Real Effects of Frequent Financial Reporting

In our paper, Real Effects of Frequent Financial Reporting, which was recently made publicly available on SSRN, we examine the impact of financial reporting frequency on firms’ investment decisions. Whether increased financial reporting frequency improves or adversely influences a manager’s investments decision is ambiguous. On the one hand, increased transparency through higher reporting frequency can beneficially affect firms’ investment decisions in two ways. First, increased transparency can reduce firms’ cost of capital and improve access to external financing, allowing firms to invest in a larger set of positive NPV projects. Second, increased transparency can improve external monitoring and help mitigate over- or under-investment stemming from managerial agency problems. On the other hand, frequent reporting can distort investment decisions. In particular, frequent reporting can cause managers to make myopic investment decisions that boost short-term performance measures at the cost of long run firm value. Which of these two forces dominate is an open empirical question that we explore in this study.

Empirical evidence is difficult to come by because after 1970, all firms in the U.S. report on a quarterly basis, making it impossible to observe variations in reporting frequency. To overcome this obstacle, we use data from a natural experiment—the transition of US firms from annual reporting to semi-annual reporting and then to quarterly reporting over the period 1950-1970 (the SEC required annual reporting in 1934, semi-annual reporting in 1955 and quarterly reporting in 1970). During these years, there are substantial variations in the reporting frequency since many firms report more frequently than required by the SEC.

The empirical results in the paper suggest that firms significantly reduce investments following an increase in reporting frequency. Specifically, firms that increase their reporting frequency reduce investments in fixed assets by 1.7% of total assets. This is an economically significant decline, as it is equivalent to a 22% decline from the mean level of investments. The reduction in investments is persistent up to at least 5 years, and is robust to controlling for a range of alternative proxies for investment opportunities. Supporting a causal interpretation, the reduction manifests only after the reporting frequency increase but not before. The findings are robust to estimation on a subsample of firms that increased reporting frequency following mandated rule changes, further mitigating endogeneity concerns. Finally, the results are robust to inclusion of industry-year interactive fixed effects, indicating that any industry level shocks to investment opportunities coinciding with reporting frequency increases cannot explain our findings.

Our finding that investments decline following a reporting frequency increase is consistent with two plausible explanations. It could reflect myopic underinvestment by managers because of amplified capital market pressures induced by frequent reporting (myopia channel). Alternatively, the decline could be a manifestation of improved monitoring by stakeholders stemming from frequent reporting (monitoring channel). That is, the decline represents a correction of previous excess investments by managers. We conduct a series of tests to distinguish between these two alternative explanations. Our evidence from these tests is inconsistent with the monitoring story and more consistent with managerial myopia.

Overall, this study makes two contributions to extant literature and may be relevant to practitioners and security regulators who are interested in exploring the consequences of higher financial reporting frequency. First, we add to our understanding of the economic consequences of frequent financial reporting by examining its effects on investments. Our findings suggest that frequent reporting can impose significant costs by inducing myopic behavior, and distorting managerial investment decisions. Second, we contribute to the literature on managerial myopia. Prior studies identify different sources of capital market pressures that can induce myopia. We suggest that frequent financial reporting is another mechanism that can encourage myopic managerial behavior. Our findings offer a starting point to evaluate this cost-benefit tradeoff by highlighting a significant cost of frequent reporting apart from the myriad benefits reported in prior research.

The paper is available for download here.