Disclosure in Financial Market: Costs and Benefits

A market can be inefficient when the parties involved in transactions have asymmetry of information available to them. Information asymmetry can lead to adverse selection which is the situation when one party has more information than other so that better informed party can take benefit of the other party. Economists George Akerlof (1970), Eugene Fama (1970), Michael Jensen and William Meckling (1976) have argued that information symmetry is key foundation to fair and efficient market. The modern financial market has adopted this notion of information symmetry. Financial market regulators have mandated periodic financial disclosures globally with the objective of protecting investors’ interests and developing fair and efficient market.

Corporate financial disclosure is defined as the process by which firms disclose financial information to the public periodically. It is any deliberate release of financial information whether numerical or qualitative, required or voluntary, via formal or informal channels (Gibbins, Richardson, & Waterhouse, 1990 ). Firms can disclose information through quarterly and annual reports, prospectus, notices. The primary aim of disclosure requirements is: (a) protect investors’ interests to enhance their confidence in the market, (b) address the agency problems, (c) ensure prices reflect all the relevant information for efficient allocation of resources (Enriques & Gilotta, 2004 ). Modern financial system relies on disclosure-based regulation to ensure fair, transparent and effective market. The arguments for or against disclosure regulation reflects debate regarding regulatory intervention versus market forces. In the absence of regulatory oversight, market forces could potentially address information problems (Pan, 2024 ). The essay is structured as follows: First, the essay explains the history of disclosure – how it came into existence. Second, it discusses costs associated with disclosures from the firm’s and investors’ perspective. Third, it explains the optimal level of disclosure for any firm.

Tracing the History

The corporate financial disclosure could be traced back to 17th century with the emergence of joint stock firms. Voyages were sponsored by firms and the earnings were divided among shareholders after each voyage. In 1633, the revenue of the East India firm declined and the shareholders requested to access the records of the firm. But the governing committee denied the access to the records arguing that no one is allowed to “ravel and dive” into the records of the firm. In 1841, the Select Committee reviewed the laws related to Joint Stock Firms and concluded that shareholders have the rights to the financial statements of the firm. The Joint Firms Act 1844 which was enacted based on the report of the select committee ensured rights of shareholders to access audited books of accounts of their firms.

The modern corporate financial disclosure came into practice after the Wall Street Collapse and the Great Depression of 1929. The Securities Act 1933 and the Securities Exchange Act 1934 introduced mandatory disclosure requirements for the firms. According to Leuz & Wysocki (2015), three developments have spurred the disclosure requirement globally. First, series of financial crisis (Asian financial crisis 1997 and global financial crisis of 2008) and scandals (Enron scandal) pressurized the regulators for more reforms. Second, increase in the adoption of IFRS to harmonize and converge the reporting standards globally. Third, increase in internationalization of capital markets have contributed to the mandatory disclosure regulation.

Market Works because of Disclosure

Akerlof (1970) in his seminal paper “The market for lemons” explained that information asymmetry between buyers and sellers can lead to the adverse selection and market failure. He argued that buyers can’t assess the quality of products due to asymmetric information so they are unable to determine the price of the products. In the financial market, investors have a number of financial asses to chose for investment. They have to assess the expected returns from different financial assets and make investment decisions based on their risk preferences. Lack of sufficient and quality information will hinder their ability to assess the financial assets. This can in turn lead to poor investment decisions and inefficient allocation of resources.¹ Adequate information ensures that market prices asset accurately (Grossman & Stiglitz, 1980 ). Because disclosure enhances pricing accuracy, mandatory disclosure is the key component of securities regulation globally. Further, disclosure also promotes market stability and liquidity through increased transparency and enhanced investor confidence (Bushman et al., 2004 ).

Disclosure benefit Firms

Disclosure increases the transparency of a firm by making relevant information publicly available. It reduces the informational advantage of certain groups like insiders. This in turn narrows the bid-ask price of the stock which improves the stock liquidity. Narrow bid-ask price also reduces the volatility while enhancing market efficiency. Broader base of investors are willing to participate in the market due to increased liquidity, reduced volatility and transparency. Leuz et. al. (2008) concluded that foreigners are reluctant to invest in firms with insider control and opaque earnings when these firms are domiciled in countries with weaker disclosure regulation and outside investor protection. Investors also seek lower return due to reduced information risk premium which ultimately reduces the cost of capital for the firm (Diamond & Verrecchia, 1991) .

Jensen & Meckling (1976) argues that agency² problem arises when there is conflict of interest between the principal and managers. Disclosure promotes corporate governance by addressing agency problems by decreasing both monitoring costs by principals and bonding costs by the agent. It forces managers to continuously collect information about the firm making them aware of activities and circumstance that they would not have known otherwise. This can have positive effect on managers’ performance (Enriques & Gilotta, 2004 ). Monitoring costs arises when shareholders need to supervise managers’ activities to prevent their opportunistic behaviours (excessive executive compensation, earnings manipulation) while bonding costs are incurred to align managers interests with shareholders’ goal. Managers involved in opportunistic behaviour are likely to engage in obfuscation to hide their manipulation and to mimic the properties of normal earnings or financial reports (Leuz & Wysocki, 2015) . Periodic financial reporting, timely updates on operation activities make firm transparent so that shareholders can scrutinize managers’ performance and make them responsible. With tight and well-designed disclosure practice, manager with ill-intent has to devise a more ingenious, complex and costly plan to conceal his actions and escape punishment (Enriques & Gilotta, 2004 ).This reduces the cost of monitoring:

Investor Protection

Enriques & Gilotta, 2004 argued that mandatory disclosure protects the investors along three dimensions: First, it provides investors with all information needed to make investment decision. Availability of firm’s information on financial health, business strategies and associated risks, help investors to find the kind of investment that matches their preferences. It also reduces cost for searching information for investors. Second, disclosure enables them not to be exploited by traders having superior information. It establishes a level playing field between unsophisticated and professional investors i.e. it gives equal access to the same information to all investors. Third, it protects investors from frauds and other opportunistic behaviour on the part of managers. It reduces the probabilities of earnings manipulation by managers that could be exposed in public filing. Disclosure is crucial for protecting investors’ interest which increases their confidence in the market.

Disclosure also reduces the costs of gathering information by investors. Without disclosure, investors may overinvest in information production that leads to: (i) redundant production i.e. two or more investors engage in production of same information, (ii) overinvestment, which occurs when investors are incentivized to beat the market. Disclosure eliminates these inefficiencies by centralizing information production Enriques & Gilotta, 2004 .

Disclosure costs can’t be ignored

Disclosure is so important for firms and investors both. But why are not firms voluntarily disclosing information? The reason is that, firms need to incur costs due to disclosure. Information exhibits the traits of public good.³ Though investors are free riders, firm has to incur costs while producing useful information. The costs include as follows: First, firms incur compliance costs in the form of accounting fees (data recording, processing costs), auditing fees. Sarbanes-Oxley Act which came into enforcement after the series of corporate scandals (Enron, Worldcom) strengthened the powers and independence of audit committee. The compliance costs averaged at around $2.3 million annually for large firms (Leuz & Wysocki, 2015) .

Second, the costs are in the form of strategic costs. Disclosure is likely to provide useful information not only to firm’s shareholders but also to competitors which can reduce disclosing firm’s competitive advantage.⁴ This shows that disclosure include externalities⁵ (Enriques & Gilotta, 2004 ). Assume that Ncell’s financial statement shows 25% increase in the capital expenditure compared to last year. Now, NTC can gauge on the strategic plans of Ncell. This shows that transparency can possibly reduce competitiveness of a firm.

Third, the risk of litigation rises as the frequency and amount of disclosed information increases. With higher frequency of disclosure, the probability of disclosing incomplete or misleading information rises which leads to greater risk of litigation (Enriques & Gilotta, 2004 ). With a hint of incomplete or misleading information, it can damage the reputation of firms. Senior executives are required to spend significant amount of their time to ensure disclosed information has no wrong information. These costs are burdensome for both large and small firms but tend to be higher for small firms. It is because most of these costs tend to be fixed. This put small firms in competitive disadvantage versus larger firms.

For investors, disclosure costs come in form of information overload contrary to belief that mandatory disclosure assists investors to make optimal investment decision. Enriques & Gilotta, (2004) argued that disclosure can sometime have unintended consequences. Information overload can impair individuals’ ability to process information correctly and make right judgement. If investors are unable to make meaningful use of information, the system of mandatory disclosure is rendered useless.

What is the optimal level of disclosure for a firm?

Traditionally, it was believed that more information is always better. However, Edmans, Huang & Heinle (2016) argued that the optimal level of disclosure is the trade-off between financial efficiency and real efficiency. Manager has to decide the level of disclosure such that he/she can balance between lower cost of capital or lower investment. The manager’s decision depend on the disclosure of “hard & soft” information. Hard information include measurable data like sales revenue, assets and liabilities values while soft information include intangibles like training and development, corporate culture. Disclosure of hard information increases financial efficiency and lowers he cost of capital.

Usually, regulation forces firm to disclose certain level of hard information but has ignored the soft information. However, these intangibles are important for the growth and stability of firms. The obligation to disclose hard information can encourage managers to be focus on short-term goals. They can cut intangible investment to boost earning but it reduces real efficiency. Imagine a company has $10 million. The manager can decide to invest the cash on research and development which can have positive impact in the long run but it will have no impact for shareholders value in the short run. By not choosing to invest in R&D, the manager can boost earning today and raise the stock price and bonuses they receive.

Edmans, Huang & Heinle (2016) further suggested that manager could find optimal balance between real and financial efficiency when there is no mandatory disclosure requirements. With disclosure requirement, managers are likely to disclose hard information because it is easier to report. They argued that firms are likely to sacrifice disclosure when they have growth opportunities. However, when growth opportunities are very storng, firms exploit those opportunities even with high disclosure. So, the disclosure is high for firms with low and high growth opportunities and low for firms with intermediate opportunities.

Disclosure in Nepal

Corporate disclosure is not a new concept in Nepal. Public companies were required to publish prospectus before issuing share and financial statements were to be made available to shareholders if they desire (Company act 1964). Company Act 2006 has mandated public companies to prepare and present annual financial statements, auditor’s report and directors’ report at annual general meeting (section 77). Securities act 2006 (section 30) and Companies Act 2006 (section 23) have obligated companies to publish prospectus before issuing securities. Similarly, Securities registration and issue regulation 2073 has provision for mandatory publication of quarterly and annual report withing a certain time frame every year for listed companies. Banks and financial institutions are subject to disclosure of financial statements from multiple acts: companies act 2006 as public company, securities act 2006 as listed company and BAFIA 2017 as BFI. Even with all these regulations, the listed companies are found to violate these legal provisions. In 2021, Securities Board of Nepal directed listed companies to publish annual reports on time. In November 2023, SEBON fined 88 listed companies for delayed submission of financial statements.

Regulators Nepal Rastra Bank, Securities Board of Nepal, Nepal Insurance Authority have adopted the disclosure-based regime to ensure fair, transparent and efficient market. However, the question raises from time regarding the quality of reporting. A report by Nepal Economic Forum (2013) stated that there is high likelihood of window dressing in Nepal as internal and external audits are not conducted in an exhaustive manner and the monitoring and verification by concerned regulatory bodies are not stringent enough to counter these frauds.

This raises another question. Is protecting investors’ interest via disclosure a proper policy? There is no doubt that disclosure can definitely assist in investors’ protection. But policymakers must understand that too much information is not always better and it depends on the quality of disclosure. Regulators also must understand the level of financial literacy of retail investors to understand what sort of information investors can utilize for optimal decision making. This can help regulators to determine the information to be disclosed by the companies. The effectiveness of disclosure system depends on the capacity and quality of regulators: weak, inept and corrupt can easily spoil the virtues of well-designed disclosure system (Enriques & Gilotta, 2004 ).

Footnotes