The benefits, and limits, of financial-reporting regulation

Marty Daks | Apr 17, 2018

Sections Accounting

Many companies in the United States and European Union complain that requiring them to publish audited financial statements is onerous and hurts economic activity. But defenders of the rules counter that such requirements help make markets more efficient.

Which is it? Research by Chicago Booth PhD candidate Matthias Breuer suggests that there may be good reasons to require financial reporting and auditing, but the efficiency argument doesn’t really hold up. 

Public companies in the US and EU have reporting requirements, as do some private companies in the EU. Regulators and others in favor of such reporting argue that capital providers, customers, and suppliers can use accurately reported financials to better evaluate disclosing and related companies, benefiting everyone. Prior research suggests that these stakeholders may indeed make use of companies’ mandatory disclosures. (See “Should private companies be required to report their financials?” Fall 2017.)

To study the efficiency argument in particular, Breuer exploited a natural experimental setup in the EU, where countries use size thresholds for establishing which small private companies will be exempt from full reporting and auditing requirements. He analyzed industry-level productivity and other metrics in 26 European countries from 2001 to 2015, comparing the effects of reporting and auditing mandates on how resources are allocated with a given industry and country.

Making private companies report their full financial statements created more competitive markets, Breuer finds. He says that it drove more companies to open (although also to close), reduced market concentration, and lowered barriers to going public.

But he says the regulation didn’t necessarily make the market more efficient in terms of resource allocation—rather than grow the economic pie, it mostly changed the relative sizes of the pie’s slices. Customers, suppliers, and competitors stood to benefit from what would otherwise have been a company’s proprietary information. While the dissipation of proprietary information may have meant lower prices for consumers, it also appears to have discouraged companies from making productivity-enhancing investments. “Interestingly, greater competition as a result of mandatory reporting appears to stifle rather than spur productivity growth, at least for the typical firm in an industry,” he adds.

And Breuer finds that requiring audited statements deterred companies, particularly small ones, from starting up—imposing costs without producing corresponding industry-wide benefits. His evidence leaves him unconvinced that mandating audits is any better than making audits voluntary.

There may be reasons for governments to impose reporting and auditing mandates, perhaps to improve tax collection or fight money laundering, he writes. But when it comes to the efficiency of market-wide resource allocation, his evidence ultimately supports recent efforts by the EU to lessen smaller companies’ reporting requirements.