Friday morning’s news that the Securities and Exchange Commission will consider whether to abandon the requirement that companies file financial reports quarterly comes after years of debate.
The SEC will look into emulating the European Union and United Kingdom, which recently stopped requiring quarterly financials.
While there has been plenty of theorizing about the subject, what’s been absent until now is large-scale evidence of the advantages less-frequent reporting offers to companies and their shareholders.
The research challenge: How to compare the effect of reporting frequency when, at present, all U.S. companies have to file quarterly.
A recent study in The Accounting Review, a peer-reviewed journal published by the American Accounting Association, found a way around that problem by analyzing evidence from periods when reporting-frequency mandates changed in the United States, permitting before-and-after comparisons to be made.
The study acknowledged that there may well be advantages in increased reporting frequency, such as lower cost of capital and more information for investors.
However, the study concluded that shorter reporting intervals engendered “managerial myopia,” which found expression in a “statistically and economically significant decline in investments” along with “a subsequent decline in operating efficiency and sales growth.”
The study reported that, when new regulatory mandates forced companies to increase the frequency of their financial reporting, they reduced their annual capital investments by about 1.5% or 1.9% of their total assets, depending on how capital investments are defined.
Considering that the average annual capital investments of these firms amounted to about 9% of assets, those were hefty cuts, wrote the study’s authors, Rahul Vashishtha and Mohan Venkatachalam of Duke University’s Fuqua School of Business and Arthur G. Kraft of the Cass Business School of City University London.
And, if one is tempted to wonder whether these cuts may have reflected a welcome increase in discipline with respect to company spending, corporate results suggest otherwise.
This emerges when the performance of companies forced to increase their reporting frequency is compared with that of similar firms that had previously been reporting at the mandated interval and didn’t have to change it.
Prior to the mandates, firms reporting at longer intervals enjoyed (1) annual sales that were about 10% greater as a percentage of assets than sales of the latter group; (2) annual sales growth that was about 3.5% greater; and (3) return on assets that was about 1.5% greater.
By contrast, in the period three to five years post-mandate, as a result of declines in the firms with reduced reporting intervals, sales and sales growth were about the same for the two groups, while the difference in return on assets was down to about 1%.
As one would expect, the researchers’ analysis controlled for an array of factors known to influence the three performance variables, including company size, profitability, leverage, and investment opportunities.
The professors also reported that investment declines following reporting-frequency increases were seen principally in industries where capital investment takes some time to generate increased earnings, such as auto manufacturing and electrical or business equipment.
Investment declines occurred much less frequently, if at all, in industries that see earnings gains from investments relatively quickly, such as personal and business services, apparel-making, and manufacture of health-care products.
The study’s findings are based on data from three occasions when U.S. companies faced mandates to increase their reporting frequencies:
- 1955, when the SEC changed the required frequency from annual to semi-annual
- 1962, when the American Stock Exchange required all newly listed firms to report quarterly and pressured already-listed companies to do so
- 1970, when the SEC mandated quarterly reporting
Identifying 545 firms that were forced to increase reporting frequency, the researchers matched each on the basis of size and industry with a company that had already been reporting at the mandated interval.
The study’s conclusions derived from comparing annual investments and performances of the two groups in the five years before and after the mandates, while controlling for known factors that affect the relevant variables.
The performance declines uncovered in the study led the authors to ask “why managers behave myopically when it ultimately hurts firm performance, and ultimately their own welfare, over longer horizons.”
To appreciate the problem, they wrote, “consider a capital investment made by a firm either to upgrade its manufacturing technology … or to penetrate a new market segment. It may take more than a quarter or two for such an investment to increase sales … and hence [it will] not be reflected in near-term earnings…. A manager who is sufficiently concerned about a short-term decrease in stock price might not make such an investment to begin with.”
The professors compared the situation to a game-theory classic, the prisoner’s dilemma, in which two members of a gang are arrested and imprisoned separately. If the two remain silent, both will face a lesser charge; but each will face the harshest penalty permitted if he remains silent while his confederate betrays him on the chance of avoiding punishment entirely.
Similarly, a lack of trust between managers and investors can lead to the unfortunate results uncovered in the current study.
As the researchers wrote, “Both managers and investors would be better off if managers did not behave myopically. However, such an equilibrium is not sustainable: even if investors conjecture no myopia, managers still have an incentive to fool them while behaving myopically.”