01 May 2006  Research & Ideas

What Companies Lose from Forced Disclosure

Increased corporate financial reporting may benefit many parties, but not necessarily the companies themselves. New research from Harvard Business School professor Romana Autrey and coauthors looks at the relationship between executive performance and public disclosure.


Increased financial disclosure standards on such issues as executive compensation should provide more useful information for investors, policy makers, and regulators. But do the companies themselves benefit? What researchers are now discovering is that increasing levels of mandatory disclosure have unforeseen consequences on executive performance and may work against the interests of employers.

Romana Autrey, an assistant professor at Harvard Business School, recently completed two working papers on this subject in collaboration with colleagues from the University of Texas at Austin. Her other research examines the design of performance measurement systems and incentive contracts for rewarding teams and channel partners.

In short, this research explores the idea that career concerns, influenced by disclosure requirements, may direct the actions of executives, sometimes against the interests of the employer. Why? Financial disclosures are read by labor markets, that is, potential future employers. An executive who has an interest in career advancement may take actions that look good in mandated disclosure but might well be against the overall interests of the company he or she works for.

Career concerns occur whenever employees take into account the impact of their current actions on their future career.

The results of the research suggest that financial disclosures have implications for the debate over whether firms should make executive compensation more transparent. The work also provides insights into how firms can create employment contracts that are in step with company goals.

This e-mail interview is based on two working papers by Autrey and colleagues Shane Dikolli and D. Paul Newman: "Career Concerns and Mandated Disclosure," a HBS Working Paper from March 2006; and "Aggregation, Precision, and Contracting with a Long-Horizon Agent in a Multi-Task Setting," a HBS Working Paper from April 2006.

Ann Cullen: How did you get interested in this topic?

Romana Autrey: Career concerns affect every industry, even academia and government. I find this topic so fascinating in part because it is so accessible—everybody understands the concept of doing a good job so you can build a good reputation—and yet so many of the consequences of career concerns remain unexplored.

Q: Why is evaluating career concerns so important to companies?

A: Career concerns occur whenever employees take into account the impact of their current actions on their future career. In essence, whenever the internal and/or external labor market observes a performance measure that helps revise its beliefs about an employee's ability, the employee works harder to make that performance measure look more favorable.

Surprisingly, this extra work can be dysfunctional from a firm's perspective, especially when labor markets are most competitive. In a hot labor market, a firm will lose employees to its competitors unless it meets the market wage, and the market wage is higher due to the extra career-related effort. The end result is that the firm may pay for more effort than it wanted to consume.

Q: Why is non-contractible information about executives important?

A: Non-contractible information distorts actions relative to the actions a firm might prefer. And, there is far more information that is not contracted upon than is contracted upon.

For example, consider the extensive details in footnotes to financial statements; this information is rarely included in compensation contracts. The distortion occurs because, in the presence of career concerns, employees are motivated to work harder to make all observable information more favorable, whether it is contractible or not (and whether it is valued by the firm or not).

Firms anticipate this extra effort and reduce current explicit incentives to offset the career incentives to yield the actions it actually wants. When information is not contractible, typically for cost reasons, a firm's ability to offset the distortions caused by career concerns is limited.

Q: What unique insight does the model you propose in these papers offer in terms of evaluating performance?

A: Our model demonstrates that, in the presence of career concerns, more measures are not always in a company's best interest. This goes against the oft-held belief that "more information is better."

This goes against the oft-held belief that "more information is better."

For example, when a firm contracts only on an aggregate measure such as net income, it can undo career concerns if that measure is the only publicly observable information. Now consider the subsequent release of additional details—for example, segment reporting—to the labor market. In this situation, the firm faces a cost-benefit tradeoff: On the one hand, more measures provide more dials to turn to get the manager to take actions consistent with the firm's best interests. On the other hand, more public information imposes more risk on the manager (more chances for things beyond the manager's control to go wrong), and that risk will be exacerbated if the manager has little or no control over the information that the labor market sees (i.e., is mandated beyond the manager's control).

Q: Given the current debate about financial transparency, do you see accountants becoming obligated to include such measures in the standard financial statements they issue for firms in the future?

A: The current debate focuses on the desirability of making additional information observable to shareholders. Of course, this information will also be observable by the labor market. Our model shows that mandated public disclosure of performance measures, particularly measures that are relatively informative about management's ability but that are difficult for management to influence, may have unintended and undesirable consequences.

Our results suggest further consideration of these unintended consequences is warranted. Indeed, this is a sensitive and important issue in practice, as evidenced by corporate pushback to recent proposals for additional mandatory disclosures. For example, the SEC has proposed mandatory disclosure of certain compensation information; however, several media companies (including Viacom, News Corp., and Disney) argue that this compensation information should be treated as a trade secret.

Q: How can regulated public disclosure of performance measures generate inefficiencies in firms' employment contracts?

A: An inefficiency can occur when the incentive effects of the additional disclosure are outweighed by additional career risk from the disclosure. Disclosures inform the labor market about ability, but management may be able to do relatively little to change the outcome of those disclosures. For example, a disclosure about stock option compensation may be correlated with information about an executive's ability, but in some cases the executive may be able to do very little to change the measured value of stock option expense.

Q: A unique feature of your model is its focus on short-term objectives of a company as opposed to the long-term objectives of the employee doing the work. You indicate that most models haven't accounted for this. Why is that?

A: The typical horizon-mismatch model studies a manager whose tendency is to take relatively myopic actions (for example, using resources to pump the stock price now at the expense of lost future value) because the manager has a shorter-term payoff than the firm. In our model, the horizon mismatch occurs because managers take actions based on longer-term consequences than the firm cares about. That is, the firm's preferred actions are myopic relative to the manager's career.

For example, a troubled firm may hire a turnaround specialist as CEO, with the intention of using the specialist for a limited time only. The specialist, on the other hand, takes actions that benefit not only the firm but also inform future employers of his or her abilities as a turnaround specialist.

Q: How can this research help boards of directors do a better job?

A: The key lesson to boards is that, for compensation and incentive purposes, when management has high career concerns, sometimes less information is better. And, recent evidence suggests that high career concerns in management is quite common: A 2005 survey by Graham, Harvey, and Rajgopal of more than 400 CFOs indicates that career concerns is a primary motivator for management—even more so than short-term compensation motivation—for hitting earnings benchmarks.

About the author

Ann Cullen is a business information librarian at Baker Library, Harvard Business School, with a specialty in finance.