The Innovation and Reporting Consequences of Financial Regulation for Young Life‐Cycle Firms

• Published date: 01 March 2022
• Author: ABIGAIL ALLEN,MELISSA F. LEWIS‐WESTERN,KRISTEN VALENTINE
• Date: 01 March 2022
• DOI: http://doi.org/10.1111/1475-679X.12398

DOI: 10.1111/1475-679X.12398

Journal of Accounting Research

Vol. 60 No. 1 March 2022

Printed in U.S.A.

The Innovation and Reporting

Consequences of Financial

Regulation for Young Life-Cycle

Firms

ABIGAIL ALLEN,∗MELISSA F. LEWIS-WESTERN,∗

AND KRISTEN VALENTINE†

Received 1 July 2020; accepted 26 June 2021

ABSTRACT

Firm life-cycle stage reflects a firm’s current strategic direction toward explo-

ration independent of age or size. We provide evidence that young life-cycle

firms are particularly vulnerable to negative innovation consequences from

financial regulation but do not appear to experience any compensating fi-

nancial reporting quality (FRQ) benefits. Using a generalized difference-in-

differences design around Sarbanes Oxley Act of 2002 (SOX), we document

a significant reduction in both research and development (R&D) spending

and innovation outputs for young life-cycle stage firms after regulation. De-

clines in innovation manifest both from the diversion of scarce resources and

from the imposition of an organizational culture mismatched to the pursuit

of explorative innovation, resulting in a less generalizable and less diversified

patent portfolio. However, we find no evidence that improvements to FRQ

∗Brigham Young University; †The University of Georgia

Accepted by Philip Berger. The authors gratefully acknowledge the financial support of

the Marriott School of Business and the Terry College of Business. The authors wish to rec-

ognize an anonymous reviewer, Vishal Balria (AAA discussant), Mike Drake, James Hansen,

Michelle Lowry, Tim Seidel, Amy Sheneman, Jake Thornock, workshop participants from

Brigham Young University, The University of Florida,Texas A&M University and The Univer-

sity of Texasat Austin, as well as conference participants at the George Washington University

Cherry Blossom Conference and the American Accounting Association annual meeting for

insightful comments that enhanced the paper.

45

© 2021 The Chookaszian Accounting Research Center at the University of Chicago Booth School of

Business

46 a. allen, m. f. lewis-western, and k. valentine

materialize to offset these costs. Event study analyses suggest that this nega-

tive impact was expected by market participants, and postregulation returns

confirm this expectation.

JEL codes: G38, L51, M40, M41, M48, O32

Keywords: firm life-cycle; innovation; explorative innovation, R&D; finan-

cial regulation; corporate governance; financial reporting quality

“It is important that our rules and regulatory actions create an environ-

ment that fosters innovation and growth.”1

1. Introduction

The last several decades have witnessed an increase in regulatory require-

ments predominantly oriented toward improving the reliability of financial

information (hereafter “financial regulation”).2Often sparked by financial

reporting scandals, the assumption implicit in such financial regulation is

that the capital markets benefit via improved financial reporting quality

(FRQ). However, there are also real costs that arise from regulation, both

direct (e.g., resources expended on implementation, attestation, litigation)

and indirect (e.g., modified firm incentives/behavior). Prior research on

these costs has emphasized the importance of firm size, and regulation has

often included size-based exemptions. In this paper, we propose that young

life-cycle stage firms not only constitute another unique population partic-

ularly vulnerable to the negative consequences of these regulations but are

also less likely to reap the intended benefits. Because young life-cycle firms

are a vital segment for national economic growth (e.g., Henrekson and Jo-

hansson [2010]) and because their size frequently exceeds size-based reg-

ulatory exclusion thresholds, we examine how financial regulation affects

the innovative capacity and FRQ of young life-cycle firms.

Firm life-cycle stage reflects a firm’s current strategic direction indepen-

dent of age or size. For example, Dickinson [2011] notes that strategic

changes that result in expansions into new markets and substantial prod-

uct innovations can transform established firms into young life-cycle firms.

The strategic direction typified by young life-cycle firms suggests that imple-

mentation of financial regulations may have detrimental consequences on

innovation for two reasons. First, young life-cycle firms are characterized by

large investments in R&D and high levels of explorative innovation as they

1Speech by former SEC Chair Mary Jo White in March of 2016: https://www.sec.gov/news/

speech/chair-white-silicon- valley-initiative-3- 31-16.html#_ftn

2For example, Sarbanes Oxley Act of 2002, Dodd-Frank Wall Street Reform and Consumer

Protection Act, and exchange-based requirements on characteristics of firms’ board structure.

innovation and reporting consequences of financial regulation 47

attempt to establish new markets (Spence [1977, 1979, 1981]).3Such inno-

vation thrives in a decentralized environment where managers are afforded

significant flexibility in decision making (e.g., Holmstrom [1989], Shadab

[2008]). Financial regulation focused on decreasing opportunism through

increased internal controls and monitoring could reduce both opportu-

nities and incentives for risky investments that are the precursor to explo-

rative innovation (Bargeron, Lehn, and Zutter [2010], Cohen, Dey, and Lys

[2013], Bernstein [2015], Balsmeier, Fleming, and Manso [2017]). Con-

sequently, we expect more severe indirect innovation consequences from

financial regulation for young life-cycle firms relative to mature life-cycle

firms. We refer to this channel as innovation hindrance.

Second, investments in financial reporting initiatives are costly (e.g., En-

gel, Hayes, and Wang [2007], Zhang [2007], Iliev [2010]) and divert re-

sources away from investments in innovation. Young life-cycle firms are

characterized by low levels of financial slack and heavy reliance on exter-

nal financing (Dickinson [2011]) and are therefore financially constrained

relative to their more mature counterparts. Thus, we expect that the direct

costs associated with financial regulation incrementally cumber innovation

for young life-cycle firms. We refer to this channel as resource diversion.

Because a primary objective of financial regulation is to enhance the ef-

ficiency of capital allocation across firms through improved reporting qual-

ity, it ispossible that the net effect of financial regulation for young life-cycle

stagefirmsactuallyincreases innovation by elevating FRQ and increasing ac-

cess to lower cost capital. The unique profile of young life-cycle firms that

often include concentrated ownership structure and constrained free cash

flows (Ang, Cole, and Lin [2000], Dickinson [2011]), however, reduce ex

ante misstatement risk (e.g., Chen et al. [2011], Roychowdhury, Shroff, and

Verdi [2019]), thereby diminishing the potential FRQ benefits of financial

regulation.

Moreover, the benefits of financial regulation are often predicated on

regulation requiring disclosure of financial statements that better reflect

the company’s investment opportunities (e.g., Biddle and Hilary [2006],

Roychowdhury, Shroff and Verdi [2019]). Financial regulation focused on

improving the measurement of recognized assets is less likely to provide

improved FRQ for young life-cycle firms as these firms’ intangible-intensive

assets (and value) are less likely to be recognized in financial statements

(e.g., Srivastava [2014]). If young life-cycle firms experience larger innova-

tion declines without offsetting improvements to FRQ, then financial regu-

lation is particularly costly for these firms.

3Explorative innovation is directed at developing new ideas, processes or customers and is

best facilitated in an environment that promotes non-routine problem solving and deviance

from existing knowledge (Jansen, Van Den Bosh, and Volberda [2006]). By contrast, mature

firms more frequently engage in exploitative innovation, which leverages existing technology

and firm product lines to achieve incremental improvements for existing customers.