How Changes to Form 8-K Disclosure Rules Affect Corporate Innovation

Studies have shown that the disclosure of information can affect a company’s technological innovation in different ways, depending on how complete or timely it is. The complete disclosure can promote innovation by making capital providers more receptive to providing financing, reducing the likelihood that managers will be fired for poor innovation output, and disciplining managers during R&D project implementation. The timeliness of disclosure can undermine innovation by creating  managerial myopia that can cause under-investment in R&D. Since completeness and timeliness are valuable to investors and encouraged by accounting-standard setters, we investigate whether disclosures that have both characteristics are good or bad for firm innovation. In a recent paper, we exploit the 2004 regulatory changes aimed at making Form 8-K disclosure more complete and timely of firm disclosures to explore that issue.

The Securities Act of 1934 requires firms to disclose information about material events through 8-K filings promptly. Effective August 23, 2004, the disclosure underwent two major changes, which we collectively refer to as “the regulatory change.” First, the filing deadline for most events was shortened from five to 15 days to four business days after the event occurred. Second, the number of event types required to be disclosed through 8-Ks was expanded from 12 to 22. Although the new event types do not focus specifically  on innovation, they may reveal innovation-related activities that had not been disclosed earlier. Even for the original event types, the enhanced regulatory scrutiny or increased resources devoted by firms to complying with the new regulatory requirements may also lead to more disclosures of innovation-related activities. Consequently, we expect 8-Ks to include more innovation-related information after the regulatory shift. To verify whether this expectation aligns with reality, we compare the average amount of innovation-related words in 8-Ks from five fiscal years before with the average amount of such words for the five fiscal years after the regulation change. Consistent with expectations, we document a steep rise in the number of those words stemming from new and original event types.

Another interesting feature of 8-K disclosures pertaining to innovation is that they are inherently indirect as they mostly describe material corporate events that are directly or indirectly related to innovation without divulging the technical details. For example, if a firm signs a material contract to jointly develop technology with another firm, this event is directly related to innovation and must be disclosed in an 8-K under Item 1.01 “Entry into a Material Definitive Agreement,” but the firm does not have to disclose the specific details of this technology. A second purpose of ours is to examine whether indirectness, another property of 8-K disclosures, helps mitigate the proprietary costs of disclosure, which is a major concern for direct disclosures such as information regarding patents or intellectual property licenses.

We expect the regulatory change to improve innovation in three ways. First, as more complete and timely 8-K disclosures enhance stock price informativeness, the stock price may better reflect the value of managers’ innovation efforts, increasing their incentives to innovate. Since managers’ contracts are based on historical information and cannot shield them from reputational damage arising from innovation failures, a more informative stock price may fulfill this shielding role. Second, enhanced 8-K disclosures may facilitate investor monitoring of managers’ innovation activities, making it harder for managers to misallocate resources or reduce R&D expenses opportunistically. We expect 8-Ks to be highly useful for investor monitoring since they are stand-alone disclosures of material events that, in turn, are easier for investors to evaluate, which avoids information overload. Moreover, their timeliness may enable investors to react early to facilitate corrective actions. Third, more and timelier disclosures may also reduce information asymmetry between managers and capital providers, relaxing financial constraints for R&D investment that, in turn, increases the resources devoted to innovation.

However, the regulatory change may also impose costs that, if sufficiently high, may undermine innovation in two ways. First, the regulatory change may have caused the disclosure of innovation-related activities that had been hidden, and it does accelerate the disclosure of innovation information. Both results could attract unnecessary attention from investors, who might pressure managers to focus more on short-term performance at the expense of projects that create long-term value. For example, if terminating an R&D alliance reduces a firm’s short-term performance but benefits its independent research ability and protects its intellectual property in the long term, investors might focus narrowly on the short-term evidence in reacting negatively to the disclosure of the termination. Second, as we outlined earlier, enhanced 8-K disclosures may still impose proprietary costs that discourage innovation despite being indirect. Overall, given that the arguments for the positive and negative effects of the regulatory change on innovation appear equally strong, the net effect remains unknown without analyzing actual data.

In comparing the level of innovation output from before and after the regulatory change, we find that the change has a net positive impact on innovation. Reflecting on material economic impacts, our estimates suggest that the annual increase in patent count, citation count, and patent value for firms that are more likely to be affected by the regulatory change is 5 percent, 10 percent, and 7 percent larger, respectively, than that for firms that are less likely to be affected by the regulatory change.

We also examine whether any of the following means by which enhanced 8-K disclosures could positively affect innovation is supported by the data: (1) bolstering managers’ incentives to innovate; (2) facilitating investor monitoring; and (3) increasing innovation inputs. Concerning the first, we expect firms whose managers face higher levels of career risk to benefit more from the regulatory change. We consider three alternative measures of managerial career risks: the intensity of product market competition that captures how much short-term performance affects managerial turnover, and the volatility of operating cash flows and stock returns, each of which captures the firm’s fundamental risk and hence its managers’ career risk. Consistent with the regulatory change reinforcing managers’ incentive to innovate by alleviating their career concerns, we find that the rise in innovation output is more heavily concentrated in firms with more intense product-market competition and with more volatile operating cash flows and stock returns. Concerning the second means, we expect firms with greater monitoring difficulty to benefit more from the regulatory change. We consider three alternative measures of monitoring difficulty: the relative effective bid-ask spread, which reflects the information asymmetry between managers and investors; financial reporting comparability, which inversely reflects investors’ difficulty in comparing the firm’s financial statements with those of its industry peers; and accounting accrual quality, which inversely captures investors’ difficulty in processing information from the financial statements. Consistent with the regulatory change facilitating investor monitoring, we find that the impact of the regulatory change is perceptibly larger for firms with greater monitoring difficulty, lending support to the intuition that the effect stems from stricter investor oversight of innovation activities. Finally, concerning the third means, we find that, after the regulatory change, the total amount of resources devoted to R&D remains stable. We also find that the impact of enhanced 8-K disclosures does not vary with the extent of financial constraints before the regulatory change. Altogether, these results suggest that increasing innovation input is unlikely to play a major role in promoting innovation output.

Our research contributes to prior work in three ways. First, we provide initial evidence on whether the 2004 regulatory shift for 8-Ks prompted more complete and timelier disclosures of innovation-related activities through the newly added event types and the original event types. Although regulators may not have had innovation specifically in mind when weighing the regulatory implications, we show that a positive externality ensues in the form of the regulatory change making 8-Ks more informative of innovation-related activities, particularly those that stem from structural changes to the firms. Second, against the backdrop of extensive academic research examining the factors that shape innovation from an economics and finance perspective, there are hardly any studies focusing on accounting issues, especially the effect of event-based disclosures, rather than properties of general financial reporting. We also complement prior academic work on general financial reporting quality by showing that enhanced disclosures of general types of activities that do not specifically target innovation could also stimulate innovation. Finally, we highlight 8-Ks as one type of disclosure whose benefits of completeness and timeliness outweigh the costs from managerial myopia and the proprietary cost of disclosures, a result relevant to firm managers, investors, and, in particular, regulators responsible for setting disclosure policies.

This post comes to us from professors Yangyang Chen at the City University of Hong Kong, Yue Luo at Nanjing University of Finance and Economics, Jeffrey Pittman at Memorial University and Virginia Tech, and Qin Tan at the City University of Hong Kong. It is based on their recent article, “The Importance of Regulatory Shifts in 8-K Disclosures on Corporate Innovation,” available here.

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