How Does Financial‐Reporting Regulation Affect Industry‐Wide Resource Allocation?

• Published date: 01 March 2021
• Author: MATTHIAS BREUER
• Date: 01 March 2021
• DOI: http://doi.org/10.1111/1475-679X.12345

DOI: 10.1111/1475-679X.12345

Journal of Accounting Research

Vol. 59 No. 1 March 2021

Printed in U.S.A.

How Does Financial-Reporting

Regulation Affect Industry-Wide

Resource Allocation?

MATTHIAS BREUER ∗

Received 12 July 2019; accepted 1 December 2020

ABSTRACT

This paper examines the impact of mandatory reporting and auditing

of firms’ financial statements on industry-wide resource allocation. Using

threshold-induced variation in the share of mandated firms in a given in-

dustry, I document that reporting mandates facilitate ownership dispersion

∗Columbia University

Accepted by Rodrigo Verdi. This paper is based on my dissertation. I greatly appreciate

the guidance and support of my dissertation committee: Philip G. Berger, Richard Hornbeck,

Christian Leuz (chair), Haresh Sapra, and Luigi Zingales. I thank an anonymous reviewer;

Ray Ball; Simcha Barkai; Pietro Bonetti; Stefano Cascino (discussant); Hans B. Christensen;

Friedrich C. Geiecke; Jörg-Markus Hitz (discussant); Katharina Hombach; Martin Jacob; Wei

Jiang; Anya Kleymenova; Mark G. Maffett; Michael Minnis; Maximilian N. Muhn; Maximilian

A. Müller; Stefan Nagel; Valeri Nikolaev; Thomas Rauter; Katherine Schipper (discussant);

Harm H. Schütt; Nemit Shroff; Douglas J. Skinner; Thorsten Sellhorn; Chad Syverson; David

W. Windisch; and seminar participants at the 2017 CMU Accounting Mini-Conference, Uni-

versity of Chicago, Stanford University, London Business School, INSEAD, Harvard Univer-

sity, University of Pennsylvania, Yale University, University of Michigan, Columbia University,

University of California San Diego, LMU Munich, the 2018 EAA Annual Meeting, and the

2019 AAA FARS Midyear Meeting for helpful comments and suggestions. I gratefully acknowl-

edge excellent research assistance provided by Patricia Breuer, Tu Cao, Florian Köhler, and

several local accounting and auditing experts; financial support of the Bradley Fellowship

awarded by the Stigler Center for the Study of the Economy and the State, the Deloitte Foun-

dation, and the Initiative for Global Markets; and data access provided by the Research Data

Centers (RDC) of the Federal Statistical Office and Statistical Offices of the Länder in Ger-

many. Any errors are my own. An online appendix to this paper can be downloaded at http:

//research.chicagobooth.edu/arc/journal-of-accounting- research/online-supplements.

59

© University of Chicago on behalf of the Accounting Research Center, 2020

60 m. breuer

in capital markets and spur competition in product markets. I, however, do

not find that reporting mandates unambiguously improve the efficiency of

industry-wide resource allocation. With respect to auditing mandates, I find

only that they impose a fixed cost on firms, deterring smaller entrants.

JEL codes: K22, L51, M41, M42, M48, O43, O47

Keywords: financial-reporting regulation; disclosure; auditing; competi-

tion; resource allocation

1. Introduction

Regulations mandating the reporting and auditing of firms’ financial state-

ments are ubiquitous. In the United States, reporting and auditing man-

dates are a centerpiece of securities regulation. They require public firms to

disclose audited financial statements to instill investor confidence in public

capital markets. In the European Union (EU) and other parts of the world,

similar mandates aimed at protecting firms’ various stakeholders are part of

corporate law, applying even to private firms. Yet, although reporting and

auditing mandates are imposed on several million firms across the globe to

aid resource allocation, their desirability remains an open question.

The literature provides evidence on firm-level costs (e.g., audit fees) and

benefits (e.g., liquidity) of reporting and auditing mandates incurred by

mandated firms (for a review, see Leuz and Wysocki [2016]). This evidence,

however, cannot directly speak to the overall desirability of the mandates,

as it provides little guidance on aggregate costs and benefits. It also tends

to neglect externalities of mandated firms’ reporting and auditing, even as

such externalities are offered up to justify the mandates.

In this paper, I examine the effects of reporting and auditing mandates

on aggregate resource allocation. I specifically investigate how subjecting

more firms in an industry to reporting or auditing mandates affects the

resource allocation in the entire industry. My focus on aggregate effects

provides two benefits. First, aggregate effects naturally weigh and combine

various firm-level costs and benefits of the mandates. Second, aggregate

effects capture not only the direct effect on mandated firms, but also exter-

nalities affecting other firms. As a relevant aggregation level, I focus on the

industry level because information and competitive (e.g., business stealing)

externalities should be most pronounced among firms in the same industry

(e.g., Foster [1981], Aghion and Howitt [1992]). Although clearly not per-

fect (e.g., cross-industry spillovers are neglected), my focus on the industry

level offers a useful first step away from the firm level toward an aggregate

assessment of the mandates.1

1To define industries, I use the four-digit NACE classification, which is the finest classi-

fication consistently coded across European countries. Although this fine classification aids

the measurement of outcome variables (e.g., productivities) and increases power, it may miss

important externalities spilling over the boundaries of four-digit industries. In untabulated

impact of financial-reporting regulation 61

Reporting and auditing mandates can affect industry-wide resource al-

location in various ways. The literature argues the mandates, by forcing

reliable public reporting, can promote a transactional type of resource al-

location, deemphasizing the importance of close relationships for allocat-

ing resources (e.g., Rajan and Zingales [2003]). In capital markets, for ex-

ample, the mandates can reduce information asymmetries between firms

and prospective investors, allowing firms to disperse their ownership more

widely (e.g., La Porta, Lopez-De-Silanes, and Shleifer [2006]). In product

markets, the mandates can help prospective entrants spot profitable niches

and prospective customers identify low-cost producers, increasing compe-

tition. To capture the mandates’ impact on the type of allocation, I ex-

amine market-structure measures such as the concentration of ownership,

the concentration of market share, and business dynamism (entry and exit

rates).

The mandates’ impact on the efficiency of resource allocation is a priori

unclear (Zingales [2009]). They may improve allocative efficiency if their

benefits offset their costs. By revealed preference, the mandated firms’ ben-

efits of expanded reporting and auditing fall short of the additional costs.

Accordingly, positive externalities enjoyed by others are crucial for the man-

dates to help aggregate resource allocation. The literature provides several

such examples for reporting (e.g., Badertscher, Shroff, and White [2013],

Shroff, Verdi, and Yost [2017]). A firm’s mandatory reporting, for exam-

ple, could help its competitors invest more efficiently and avoid duplicate

market-intelligence efforts. If this helps competitors more than the loss of

proprietary information hurts the reporting firm, this mandate improves

the aggregate allocation of resources (see Roychowdhury, Shroff, and Verdi

[2019] for discussion). The literature provides fewer examples of positive

externalities for auditing (e.g., Donovan et al. [2014], Minnis and Shroff

[2017]). Nevertheless, it is an empirical question whether reporting and au-

diting mandates help or hurt aggregate allocative efficiency. To capture the

mandates’ impact on allocative efficiency, I examine market-performance

measures such as the within-industry dispersion of productivities (Hsieh

and Klenow [2009]), the covariation of market shares and productivities

(Bartelsman, Haltiwanger, and Scarpetta [2013]), and aggregate productiv-

ity levels and growth (Basu et al. [2010], Fuchs, Green, and Papanikolaou

[2016]). Following the literature, I view a narrow productivity dispersion

(e.g., due to competitor learning), a positive size–productivity covariance

(e.g., due to customers reallocating business to more efficient firms), and,

above all, high aggregate productivity levels and growth (e.g., due to a faster

reallocation of resources) as indicators of an efficient resource allocation.

To test the industry-wide effects of reporting and auditing mandates, the

EU financial-reporting regulation implemented by members of the Euro-

pean Economic Area (EEA) provides a suitable setting. It stipulates that

results, I find that my inferences remain largely unchanged when I use coarser three-digit or

two-digit classifications.