Regulation mandating public disclosures by firms does not come without cost. Surveying managers’ beliefs reveals that one of the most important costs is a perceived loss of competitive advantage arising from disclosing proprietary information (i.e., proprietary cost). Almost 60% of CFOs of firms in the United States are concerned that public disclosure regulation affects their competitive position. Research shows that firms incorporate proprietary cost in their decision whether to publicly disclose private information.
However, it is not clear to what extent firms can foresee how substantial the proprietary cost of mandatory disclosures is. For instance, research shows that manager disclosure choice seems more strongly influenced by perceptions of competition than to archival measures of competition such as industry structure and industry profitability. Archival research on the effect of proprietary cost on disclosure decisions by management is inconclusive due to problems in observing and measuring proprietary costs. Nonetheless, proprietary cost of information is frequently used as an argument by firms when lobbying against more stringent disclosure regulation proposed by standard setters. The validity of this argument, however, is difficult to verify and constrains regulators in formulating a well-founded response to the firms’ lobbying activities. Therefore, understanding the significance of proprietary cost imposed on firms by mandatory disclosures is essential to design efficient regulation.
In our research, we utilize a supply and demand model to test whether firms foresee proprietary costs. We focus on private firms in the Netherlands, where proprietary cost appears to be the primary driver for both a firm’s public disclosure decision and the subsequent demand for these disclosures. This institutional setting is a key element of our research and allows for a clean test of proprietary cost (see frame below for more details on the institutional setting). Specifically, we obtained proprietary data provided by the Chamber of Commerce in the Netherlands that registers when domestic private firms’ mandatory financial statements are made publicly available and when subsequent paid requests for these annual reports arise (For each report that is requested at the Chamber of Commerce a fixed fee of EUR 2.90 is charged. This is in contrast with filings in EDGAR by listed firms in the U.S. which are free to access). Our final sample consists of 116,121 firm-year observations (24,494 firms). Our research hypothesizes that when the financial statements of a private firms are more likely to contain proprietary information (i.e., contains more detailed profit and loss information), then this firm will file its financial statements later within the 13 month filing period and demand for these financial statements will be higher and arise sooner.
The institutional private firm setting in the Netherlands is particularly suitable to analyse the significance of proprietary cost imposed on firms by disclosure regulation:
- Private firms in the Netherlands have to publicly disclose their financial statements;
- The public disclosure decision and subsequent demand is not obscured by agency cost, as private firms can privately communicate relevant information to individual stakeholders like shareholders or banks;
- The deadline for firms to file their financial statements is 13 months after fiscal year end. This allows firms to significantly delay filing as a rational response to avoid or reduce proprietary cost of disclosure; and
- There is an ex-ante difference in the amount of (proprietary) information to be disclosed: small firms only have to file a balance sheet, medium firms have to file a balance sheet with an abbreviated profit and loss account, and large firms have to file a balance sheet with an extended profit and loss account.
The results support our hypotheses. We find that supply (public disclosure) and subsequent demand for this disclosure are correlated: where the unwillingness of firms to disclose their annual report is higher (as measured by the greater number of days between fiscal year-end and the filing date), the demand for this report arises earlier (difference in days between the filing date and median subsequent paid demand). This correlation varies predictably with the ex-ante institutional differences in disclosure requirements based on firm size: the correlation becomes stronger for firms that have to file more detailed profit and loss information. The main findings are supported by difference-in-difference tests, exogenous legislative changes, alternative measures of demand and supply, and the use of industry instead of firm measures of proprietary cost.
Our analysis shows that firms faced with higher proprietary costs delay public disclosure by 10% (from 280 to 307 days), and subsequent paid demand for these disclosures arises almost 27% earlier (from 382 to 279 days). Furthermore, for firms that must file more detailed profit and loss information than the previous years, thereby experiencing an increase in proprietary cost, we observe that these firms increase the delay in their filing by 60 days on average and that paid demand for these filings arises 40 days earlier on average. Consistent with risk aversion, firms respond more strongly to an institutional increase in proprietary cost than a decrease (60 days/21% versus 48 days/17%). Conversely, paid demand is stronger for an institutional decrease than an increase (70 days/21% versus 40 days/12%).
We continue our economic analysis by testing whether greater paid demand for proprietary information subsequently has real economic effects in the three years after demand. We find that firms that file profit and loss information with more (less) timely demand subsequently experience on average a 10% decrease in firm profitability and are more (less) likely to engage in patent protection and face higher (lower) merger and acquisition probability. In sum, proprietary costs of mandatory public disclosure appear economically significant and results in real economic effects.
There is a growing public demand for firms to disclose non-financial information such as sustainability or CSR reporting. Our findings imply that a proper understanding of the proprietary nature of these new disclosures is essential for standard setters when deciding to make these disclosures mandatory. Particularly in an unprecedented economic crisis and expected long recovery due to the current COVID-19 pandemic, the significance of proprietary costs of public disclosure might increase significantly. We would therefore welcome more research on the welfare effects of public disclosure requirements for (private) firms.