The Financial Reporting Fast Lane
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Policy Aug 1, 2011

The Finan­cial Report­ing Fast Lane

Unex­pect­ed reac­tions to real-time reporting

Based on the research of

Ronald A. Dye

After pas­sage of the Secu­ri­ties and Exchange Acts in the 1930s, cor­po­ra­tions adopt­ed a con­sis­tent method of finan­cial report­ing. They issue annu­al audit­ed finan­cial state­ments, con­sist­ing of so-called 10-K fil­ings with the SEC, along with annu­al reports to their share­hold­ers and unau­dit­ed quar­ter­ly state­ments that sum­ma­rize their firm’s per­for­mance peri­od­i­cal­ly. They sup­ple­ment these reports by occa­sion­al dis­clo­sures of addi­tion­al mate­r­i­al infor­ma­tion in spe­cial fil­ings known as 8-Ks and the like.

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Some spe­cial­ists in account­ing method­ol­o­gy regard these peri­od­ic reports as relics of a past era, giv­en the dis­con­nect between the quar­ter­ly report­ing mod­el and the pace of change in mod­ern busi­ness­es. These spe­cial­ists have called for the replace­ment of peri­od­ic reports by real-time” finan­cial report­ing. How­ev­er, a recent paper by Ronald Dye, a pro­fes­sor of account­ing infor­ma­tion and man­age­ment at the Kel­logg School of Man­age­ment, sug­gests cau­tion in any effort to change the cur­rent report­ing sys­tem. Why? Because, he warns, any such change can have unex­pect­ed consequences.

Real-time finan­cial report­ing would require firms to dis­close updat­ed income state­ments, bal­ance sheets, and cash flow state­ments as trans­ac­tions occur, not just at the end of every quar­ter. Imple­ment­ing such a require­ment would have been infea­si­ble up until recent­ly, since few cor­po­ra­tions’ infor­ma­tion sys­tems could pro­duce such rapid updat­ing of their finan­cial state­ments on a con­sis­tent basis.

This has changed with the wide­spread imple­men­ta­tion of enter­prise resource plan­ning and relat­ed IT sys­tems. Real-time report­ing is now fea­si­ble. Some high-tech­nol­o­gy firms such as Cis­co Sys­tems are believed to pro­duce dai­ly income state­ments for inter­nal plan­ning and con­trol pur­pos­es already. But, Dye asserts, just because the tech­nol­o­gy now exists to imple­ment real-time finan­cial report­ing, it does not fol­low that it is desir­able to do so. Adopt­ing real-time report­ing could affect firms’ behav­ior in unex­pect­ed ways.

An Unex­pect­ed Response

Dye exam­ines some of those unex­pect­ed effects in his recent paper Dis­clo­sure Bunch­ing’.” One of the main con­clu­sions of the paper is that firms might respond to the adop­tion of real-time report­ing by alter­ing their pro­duc­tion of account­ing infor­ma­tion. If an effec­tive real-time finan­cial report­ing sys­tem were adopt­ed and enforced,” Dye explains, the only dis­cre­tion firms would have under the sys­tem in choos­ing when to report finan­cial infor­ma­tion would be in choos­ing when to acquire information.”

This change might not have much of an effect on the acqui­si­tion of some rou­tine finan­cial infor­ma­tion relat­ed to a firm’s oper­a­tions, such as its dai­ly sales or inven­to­ry lev­els, because that infor­ma­tion is acquired in the ordi­nary course of a firm’s dai­ly busi­ness. But firms obtain oth­er forms of infor­ma­tion on a dis­cre­tionary basis. They decide when to eval­u­ate their costs of pro­duc­tion more care­ful­ly, when to reeval­u­ate the cred­it-wor­thi­ness of their cus­tomers, and when to devel­op pro for­ma finan­cial state­ments for bud­get­ing, coor­di­nat­ing, and oth­er plan­ning pur­pos­es, all on an ad hoc basis. Here, an effec­tive real-time report­ing sys­tem cer­tain­ly has the poten­tial to alter the tim­ing of the acqui­si­tion of such information.

To eval­u­ate man­agers’ pref­er­ences across dif­fer­ent pos­si­ble tim­ings for the acqui­si­tion and dis­clo­sure of finan­cial infor­ma­tion, Dye first had to estab­lish man­agers’ pref­er­ences across dif­fer­ent pos­si­ble time paths for their firms’ stock prices. If they could take actions or adopt dis­clo­sure poli­cies that made one time series of their stock prices uni­form­ly high­er than anoth­er, vir­tu­al­ly all man­agers would pre­fer the high­er time series. But since a change in a manager’s dis­clo­sure pol­i­cy sel­dom results in his firm’s prices being uni­form­ly high­er or uni­form­ly low­er than they were before the change in dis­clo­sure pol­i­cy, Dye had to iden­ti­fy a more inclu­sive way of rank­ing man­agers’ pref­er­ences across dif­fer­ent stock price paths.

After eval­u­at­ing sev­er­al alter­na­tives, he opt­ed for a method derived from recent so-called 10b-5(1) trad­ing plans. In such plans, man­agers announce their inten­tions to buy or sell shares in their firms accord­ing to a pre­spec­i­fied sched­ule. The advan­tage man­agers derive from con­struct­ing, and sub­se­quent­ly adher­ing to, sched­ules of their future trad­ing plans is that the sched­ules fore­stall crit­i­cism that the man­agers’ trad­ing deci­sions are moti­vat­ed by an attempt to exploit their inside infor­ma­tion. Dye used the 10b-5(1) sched­ules to exam­ine the assump­tion that man­agers pre­fer time series of stock prices that max­i­mize their expect­ed util­i­ty cal­cu­lat­ed on the basis of such schedules.

To his sur­prise, one impli­ca­tion of his mod­el is that the adop­tion of real-time report­ing would cause some firms to bunch” their infor­ma­tion acqui­si­tion and dis­clo­sure deci­sions. In oth­er words, he explains, they would acquire and dis­close their dis­cre­tionary infor­ma­tion all at a sin­gle point in time rather than spread­ing that infor­ma­tion acqui­si­tion and dis­clo­sure over time.”

Two Oppos­ing Forces

This unfore­seen result stems from a bal­ance of two oppos­ing forces, which Dye calls a race over risk pre­mi­ums.” The race refers to the two dis­tinct forces that lead investors and man­agers to change their atti­tudes toward risk about infor­ma­tion their firms acquire and dis­close over time.

One force stems from the fact that, as time march­es on, the man­agers’ aver­sion to the risk asso­ci­at­ed with dis­clos­ing infor­ma­tion declines. This occurs because, over time, senior man­agers unwind their stakes in their firm. Hence they become less con­cerned about any volatil­i­ty inter­ject­ed in the time series of their firm’s prices due to the firm’s dis­clo­sures, because the frac­tion of their wealth in the firm declines over time.

‘Dis­clo­sure bunch­ing’ is like­ly to fea­ture promi­nent­ly in any dynam­ic set­ting of firms’ acqui­si­tion and dis­clo­sure deci­sions under a real-time report­ing environment.”

But a sec­ond fac­tor affects man­agers’ dis­clo­sure deci­sions: The longer a firm stays in busi­ness, the less uncer­tain­ty there is about the process­es respon­si­ble for gen­er­at­ing its cash flows. That reduces the risk pre­mi­um that risk-averse investors must bear for acquir­ing firms with uncer­tain cash flow – gen­er­at­ing poten­tial. Dye found that the race over risk pre­mi­ums, deter­mined by com­bin­ing these two fac­tors, reach­es a min­i­mum val­ue at a par­tic­u­lar point in time. His mod­el pre­dicts that at this point, firms will choose the full extent of the dis­cre­tionary por­tion of their infor­ma­tion acqui­si­tion and pro­duc­tion activ­i­ties. In oth­er words, a firm will use that time to bunch” its disclosures.

Dis­clo­sure bunch­ing” is a famil­iar fea­ture of the finan­cial account­ing land­scape. Quar­ter­ly reports and annu­al reports already bunch a lot of infor­ma­tion; infor­ma­tion doesn’t come out in a con­tin­u­ous stream over time with such reports,” Dye observes. So what I thought was both sur­pris­ing and com­pelling was that one of the pri­ma­ry con­se­quences of imple­ment­ing real-time report­ing require­ments might not actu­al­ly be so dif­fer­ent from what hap­pens cur­rent­ly: Finan­cial infor­ma­tion got bunched before any­one ever sug­gest­ed real-time report­ing require­ments, and finan­cial infor­ma­tion will con­tin­ue to be bunched even if real-time report­ing is adopt­ed. I’d be sur­prised if this con­clu­sion didn’t shock most advo­cates of real-time finan­cial reporting.”

The Law of Unin­tend­ed Con­se­quences

Dye acknowl­edges that oth­er fac­tors besides the race over risk pre­mi­ums might affect firms’ tim­ing of their acqui­si­tion and dis­clo­sure of infor­ma­tion under a real-time report­ing sys­tem, includ­ing how the infor­ma­tion acqui­si­tion deci­sions of a firm’s senior man­agers will affect the infor­ma­tion acqui­si­tion deci­sions of their prin­ci­pal com­peti­tors. How­ev­er, Dye notes, The the­o­ry seems pret­ty robust, so dis­clo­sure bunch­ing’ is like­ly to fea­ture promi­nent­ly in any dynam­ic set­ting of firms’ acqui­si­tion and dis­clo­sure deci­sions under a real-time report­ing environment.”

The research project also high­lights a broad­er issue. Firms’ response to changes in finan­cial account­ing and dis­clo­sure reg­u­la­tions is one of the prime exam­ples of where the law of unin­tend­ed con­se­quences’ oper­ates,” Dye says. Reg­u­la­tors and stan­dard set­ters too often incor­rect­ly believe that they under­stand and antic­i­pate how the eco­nom­ic par­ties affect­ed by their reg­u­la­tions — the firms that are oblig­ed to adhere to the require­ments they set, the investors who try to unrav­el infor­ma­tion firms pro­duce in response to the reg­u­la­tions, the audi­tors who must ver­i­fy com­pli­ance with the require­ments, and the courts who have the respon­si­bil­i­ty of deter­min­ing ex post whether the reg­u­la­tions were adhered to in con­test­ed cas­es — will respond to their regulations.”

Too often, reg­u­la­tors pre­dict that peo­ple will react in naive­ly pre­dictable ways in response to changes in finan­cial report­ing and dis­clo­sure reg­u­la­tions,” Dye adds. My paper is a reminder to reg­u­la­tors and oth­ers who pro­pose new finan­cial report­ing reg­u­la­tions that the adop­tion of inno­v­a­tive reg­u­la­tions can have sur­pris­ing­ly dif­fer­ent con­se­quences from those anticipated.”

Featured Faculty

Ronald A. Dye

Leonard Spacek Professor of Accounting Information & Management; Director, Accounting Research Center

About the Writer

Peter Gwynne is a freelance writer based in Sandwich, Mass.

About the Research

Dye, Ronald A. 2010. “Disclosure ‘Bunching’.” Journal of Accounting Research. 24(1): 489-530.

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