Firms often face a free-rider problem when competitors learn about and implement the firms’ innovations without bearing the costs of development, a phenomenon known as knowledge spillovers. As recent empirical evidence shows, this causes substantial underinvestment in research and development (Lucking et al., 2019).

Disclosure practices affect the extent of knowledge spillovers, making disclosure a critical factor in shaping innovation incentives. In particular, financial disclosure provides valuable insights into a company’s efficiency and strategy and can reveal a firm’s commitment to innovation and its potential future benefits. In a new paper, I explore how financial disclosure affects firms’ innovation incentives in the presence of knowledge spillovers.

Model Framework

The paper extends the standard innovation disclosure model to a setting with two firms, incorporating learning over time and across firms (Chen et al., 2024; Manso, 2011). In this setting, the manager of each firm chooses between an old, conventional production method and a new, innovative method. Each firm’s final cash flow is the sum of the production output at the end of the first period, and the production output at the end of the second period. The relative size of the second-period output reflects the expected future benefits of innovation, acknowledging that production can vary significantly for innovative projects between initial trials and full-scale launches. Managers make innovation decisions at the beginning of each period and report on the first-period output at its end. Outside investors then determine the value of each firm  based on these reports.

The probability of success under the old, conventional method is publicly known. By contrast, the new innovative method has a random probability of success, initially lower than the old method to account for the initial cost of innovation. The success probability under the new method is the same in both periods and is consistent across firms, facilitating learning over time and across firms. The first-period output under the new method is therefore informative about its success probability in the second period, influencing future innovation decisions.

Disclosure Regimes

Managers do not always know about their firms’ first-period outputs but may disclose information that suggests the results. The paper considers three disclosure regimes. First, a no-disclosure regime in which managers do not report any information at the end of the first period. Second, a mandatory disclosure regime in which managers perfectly reveal their private information. Third, a voluntary disclosure regime in which managers decide whether to disclose their private information (Dye, 1985). The mandatory disclosure regime is typical for public firms, while the voluntary disclosure regime is more common for private firms. The no-disclosure regime applies where disclosure is not mandated, and voluntary disclosure is not credible.

Equilibrium Analysis

The paper first derives the equilibrium for managers who only maximize long-term cash flows. In this scenario, both the no-disclosure and mandatory disclosure regimes generate inefficiencies relative to a first-best benchmark. The no-disclosure regime can lead to over-innovation due to the absence of knowledge spillovers, while the mandatory disclosure regime can result in under-innovation due to the free-rider problem. However, compared with the no-disclosure regime, the mandatory disclosure regime results in more investment efficiency, though in the single-firm setting the no-disclosure regime maximizes efficiency.

The analysis then considers managers that are myopic, i.e., they focus on long-term cash flows as well as short-term prices. These managers may introduce an additional cost to financial disclosure by choosing the old method to boost short-term prices. The voluntary disclosure regime is more efficient than the mandatory disclosure regime in this context, as firms have more incentives to innovate under the voluntary disclosure regime because managers have the option to conceal bad news. Interestingly, the voluntary disclosure regime does not impair learning across firms relative to the mandatory regime, as managers always voluntarily report good news to maximize short-term prices. Moreover, with myopic managers, the mandatory disclosure regime is not always more efficient than the no-disclosure regime. When managers are sufficiently myopic, they have little incentive to innovate under the mandatory regime. This result highlights an important tradeoff between firms’ innovation incentives and knowledge spillovers, with financial disclosure playing a central role in balancing these factors.

Policy and Empirical Implications

In environments where voluntary disclosure is not credible, regulators face a tradeoff between encouraging innovation and promoting learning across firms. In contrast, when voluntary disclosure is credible, regulators may opt not to impose mandatory disclosure, as the voluntary disclosure regime is more efficient in terms of investment. Furthermore, the results align with recent empirical evidence on the impact of financial disclosure on corporate innovation, emphasizing the role of knowledge spillovers in shaping innovation incentives (see, e.g., Bernard et al., 2020; Breuer et al., 2025; Chang et al., 2024; Kim et al., 2024).

The paper shows that financial disclosure significantly influences firms’ innovation incentives in the presence of knowledge spillovers. The choice of disclosure regime affects the balance between innovation incentives and knowledge spillovers, with important implications for policymakers and empirical research. Understanding these dynamics is important for fostering corporate innovation and economic development.

REFERENCES

Bernard, D., Blackburne, T. and Thornock, J. (2020), “Information flows among rivals and corporate investment,” Journal of Financial Economics 136(3), 760–779.

Breuer, M., Leuz, C. and Vanhaverbeke, S. (2025), “Reporting regulation and corporate innovation,” Journal of Accounting and Economics p. 101769.

Chang, Y.-C., Tseng, K. and Yu, T.-W. (2024), “Access to financial disclosure and knowledge spillover,” The Accounting Review pp. 1–24.

Chen, H., Liang, P. J. and Petrov, E. (2024), “Innovation and financial disclosure,” Journal of Accounting Research 62(3), 935–979.

Dye, R. A. (1985), “Disclosure of Nonproprietary Information,” Journal of Accounting Research pp. 123–145.

Kim, J. B., Kim, J. S. and Koo, K. (2024), “Financial information, spillovers, and innovation performance,” Journal of Accounting and Public Policy 45, 107212.

Lucking, B., Bloom, N. and Van Reenen, J. (2019), “Have r&d spillovers declined in the 21^st century?” Fiscal Studies 40(4), 561–590.

Manso, G. (2011), “Motivating innovation.” The journal of finance 66(5), 1823–1860.

Schumpeter, J. A. (1942), Capitalism, socialism and democracy, New York: Harper and Brothers.

This post comes to us from Professor Lucas Mahieux at the Tilburg School of Economics and Management, Tilburg University. It is based on his recent paper, “Financial Disclosure, Knowledge Spillovers, and Corporate Innovation,” available here.