The Economics of Disclosure and Financial Reporting Regulation

Disclosure and reporting regulation is a central and recurring policy issue that has received significant attention in academic research on accounting, finance, and economics. Further fueling demand for this research are increasingly frequent requests that policy makers and regulators conduct cost-benefit or economic analyses of both existing and planned regulations and standards.

In a recent paper, we review the empirical literature on the economic consequences of disclosure and financial reporting regulation, drawing on U.S. and international evidence. We also extensively review the literature on mandatory International Financial Reporting Standards (IFRS). Our efforts are timely, because three developments have spurred disclosure and financial reporting regulation around the world. First, a series of financial crises and corporate scandals have prompted calls for regulatory reform. The Asian financial crisis of 1997, the Enron scandal in the U.S., and the financial crisis in 2008 are important examples. In the aftermath of these events, policy makers and regulators enacted significant changes to disclosure and reporting regulation. Second, over the past decade many countries have adopted IFRS in an attempt to increase the harmonization and global convergence of accounting rules and reporting standards. Third, debates in various nations about the competitiveness of their capital markets and the increasing internationalization of capital markets have spurred discussions about reforms to securities and disclosure regulation. In addition, disclosure regimes are increasingly applied in areas such as product quality, consumer protection, conflicts of interest, environmental policy, and health care, where mandatory disclosure substitutes for regulation that explicitly requires or restricts certain behaviors. This widespread use of disclosure regulation underscores the importance of disclosure and transparency as a research topic and highlights that it is important to understand the economic effects of disclosure regulation in areas beyond accounting and finance.

From a theoretical perspective, the argument in favor or against regulating disclosure and reporting is not obvious. Furthermore, the relative magnitudes of costs and benefits of a mandate are largely an empirical matter. For this reason, we focus on empirical evidence of the trade-offs in regulating disclosure and reporting. We highlight the challenges of (i) quantifying regulatory costs and benefits, (ii) measuring disclosure and reporting outcomes, and (iii) drawing causal inferences from regulatory studies. We particularly emphasize issues related to research design and identification. Identification and causal inferences are of first-order importance for policy and regulatory debates. Lack of identification gives rise to alternative explanations and raises concerns about the interpretation of the estimated magnitudes, which in turn restricts researchers’ ability to inform policy makers and regulators.

We first discuss empirical studies that link disclosure and reporting activities to firm-specific and market-wide economic outcomes. Understanding these links is important when evaluating regulation as they illustrate the existence of certain costs and benefits from corporate disclosure and reporting activities.

Next, we synthesize the empirical evidence on the economic effects of disclosure regulation, enforcement, and reporting standards, with a focus on the introduction of new disclosure mandates as well as major extensions of the entire disclosure regime, international differences in disclosure regulation, and evidence on mandatory IFRS adoption.

We draw several important conclusions. First, we generally lack evidence on market-wide effects and externalities from regulation, yet such evidence is central to the economic justification of regulation. Regulatory studies document primarily economic consequences for individual firms in a market or an economy.  But we need more evidence that reporting standards and disclosure regulation produce (positive) information spillovers, externalities, or network effects and on the magnitudes of these effects. Second, evidence on causal effects of disclosure and reporting regulation is still relatively rare. Studies often struggle to identify counterfactuals, unaffected control groups, or natural experiments that would allow a clean identification of the regulatory effects and their economic consequences. For most regulatory changes, we are unable to provide causal estimates of the costs and benefits, let alone elasticities for the capital-market effects and other outcomes of disclosure and reporting mandates. Thus, while we have a lot of evidence that is qualitatively useful, we are still far from being able to perform quantitative cost-benefit analyses. Third, we lack evidence on the real effects of disclosure and reporting regulation. We have much less evidence on how disclosure regulation affects corporate behavior than on its capital-market effects, which reflects among other things the behavior of investors and financial analysts. These limitations provide many new research opportunities.

Finally, to make significant progress with respect to the (causal) estimation of regulatory effects and cost-benefit analysis, researchers likely need help from legislators and regulators. If we want better economic analysis, then we need to design regulation with ex-post analysis in mind. For example, regulators could consider including thresholds or implementing the rules in a staggered fashion, which facilitates economic analyses. We also discuss that legislators and regulators should consider the data necessary to conduct ex-post analyses and how such data could be made available. In addition, we need more pilot studies and field experiments. Such studies would facilitate ex-ante economic analysis and could mitigate the risks of unintended consequences.

This post comes to us from Professor Christian Leuz at the University of Chicago’s Booth School of Business and Professor Peter D. Wysocki at Boston University’s Questrom School of Business. It is based on their recent paper, “The Economics of Disclosure and Financial Reporting Regulation: Evidence and Suggestions for Future Research,” available here.