The Financial Reporting Fast Lane

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.

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.”