New research shows it’s the type of disclosure — not the amount — that counts


Photo courtesy of winnifredxoxo on Flickr

Photo courtesy of winnifredxoxo on Flickr

Rob Swystun, Pristine Advisers

Is it preferable for a company to disclose as much information as it can to shareholders and the public, regardless of what that information is?

A new study says no.

Even when all disclosure rules are followed, it may run counter to not only a firm’s best interests, but shareholders’ best interests, too, an article on the website of the Wharton School at the University of Pennsylvania, says.

To understand this, you first have to understand “hard” and “soft” information.

  • Hard information – easy-to-measure data like revenues and sales, net profits and the value of assets owned.
  • Soft information – intangibles like the value of research and development, employee training and morale.

The study referenced above is a paper called “Optimal Disclosure When Some Information Is Soft” and was written by Wharton finance professor Alex Edmans and accounting professor Mirko Heinle, and their colleague Chong Huang of the University of California at Irvine.

What it found was that an imbalance in disclosure between hard and soft information can cause companies to focus on the short term corporate performance while ignoring long term performance.

This happens because it’s difficult to convey how soft activities like investing in R&D and employee morale will pay off over time, whereas it’s easy to relay hard items like per-quarter profit.

And this discrepancy in disclosure can distort a company’s investment incentives.

As an example, Edmans says to imagine a CEO who has $1 million in cash at her disposal. Spending that money on R&D or employee training might be good for the company in the long-term, but it’s not going to have an immediate effect on the company’s value to its shareholders. Just keeping the money, on the other hand, would raise the company’s reported profit by $1 million, which would look good to shareholders and may even increase the share price.

So, the dilemma is the choice of whether to do what is good for the company in the long term vs what appears to be good for shareholders in the short term.

The researchers surmise that if neither hard nor soft information is required to be disclosed, the CEO in the example situation would be free to make the optimal investment choice for the company. However, if rules are in place to force the disclosure of hard information, then the CEO has more incentive to put the money toward hard investments at the expense of soft investments.

“Since rules can only stipulate the disclosure of hard information, and not soft, they change the relative weight of hard information versus soft information,” Edmans says. “Then managers are going to take actions to boost earnings at the expense of long-run intangible value.”

And the numbers back Edmans up on that. Previous research done by others has found that 78% of executives said they would sacrifice long-term value to their companies to meet earning targets.

Not that releasing hard information is a bad thing. Prior research on the stock market has shown the benefits of disclosing hard information:

  • It gives a clearer view of risks – more disclosure should reduce the company’s cost of raising cash
  • It reduces the individual investor’s cost of research – this makes investing more efficient and draws more players into the game.
  • It improves price efficiency – this narrows the swings in price commonly seen when uncertain investors oscillate between exuberance and despair.
  • It causes share prices to more accurately reflect a firm’s true value – this encourages executives to invest more of their own wealth and gives them a stronger incentive to perform well.

But the majority of prior analyses apply only to quantifiable, verifiable and easy-to-disclose hard information.

Hard information, though, is only half the story of any company. The other half consists of intangibles, which are not as easy to put into a report. As the researchers write: “a firm can credibly communicate its earnings, but not the quality of its intangible assets, such as its human capital, corporate culture or R&D capability.”

They add that research has shown these intangibles to be important in the modern firm.

Another X factor is that intangibles are more important to the success of some companies than others. Investing in R&D for a software company where things change quickly would be more important than for a traditional manufacturing firm that churns out the same product year after year, Edmans says.

This means there is no one formula for balancing the disclosure of hard and soft information because the balance of what to disclose will be different for each company. Companies in industries like software, internet services or pharmaceuticals will probably see the biggest distortion from regulations that force disclosure of hard information.

Some firms believe in just disclosing as much hard information as they are obliged to and not worrying about the soft information.

But, that’s not a real answer to the problem, says Edmans.

“One might think the existence of soft information is completely moot. If some information cannot be disclosed, just disclose as much information as possible — just ignore the soft information because you cannot do anything about it,” Edmans says. “The world is more complex than that. With anything, there are tradeoffs, there are costs and benefits …. Nothing is ever black and white.”

The current rules for disclosure, which all relate to hard information due to its ease of reporting, means managers in a company generally lean toward hard investments at the expense of soft investments.

The three researchers have come up with a model that they believe shows if no disclosure was required, that executives could find their own optimal balance between hard and soft investments in the company easily, correcting this imbalance. Even if hard information disclosure policies were relaxed, that would help, they write.

However, the culture of hard information disclosure would be difficult to change, as hard information is much easier to report and people generally believe that more disclosure is automatically better.

Edmans and his colleagues know that having disclosure policies rewritten to be more lenient is a long shot, so they hope their research at least sheds light on this hard/soft information imbalance and prompts corporations to better explain what they are doing on the soft side and limit their hard info disclosure when possible to allow them to focus on the long-term health of the company.

The researchers cite the example of Google, which stated at the time of its IPO that it would refrain from disclosing estimates of future earnings, stating that “artificially creating short-term target numbers serves our shareholders poorly.”

Investors and regulators can use the team’s research to better understand the limitations of the corporate filings on which they rely, Edmans says, while lawmakers and regulators can use it to fine-tune disclosure requirements.


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