of the EU accounting directives, which since the 1980s have regulated companies’ financial reporting and have generally required companies (both publicly listed and privately owned) to disclose a full set of audited financial statements. Recognizing that this requirement can be burdensome, the EU permits individual countries to grant exemptions to smaller private businesses, which has created variation ripe for study.

In addition, Germany essentially didn’t enforce the reporting mandate until 2007, when mounting pressure from the EU drove it into line, which resulted in a before-and-after comparison also useful for research.

Breuer, Leuz, and Vanhaverbeke used information on corporate innovation activity across Europe from Eurostat’s Community Innovation Survey, which is the largest of its kind in the world based on the number of participating countries and responding firms. The researchers’ European sample covers up to 26 countries over 15 years from 2000 to 2014, and their German sample covers more than 20,000 companies in Germany between 2002 and 2013.