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Mandatory accounting disclosure by small private companies

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Abstract

This article analyzes how mandatory accounting disclosure is grounded on different rationales for private and public companies. It also explores technological changes, such as computerised databases and the Internet, which have recently made disclosure of company accounts by small companies potentially less costly and more valuable, thanks to electronic filing and universal online access to credit information systems. These recent developments favour policies that would expand the scope of mandatory publication for small companies in countries where it is voluntary. They also encourage policies to reduce the costs and enhance the value of disclosure through administrative reforms of filing, archive and retrieval systems. Survey and registry evidence on how the information in the accounts is valued and used by companies is consistent with these claims about the evolution of the tradeoff of costs and benefits that should guide policy in this area.

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Notes

  1. The Commission of the European Communities (2009a) has finally proposed to define a category of small companies or “micro entities” that would be exempt from the accounting directives. This category of potentially exempted firms would cover companies which on their balance sheet dates do not exceed the limits of two of the three following criteria: 500,000 € in assets, 1,000,000 € in net turnover and an average of 10 employees in the financial year. In addition, the Commission (2007) had initially suggested relieving from publication requirements all “small” companies—that is, those meeting at least two of the following three criteria: less than 50 employees, less than 4.4 m € in assets and less than 8.8 m € in turnover. The Commission had also proposed treating medium-sized companies without a “particular external user” as small companies. A company would be considered medium-sized if it meets at least two of the following three criteria: less than 250 employees, assets lower than 17.5 m € and turnover lower than 35 m €. The number of companies potentially exempted would be between 88 and 97% in different EU countries, according to the European Committee of Central Balance Sheet Data Offices (ECCBSO 2007: 3).

  2. According to the Commission, publishing the accounts constitutes a major administrative burden but is inconsequential if—when given freedom to disclose or not—small firms choose not to disclose because their accounts are only “used by a limited number of stakeholders, such as credit institutions and suppliers that have the possibility to require financial information directly from the company” (Commission of the European Communities 2007: 17).

  3. In the USA, Japan and some other countries most private companies, whatever their size, are not obliged to disclose financial information. However, “in most countries, many or even all entities are required by national law or regulation to prepare financial statements that conform to a required set of generally accepted accounting principles, and for these financial statements to be audited in accordance with a required set of generally accepted auditing standards. These audited financial statements are normally filed with a government agency and thus are available to creditors, suppliers, employees, governments, and others” (UNCTAD 2005: 92).

  4. After more than four decades of empirical studies, evidence on the effects of mandatory disclosure is mixed. The main studies that avoid confounding the effect of introducing the mandatory disclosure rule with unobserved shocks experienced by all companies’ shares are the following. Chow (1983) finds a negative effect on value in a small sample of companies after the 1933 Securities Act. Simon (1989) observes a significant decrease in risk (as measured by the dispersion of abnormal returns) for new issues after the 1933 Act. Bushee and Leuz (2005) find many smaller firms delisting and value increases for firms previously disclosing and those which started disclosing after disclosure requirements were extended in 1999 to small companies trading in the over-the-counter market. Greenstone et al. (2006) find a substantial increase in value for companies affected by the 1964 Amendments that extended disclosure requirements to large firms trading over-the-counter.

  5. For opposing views on empirical evidence and policy, see Easterbrook and Fischel (1984), Coffee (1984), Romano (1998), Choi (2000), Healy and Palepu (2001), and Zingales (2004).

  6. So-called “investor protection”—in fact, transaction protection, as rational investors cease transacting when foreseeing they will not be paid back—has been claimed to facilitate dispersed share ownership, large equity markets and entrepreneurs’ access to capital (La Porta et al. 1999, 1997, 2002).

  7. Rajan and Zingales (1998), and Castro et al. (2004).

  8. Hansmann et al. also conjecture that creditor protection—including mandatory publication of financial statements by private companies—may be a precondition for contractual freedom among investors (2005: 5). Whatever the overall merits of their argument, its application to mandatory publication of financial statements is flawed to the extent that publication was introduced in continental Europe long after such flexible forms were developed (the relevant EU directives date from 1968 to 1978) and even most German companies do not comply with the rule (Weilbach 1991).

  9. Mainly Jaffee and Russell (1976) and Stiglitz and Weiss (1981).

  10. Mainly Townsend (1979), Aghion and Bolton (1992), and Hart and Moore (1994, 1998).

  11. Jappelli and Pagano (2002), Sapienza (2002), and Djankov et al. (2007).

  12. The impact assessment by the Commission of the European Communities (2009b: 19) considers that the cost of publishing abridged accounts for a company qualifying as a “micro entity” is 1,558 Euros, equivalent to 10 h of a professional external accountant and added internal work equivalent to a 30% cost. If these accounts are provided as a by-product of the standard service package, this seems a gross overestimation except for the few small companies with exceedingly complex corporate structures.

  13. Moreover, use of the “extensible business reporting language” (XBRL) filing format, now permitted, for instance, by the USA’s Securities and Exchange Commission, holds the promise of further cost reductions (see, e.g., Hannon and Gold 2005).

  14. The limited formal control that the register can perform may even be counterproductive. For example, some registers consistently check that the figures in the accounts add up, and reject them if otherwise. However, unbalanced accounts are probably more informative to users when they are trying to ascertain any unreliability in the filing firm.

  15. “It is highly probable that SMEs would have to face more individual questions from public authorities, bankers and other stakeholders and consequently several requirements and formats will replace the former ones and therefore they will incur additional costs” (ECCBSO 2007: 4).

  16. For a similar reason, the lack of separation of ownership and control in private companies avoids another source of costs: suboptimal decisions by managers. For public companies, surveys find that most managers of public companies are willing to sacrifice long-term value to smooth earnings (Graham et al. 2005). See, however, Arya et al. (2003), who argue that managed earnings may be good for shareholders.

  17. The difference has been pointed out by Barry (2006: 20). Arruñada et al. (2008) make use of public information to observe substantial differences in performance between these vertical structures.

  18. The contents of the land registers are wholly open to the public in 28 of the 42 jurisdictions reported in UN-ECE (2000).

  19. As modelled, among many others, by Diamond and Verrecchia (1991) and shown empirically, e.g., by Francis et al. (2005), using firm-level data, and Bhattacharya et al. (2003), using country-level data, as well as Hail (2002) and Nikolaev and Van Lent (2005). Good quality in financial reporting has been associated with lower price declines in financial crises, according to Mitton (2002), in the 1997–1998 Asian crisis, and to Barton and Waymire (2004), in the 1920s. See, however, Leftwich (2004). It has also been observed that companies enjoy lower cost of credit after selling shares for the first time to the public, with the disclosure that this implies (Pagano et al. 1998). Similarly, bond yields are lower in USA states that have mandated GAAP disclosure, especially among organisations with relatively higher information asymmetry (Gore 2004).

  20. For information on this and other practices mentioned in different sections of the paper, see, on checking creditworthiness, http://www.payontime.co.uk/collect/collect_creditworthy.html; about understanding credit rating, http://www.payontime.co.uk/collect/collect_understand_ratings.html; and about reducing risk, http://payontime.co.uk/collect/collect_riskreduce.html (visited October 5, 2007).

  21. In particular, the Commission states that “there is a lack of broad demand” for accounts of micro-entities, (2007: 8) and that those of small companies “are used by a limited number of stakeholders, such as credit institutions and suppliers that have the possibility to require financial information from the company” (2007: 17). Its later impact assessment repeats the mistake (2009b: 16–18).

  22. The demand for information on small companies can also be inferred from the massive nature of the demand for this type of information. In the first 9 months of 2007, information on 1,933,220 different firms—as identified by their tax ID numbers—was requested at least once from one database in one EU country. Considering the size distribution of firms in the economy, it is clear that the bulk of this demand consists of information on micro and small firms. Such massive demand is also in line with the communication strategies that these agencies are following: e.g., an online provider specialising in small firms has recently run advertising campaigns at prime time on main national radio networks.

  23. The additional difficulties suffered by a regime of voluntary disclosure for small firms, as analyzed below, make this consistent with the empirical correlation found between firm size and voluntary disclosure (e.g., Raffournier 1995; Giner Inchausti 1997; Depoers 2000).

  24. See, for instance, North and Thomas (1973), Granovetter (1985), and Seabright (2004).

  25. See two descriptions of the services offered by two leading firms in Spain at http://www.informa.es/infornet/Main/idioma/01/idioma/01/screen/SShowPage/pagina/infoeconomica.html and http://www.iberinform.es/Servicios/InfEstandarIber+.htm (visited October 2, 2007).

  26. See, e.g., in the case of Spain, TDC (2005).

  27. This sort of “relationship banking” plays an important role in different models of the banking firm, from, e.g., Benston and Smith (1976) to Freixas and Rochet (1997).

  28. Credit insurance relies heavily on credit information services, and the two activities are vertically integrated in many firms: the market leader on the Spanish market was created by a credit insurer (Informa 2007), and the main French credit insurer acquired a credit information firm in 2004 to become the leader on the French market (Coface 2007).

  29. “The Committee permits banks a choice between two broad methodologies for calculating their capital requirements for credit risk. One alternative, the Standardised Approach, will be to measure credit risk in a standardised manner, supported by external credit assessments… In determining the risk weights in the standardised approach, banks may use assessments by external credit assessment institutions recognised as eligible for capital purposes by national supervisors” (BIS 2006: 19).

  30. Not only for deciding on loan applications but also for establishing more precise risk premiums and even establishing market transfer prices for loans made by parent companies to their subsidiaries.

  31. The ECCBSO was set up in November 1987 on the initiative of several European central banks and the European Commission to “to improve the analysis of company data through the exchange of information, comparison of analytical methods and joint studies. It is composed of institutions from twelve European Union Member States and European Commission and OECD” (http://ec.europa.eu/economy_finance/indicators/bachdatabase_en.htm, visited on October 14, 2007).

  32. Evidence for public companies was given in n. 19.

  33. Unreported regression analysis shows that larger firms are more benign when interpreting failure to file the accounts, whereas older firms and those which file their accounts earlier in the year tend to give a worse rating to firms which have failed to file theirs.

  34. This goes even for authors that are generally sceptical about the overall merits of financial regulation. For example, Zingales considers that “we can identify three areas where intervention is needed. First, in the area of disclosure: companies tend to have too little incentive to disclose” (2004: 40). Some other rationales for mandatory disclosure, such as protecting small investors or increasing confidence in capital markets, enjoy less unanimous support in the literature. Compare, e.g., Easterbrook and Fischel (1991: 296–300) with the studies cited in n. 6. We skip discussion of these studies here because they do not apply to private small companies, which do not sell securities in the market and, given their small size, the reputational effect of their eventual failure or fraudulent behaviour would in any case be very limited.

  35. As suggested by the finding that firms doing well disclose more (Lang and Lundholm 1993).

  36. Moreover, cognitive arguments open the door to explanations in all directions. For instance, Arya and Mittendorf explain, on the basis of herding behaviour amongst third-party information providers, why voluntary disclosure may benefit the discloser even though the information directly benefits competitors, by guiding the information gathering and dissemination amongst these third parties. “Roughly stated, the infusion of early precise information can have a domino effect on followers, leading to a consensus view that does a poor job of reflecting the diversity of information” (2005: 232).

  37. The aversion to disclosure in Chinese business circles was weighted when exempting small companies from publication in Hong Kong (SCCLR 2000: 195).

  38. The importance of this emerging-markets dimension of the problem is compounded in the light of the evidence provided by Djankov et al. (2007) who show that in less developed countries credit volume depends relatively more on the ex ante availability of information on debtors’ quality than on the strength of creditors’ rights.

  39. Different social norms are in place within the EU in many areas, one such being payment periods and payment delays (Arruñada 1999a, b, 2000), which have led to the issue of Directive 2000/35/EC to combat late payment in commercial transactions and achieve greater harmonisation in the internal market.

  40. The need for a speedy register is clear when considering that cost and value are in conflict: more recent accounts are more informative for users but filing sooner is also costlier for filers. This trade-off is illustrated by the failure of the 2006 UK Companies Act to substantially reduce the filing period. The final wording of section 442 shortened it from 10 to 9 months for private companies. However, the White Paper for the UK’s Company Law Reform Bill of 2005 had proposed to reduce filing times to 7 months because, according to small business organisations, the increase in costs “would not adversely affect work patterns… [and] be of benefit to third-party small company users of those accounts” (DTI 2005: 281).

  41. Easterbrook and Fischel admit that competition among USA states cannot produce optimal solutions in the presence of interstate effects (1991: 295, 300–2, 304–5): some states would tend to be holdouts to benefit their firms.

  42. In addition, the presence of sunk costs may also motivate substantial rent-seeking activities. (Or, more precisely, “quasi-rent-seeking” activities). It might therefore be more wasteful to apply the subsidiarity principle in this area, whatever the decision taken by the European Union.

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Acknowledgments

I thank Mariano Álvarez Pérez, Michael Buneman, Belén de la Casa, Salvador Carmona, Luis Fernández del Pozo, Uriel González-Montes, Andreas Kalenteridis, Gema Pérez and Celestino Suárez Viñuela. Usual disclaimers apply. This study received financial support from the Spanish Ministry of Education and Science, through grant ECO2008-01116 and the European Commission through the Integrated Project CIT3-513420.

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  1. Department of Economics and Business, Pompeu Fabra University and Barcelona GSE, Trias Fargas, 25, 08005, Barcelona, Spain

    Benito Arruñada

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Arruñada, B. Mandatory accounting disclosure by small private companies. Eur J Law Econ 32, 377–413 (2011). https://doi.org/10.1007/s10657-010-9145-3

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