Deciding how much to disclose

By Rebecca Tan

SMU Office of Research & Tech Transfer – In business, as in other spheres of life, knowledge is power. Information about how a firm is performing is so important to investors that governments around the world require publicly traded companies to periodically issue financial reports. Regulations aside, companies that provide timely and accurate financial reports signal their reliability and commitment to transparency; the reduced information asymmetry between managers and investors may also make it easier for these companies to raise capital.

But full disclosure of a company’s inner workings is seldom seen in reality. The reason is that disclosure also comes at a cost: it reveals proprietary information to competitors. How then do firms decide how much to disclose?

“The main theme of my research is to understand the determinants and economic consequences of the quantity and quality of corporate financial reporting and disclosure,” said Zhang Liandong, Professor of Accounting and Associate Dean (Research) at the Singapore Management University (SMU) School of Accountancy.

The cost of keeping (trade) secrets

Although disclosures are believed to reduce a firm’s competitiveness by revealing private information to rivals, this theory – called the proprietary cost hypothesis – has been difficult to prove in real life. One challenge, Professor Zhang explained, is that it is difficult to disentangle the effects of proprietary costs from other factors that influence disclosure decisions, such as shareholder scrutiny and lower cost of capital.

For example, the proprietary cost hypothesis would suggest that managers hide information about the most profitable parts of their company to prevent competitors from entering that market segment and eroding their advantage. However, as competitors can still infer which segments are more profitable from the average profits reported in income statements, managers would also have to hide the segments that are not as profitable.

It is impossible for an outside observer to know if managers are hiding information to prevent it from falling into the hands of their competitors or simply to avoid angering their shareholders. To overcome these challenges, Professor Zhang and his colleagues from Arizona State University and the National University of Singapore studied the impact that a trade secrets law known as inevitable disclosure doctrine (IDD) had on disclosures.

IDD enables employers to prevent a current or former employees from working for another company on the grounds that they would inevitably disclose trade secrets while in their new role. “The adoption of IDD essentially blocks one of the most important channels through which a firm’s rival can obtain its confidential information,” Professor Zhang said. “With less access to trade secrets via employees’ job switching, rival firms would rely more heavily on a firm’s public disclosure in discovering proprietary information.”

As predicted by the proprietary cost hypothesis, adoption of IDD drives up the cost of publicly disclosing information, a conclusion confirmed by Professor Zhang’s analysis of over 28,000 firm-years between 1994 and 2010. These findings have been published in the Journal of Accounting Research in a paper titled “Trade secrets law and corporate disclosure: Causal evidence on the proprietary cost hypothesis”.

“Our study is the first empirical research to demonstrate the causal effect of the proprietary cost of disclosure on the quantity of disclosure,” he said. “This evidence is important because it suggests that regulators should take into account the potential proprietary costs of disclosure in their regulation of corporate disclosure.”

When traders have options

While the fear of competition can deter companies from disclosing more information about themselves, other pressures can encourage them in the opposite direction. In his current research, Professor Zhang is studying how opening firms up to options trading can motivate managers to be more forthcoming in voluntary disclosure, particularly with regards to disclosing bad news.

Unlike stocks which are simply a share of a listed company, options are a contract that provide the buyer the right, but not the obligation, to buy or sell a financial asset at an agreed upon price. A trader who buys a call option would benefit if the stock price rises above the agreed price while the buyer of a put option benefits if the stock price falls below the set price. Therefore, options traders actively seek out private information that could tell them how a stock’s price would rise or fall.

This behaviour of options traders makes it more difficult for managers to withhold information, Professor Zhang said, forcing them to disclose information in a more timely manner. This is especially true for bad news that is dug out by options traders, as it could lead investors to sue the company’s managers for failing to disclose the information and cause them severe reputational damage.

“Conventional wisdom in the accounting literature is that corporate disclosures have a one-way influence on the financial market. Our findings suggest that the development of financial markets can actually shape managerial disclosure decisions instead,” Professor Zhang added.

In a separate research project, Professor Zhang is studying the impact of using accounting techniques to present an overly positive view of a company’s finances, a practice known as earnings management. So far, his initial findings suggest that attempts to inflate reported earnings can compromise a company’s cybersecurity.

“Accounting information is critical in the efficient functioning of the capital market and it is challenging to ensure that accounting information supplied by firms is sufficient and accurate,” Professor Zhang said. “This is what motivates my research and guides my research direction.”

Back to Research@SMU Aug 2019 Issue