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Mandated Financial Disclosure Leads to Fewer Innovative Companies
- June 06, 2022
- CBR - Accounting
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.
More transparency meant less spending on innovation
In Germany, corporate spending on innovation declined in counties with a higher share of companies required to comply with the EU financial reporting mandate.
Among the European countries in the first sample, the researchers find, more-extensive financial-reporting mandates were negatively associated with innovation inputs such as personnel working in research and development, and with outputs such as new processes and products. The increased disclosure was also negatively associated with the number of innovating companies. “In terms of economic magnitude, our results suggest that requiring an additional 10 percent of firms in an industry to report is associated with a 3 percent decrease in the share of innovating firms, relative to its mean,” the researchers write.
But overall spending in the sample didn’t decline. This suggests that while smaller companies stopped innovating, larger companies took on the bulk of their innovation-related spending, the researchers argue.
Breuer, Leuz, and Vanhaverbeke find a similar story among the German businesses, where the costs of mandated disclosures fell most heavily on small companies. “But here, we even find that reporting mandates are negatively associated with total innovation spending in local markets,” they write, describing a situation where many regions populated with small companies experienced declines in innovation activity as a result of competition from a few large companies operating at the national or even international level. The mandates reallocated the activity to bigger players, the researchers emphasize.
“Our evidence is remarkably consistent across the two settings and designs: Mandatory reporting discourages innovation, especially by smaller firms in niche markets with few competitors,” they write. The end result: small companies quit innovating, leaving bigger companies to be stewards of innovation.
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