Aurora Borealis
1 November 2014 CFA Institute Journal Review

How Frequent Financial Reporting Can Cause Managerial Short-Termism: An Analysis of the Costs and Benefits of Increasing Reporting Frequency (Digest Summary)

  1. Imrith Ramtohul, CFA

There is a cost–benefit trade-off involved in increasing the frequency of financial reporting. The main benefit is that it may discourage investments in unattractive projects. But increased reporting frequency can potentially encourage managerial short-termism. Certain conditions justify a greater frequency of disclosure, whereas others do not require more frequent reporting.

What’s Inside?

Increasing the frequency of financial reporting is not always desirable. Investigating the cost–benefit trade-off, the authors highlight that the main inefficiency associated with more frequent reporting is that managers may adopt a short-term attitude when appraising investments. The benefit of more regular financial reporting is that it encourages discipline and thus may decrease the probability of the company’s entering into negative net present value projects. The authors then describe certain conditions that make increased frequency more desirable as well as conditions that do not support more frequent reporting.

How Is This Research Useful to Practitioners?

The authors identify the costs and benefits of increasing the frequency of financial reporting. Reporting that occurs too regularly is not always desirable. Managers may adopt a short-term perspective when analyzing projects, especially when the firm’s project choice cannot be easily observed. They might focus on short-term projects that could increase share price. Regular reporting, however, also encourages discipline and thus may deter investment in negative net present value projects when the firm’s investment is observable. As such, firms may avoid overinvestment and could return cash to shareholders in a frequent reporting regime.

Certain conditions favor regular reporting, and others do not. The inefficiency caused by frequent reporting may be reduced with well-designed managerial compensation contracts. Shareholders should also avoid having a short-term investment horizon.

Portfolio managers, investors, and regulators will find the conclusions of this research useful. It would seem that encouraging more frequent reporting is not always beneficial given the potential of managerial short-termism. Thus, regulators should select a disclosure frequency with care. Similarly, portfolio managers and investors should avoid focusing on short-term financial performance when making decisions.

How Did the Authors Conduct This Research?

The authors begin with a stochastic model to study the impact of impatience in the capital market. They find that managerial myopia will prevail when there is a combination of impatience in the capital market, informational imperfections, and frequent financial reporting. When the market and the manager have identical information, it is not expected to result in managerial short-termism.

Next, the authors use a two-period model to analyze the impact of frequent and infrequent reporting. Two scenarios are considered—namely, “equilibrium with infrequent reporting” and “equilibrium with frequent reporting.” Frequent reporting will encourage managerial short-termism when there is a high degree of impatience in the capital market. The authors then attempt to assess the cost associated with increasing the frequency of financial reporting.

They measure social welfare as the ex ante expected surplus over the two-period investment horizon. Their analysis shows that frequent reporting imposes greater discipline on managers. Assuming that shareholders are patient, there will be clear benefits associated with increasing the frequency of reporting. But impatience in shareholders can lead to managerial short-term myopia. Therefore, there is a trade-off associated with more regular financial reporting.

The authors assume that managers are “benevolent” when assessing the impact of short-term myopia and that there are no conflicts of interest between managers and shareholders. Their analysis also ignores the impact of voluntary disclosure in the infrequent reporting regime.

Abstractor’s Viewpoint

There have been various debates on whether increasing the frequency of financial reporting is desirable. The authors identify a trade-off between the costs and benefits of more frequent reporting. Although I do have concerns that the analysis assumes that capital markets are efficient (which is not necessarily applicable in all countries), the authors highlight that greater frequency of disclosure is not always beneficial. Shareholders and investors potentially stand to benefit from greater discipline by managers. But there is the risk that managers will focus too much on the short term. Regulators, therefore, have to decide what represents an ideal reporting frequency.

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