Did Public Firms’ Financial Reporting Affect U.S. Manufacturing?

U.S. manufacturing employment fell by more than 40 percent over the last two decades, from 18 percent of the total U.S. workforce in 1997 to just 10 percent by 2018. Prior work identifies increased import competition from foreign competitors as a primary cause of this decline. Against this backdrop, the economics literature argues that indirect trade costs, such as information frictions, have a stronger effect on import competition than direct costs, such as tariffs and quotas. We explore the effects of a potential source of information frictions in trade that is unrelated to trade policy. Specifically, we find that the information created by and about public firms helps foreign competitors overcome information frictions and compete with U.S. manufacturers.

The U.S. Securities and Exchange Commission (SEC) requires public firms to prepare financial reports for the stated purposes of protecting investors, facilitating capital formation, and maintaining fair, orderly, and efficient capital markets. These financial reports contain a staggering amount of information (e.g., Ford Motor Company’s 2017 annual report includes over 200 pages of information). Firms must include details of their investments, financial performance, exposure to risk factors, material contracts, expansion plans, and production schedules. Much of this information must be machine readable. Independent auditors review these reports to ensure they are a “fair representation of [the] entity’s financial position.”

The information created about public firms is not limited to SEC-mandated disclosures. Public firms commonly hold open conference calls to discuss performance with analysts, who in turn produce their own forecasts based on firm guidance and independent research. The business press also follows and reports on public firms. Although investors are the intended beneficiaries of this information, competitors can also take advantage of it. For example, foreign competitors can use disclosed profitability information to enter (or avoid) the markets where U.S. public firms are profitable (or unprofitable). Foreign competitors can also use other disclosed information to understand supply and demand conditions facing U.S. firms, U.S. firms’ capacity and financial health, and even what does and does not work for U.S. firms. Consequently, the presence of public firms  can produce information that reduces the uncertainty facing foreign competitors and facilitate import competition regardless of U.S. firm profitability. Moreover, this information can help importers contract with U.S. firms and can therefore increase import competition even when importers do not sell directly to U.S. consumers.

However, public firm presence may also hinder import competition. Public firms can access a large pool of liquid capital and are more responsive to investment opportunities because of their public status and superior information environments. Consequently, public firms may have a greater ability to respond to actual or potential import competition by investing in projects designed to help them escape competition. Consequently, public firms may be stronger competitors, and their presence may deter import competition as a result. Public firms’ access to outside capital may also affect the separation of ownership and control and ultimately their governance structures. The different governance structures of private and public firms may affect their relative ability and willingness to respond to import competition (e.g., public firm CEOs may be less willing to lay off workers in the face of import competition because of agency conflicts). Therefore, the relation between public firm presence and import competition is an open empirical question.

To understand the effects of public firm presence on import competition, we first examine the industry-level relation between import competition and public firm presence. Consistent with public firm presence facilitating import competition by alleviating information frictions, we find a positive association between the sales-weighted fraction of public firms in an industry and subsequent import competition in that industry. This association is robust to the inclusion of time-varying controls, industry and year fixed effects, and alternative specifications. These alternative specifications include disaggregating imports to the industry-exporting country-year level and including country-year fixed effects to absorb all variation at the country-year level. This absorbed variation includes characteristics commonly examined by gravity models of international trade (e.g., distance between countries, language, and both U.S. and exporting country macroeconomic conditions).

While the association between public firm presence and import competition is suggestive, other reasonable explanations exist for this association. Therefore, we use a natural experiment created by the Sarbanes-Oxley Act (SOX) to provide evidence on the causality of this association. SOX imposed high regulatory compliance costs that varied by industry, leading firms in some industries to avoid public listing. We use inter-industry differences in the expected costs of SOX as an instrument for inter-industry changes in public firm presence after the passage of the act. We follow prior work to calculate the expected costs and find significant differences in these costs between industries. Consistent with prior work, our first stage results suggest that the expected costs of SOX affect changes in public firm presence after the passage of the act. In the second stage, we find that changes in public firm presence cause changes in import competition.

The estimated effect of public firm presence on import competition is economically significant. We compare the effect of public firm presence to the effect of China’s ascension to the World Trade Organization, which reduced trade uncertainty and increased Chinese import competition. The results from our country-level SOX analysis suggest that the effect of moving from the median to the 75th percentile of public firm presence is about one fourth of the average effect of China’s ascension to the World Trade Organization on Chinese import competition.

Next, we examine whether the information created by public firm presence, particularly by SEC-mandated financial reports, is an important mechanism through which public firm presence affects import competition. To do so, we provide descriptive evidence on which foreign competitors respond to changes in public firm presence, what information they respond to, and when they respond.

We next test for cross-sectional differences in the response to public firm presence based on foreign competitors’ ability to understand and process the financial disclosures of U.S. manufacturers. We find that foreign competitors from countries where local Generally Accepted Accounting Principles (GAAP) is more similar to U.S. GAAP are more sensitive to changes in public firm presence. We argue that this effect is consistent with these competitors having a greater ability to process and understand U.S. financial reports and therefore relying more on them when deciding whether, where, and how to compete with U.S. firms.

We next examine whether foreign competitors appear to pay attention to specific types of information generated by public manufacturing firms. We find that increases in downloads of U.S. financial statements in a given industry from the SEC’s Electronic Data Gathering, Analysis, and Retrieval system by users in a foreign country precede increases in import competition from that country in that industry. We also find that import competition is sensitive to changes in the publicly disclosed gross margins of public firms but not to changes in the imputed gross margins of private firms, which are only disclosed in an aggregate fashion after a relative delay of a year or more. This result is consistent with an “imitation effect” of financial reporting; foreign competitors use the performance information contained in financial reports to understand the profitability of importing.

However, we also find that the presence of public firms incrementally affects import competition independently of disclosed performance, consistent with financial reports affecting import competition by serving in an “uncertainty reduction” role. Finally, we find that when 10-K, 10-Q, and earnings announcements are more informative to investors, as measured using trading volume and absolute market returns around their release, the relation between public firm presence and import competition is stronger. In total, these findings suggest that foreign firms respond to the information in financial disclosures and not to other differences between industries with greater or lesser public firm presence.

We conduct a final falsification test to bolster our inference that public firm presence affects import competition via the production of SEC-mandated financial reports. In many developed countries both public and private firms must report publicly, unlike in the U.S. where only public firms report publicly. If the sensitivity of import competition to public firm presence is due to financial reporting, then we should not observe a relation between import competition and public firm presence in countries where both public and private firms must report publicly. Alternatively, we should observe a differential relation in these countries if the sensitivity is driven by some omitted variable, selection issue, or alternative mechanism. Consistent with the first explanation, we find that import competition is not sensitive to public firm presence in the UK, where both public and most private firms must report publicly.

In total, the evidence from our association tests, natural experiment, cross-sectional specifications, and falsification test provide consistent evidence that financial reporting provides foreign competitors with insights for competing with U.S. manufacturing firms, reducing trade costs and increasing import competition.

This post comes to us from professors Stephen Glaeser at the University of North Carolina, Chapel Hill, and James D. Omartian at the University of Michigan’s Ross School of Business. It is based on their recent paper, “Public Firm Presence, Financial Reporting, and the Decline of U.S. Manufacturing,” available here.

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