Interim Reporting: Benefits and Drawbacks

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Table of Contents

Review of the UK regulatory context before 2007
The effect of switching to quarterly reporting
Regulatory context promoting a shift back to semi-annual reporting
Consequences of removing mandatory interim reporting
Benefits and drawbacks of interim reporting
References

Review of the UK regulatory context before 2007

Transparency Directive in 2004

The primary trend in the policymaking of the EU in the decade before 2007 was to encourage transparency of companies’ performance for investors. The central idea of such a discourse was that “efficient, transparent and integrated securities markets contribute to a genuine single market” (European Parliament and Council 2004, para. 1). However, many member states, including the UK, opposed the push for more frequent financial disclosures (Pozen et al. 2017). As a compromise, in 2004 the European Commission issued a directive requiring companies to start publishing quarterly interim reports by 2007 without disclosing their financial position. Before 2007, companies needed to publish income statements and balance sheets on semi-annual basis. Quarterly reports needed to include neither income statements nor balance sheets; instead the reports were to include descriptions of major events and transactions by the company, their impact on the financial position, and a general description of the issuer’s financial position (European Parliament and Council 2004). In 2004, private firms in the UK started moving towards interim reporting practices to comply with the new directive.

Prior to this date, the majority private firms in the UK were required to publish only annual and semi-annual financial reports (Pozen et al. 2017). The half-year statements only had to include earnings data: balance sheets and income statements had to be included (Pozen et al. 2017). In addition, the firms were required to disclose information on material developments regularly; however, delays were allowed in a number of exclusive cases (Financial Conduct Authority, 2021). Companies were also encouraged to publish trade reports frequently to disclose information about trends and projections about sales (Pozen et al. 2017). Additionally, some companies voluntarily published quarterly financial statements, even though they were not required to do so by regulators (Pozen et al. 2017). The Transparency Directive of 2004 made it obligatory to publish interim reports after the first and the third fiscal quarters, in addition to annual and semi-annual reports starting from 2007.

Financial Services and Markets Act 2000

In 2006, the UK government also increased the liability for publishing misleading financial statements. In particular, under Section 90A of the Financial Services and Markets Act 2000, issuers were required to repay any losses to relevant stakeholders suffered due to untrue information in annual, semi-annual or quarterly reports (Green et al. 2010). However, the company was obliged to pay damages only if the issuer knew that the information was untrue, failed to ensure that the information was true or knew that an omission could lead to the dishonest concealment of information (Morrison and Foerster, 2010). The period between 2004 and 2007 was when UK companies were forced to review their reporting practices to comply with a rapidly changing regulatory environment.

The effect of switching to quarterly reporting

Reporting Trends after 2007

The effect of switching to quarterly reporting was not homogeneous because UK firms had differing reporting practices prior to the changes in 2007. Moreover, the Financial Conduct Authority (FCA) did not provide strict guidelines regarding the contents of the reports, allowing them to evolve naturally according to the needs of the market (Nallareddy et al. 2017). Quarterly reports did not need to include quantitative information on the financial position and income statements. This requirement encouraged some companies that provided quantitative information about their financial performance to change their practices. In particular, the number of firms reporting quantitative quarterly estimates decreased by 50% and the number of companies that issued quantitative financial statements decreased from 52% of all quarterly reporters to 19% (Pozen et al. 2017). At the same time, the overall number of quarterly reporters in the UK increased significantly to comply with changes in the regulatory environment (Nallareddy et al. 2017).

Short-termism Concerns and Managerial Burden

The qualitative effect of the regulatory change, however, remains unclear. Previous studies conducted into the effects of interim reports on UK equities have reached contrasting conclusions. For instance, a report conducted by Kay (2012) claimed that short-termism was the main problem in the UK equity market. The main reason for moving to the short-term strategy is the lack of trust between stakeholders and increased control over managerial decisions. The report stated that the atmosphere of distrust was supported by regulatory practices because mandatory quarterly reporting increased pressure on the manager which forced them to adopt risk-averse strategies and make decisions that provide short-term results (Kay 2012). The European Commission (2013) supported the findings of Kay (2012), stating that the Transparency Directive issued in 2004 had a negative impact on long-term decision-making and encouraged firms to focus on short-term results to maintain the trust of investors. Additionally, the European Commission (2013) stated that the increased frequency of reporting imposes additional administrative burden. The situation in the UK was even more stressful due to the imposition of liability for issuing untrue information. In summary, the fundamental forces that moved away from required quarterly reporting included growing short-termism in managerial decision-making and an increased financial burden on SMEs.

Recent Evidence about Short-terminsm

Recent research, however, suggests that quarterly financial reporting had no direct effect on managerial short-termism. Nallareddy et al. (2017) conducted a quantitative study that found no support for the claims of the European Commission (2013) and Kay (2012). The researchers utilised a difference-in-differences analysis to conclude that after controlling for market fluctuations due to the global financial crisis of 2008, the changes in policies had virtually no effect on UK equity markets and the managerial decision-making process.

Pozen et al. (2017) in the same year found no “statistically significant differences in the changes in the level of company investment for mandatory switchers as compared to voluntary adopters between 2007 and 2010” (p. 6). In particular, there was no significant difference in the rate of investment in capital expenditures, research and development, and net property, plant and equipment which were used to represent long-term investments. The current body of research concerning the problem does not provide a unequivocal answer regarding whether the increased frequency of reporting had a significant impact on the decision-making processes of managers. However, it should be noted that the number of auditors analysing reports increased significantly for various reasons (Pozen et al. 2017). This attention was partially the result of the reduced quality of reports because many managers claimed that providing accurate forecasts four times a year was more difficult in comparison with semi-annual reporting (Pozen et al. 2017).

Regulatory context promoting a shift back to semi-annual reporting

The primary reason for taking the step away from forced quarterly financial reporting was the report by Kay in 2012, as mentioned in the previous section. This report was commissioned by the UK government and provided a high degree of reliability. The central finding was that equity markets were characterised by increased short-termism due to the loss of trust (Kay, 2012). As a result, Kay (2012) issued 17 recommendations for improving the situation. The eleventh recommendation was to abolish mandatory quarterly reporting. The European Commission adopted the findings of this report and made corrections in the Transparency Directive issued in 2013, abolishing mandatory quarterly financial reporting (European Commission 2013). Even though the member states did not have to follow these corrections until 2015, the FCA (2014) removed mandatory interim reporting on 7^th November 2014. These three main documents promoted the shift back to semi-annual reporting in the UK.

Consequences of removing mandatory interim reporting

Reporting Trends

Even though mandatory quarterly financial reporting was abolished in the UK, not many companies decided to stop issuing interim reports. In particular, Pozen et al. (2017) revealed that only 7% of firms ceased the practice of interim reporting following the changes to the regulatory environment. Nallareddy et al. (2017) demonstrated that the majority of companies that returned to semi-annual reporting were operating in the energy and utility sectors. Additionally, the companies that stopped providing quarterly reports typically had a small number of investors and stakeholders which implies that they do not need to disclose information frequently (Pozen et al. 2017). Moreover, these companies do not have a large investor base outside the UK where interim reporting is expected., The number of firms that abolished the practice of interim reporting in the UK was low due to increased internationalisation and the desire of managers to improve relationships with investors.

Short-termisn

The effect of abolishing mandatory interim reporting was unclear. Based on the report conducted by Kay (2012), it was expected that firms would experience a significant increase in long-term investment after returning to semi-annual reporting. However, research by Pozen et al. (2017) demonstrated that such changes did not happen. The few firms that decided to cease publishing interim reports experienced no significant change in investment behaviour after controlling for possible covariates. The research provides significant evidence that firms should guide their decision-making processes regarding abolishing the practice of interim reporting based on the idea that returning to semi-annual reporting can significantly improve the decision-making process by making it less myopic.

Benefits and drawbacks of interim reporting

Benefits

Interim reporting offers benefits for both the reporting company and peer companies. First, interim reporting provides considerable information for informed decision-making. According to Shroff (2017), interim financial statements force managers to collect data they otherwise would not gather. Such information helps to make data-driven decisions using data that would otherwise be missed. Bae et al. (2017) added that knowledgeable managers help to increase the efficiency of investment decisions by providing accurate information in the interim reports. Heitzman and Huang (2019) also claimed that high-quality interim reports have a significant positive impact on the decision-making process because managers tend to rely on data rather than on other insights such as expert opinions and qualitative assessments. Quarterly financial reports also help peer companies to make informed decisions, improving their financial performance (Roychowdhury et al. 2019). In summary, high-quality interim reports appear to positively affect the decision-making processes of managers.

Second, interim financial reports help to improve relationships with investors. According to a literature review conducted by Kajüter et al. (2021), the increased frequency of financial reporting is perceived as a positive development. Third, Tsao (2018) provided significant evidence that the increased frequency of financial reporting can be used as a mechanism to reduce accrual mispricing. Finally, quarterly financial reporting leads to improved control over performance, especially when a firm has poor monitoring mechanisms (Kajüter et al., 2021). However, there is no conclusive evidence that such increased controls lead to an improvement in liquidity in either the long- or short-term (Kajüter et al., 2021). In short, interim reporting is associated with significant benefits. However, it should be noted that only high-quality information is associated with positive developments in the decision-making process (Roychowdhury et al. 2019). However, high-quality reporting is associated with an increased time lag and significant costs (Roychowdhury et al. 2019; Kajüter et al., 2021). It is unclear if the benefits of such reports outweigh the costs and associated drawbacks.

Drawbacks

The main drawback associated with interim reporting which is mentioned in a wide range of recent studies is the effect of so-called ‘managerial myopia.’ According to Kraft et al. (2018), managerial myopia is a phenomenon described as an increased focus on short-term investments. Because one of the central objectives of interim reports is to assess the effectiveness of managers, they may be inclined to make short-term investments to avoid significant investments that do not deliver short-term results because the effectiveness of management is assessed based on short-term results (Kraft et al. 2018). As a result, a conflict of interest arises between managers and all other stakeholders which may lead to an overall decline in the performance of the company (Roychowdhury et al. 2019). Moreover, interim reporting puts greater pressure on managers, distracting them from their other duties which also adversely affects their effectiveness (Roychowdhury et al. 2019).

After conducting an empirical study into the effect of quarterly financial reporting on firms’ business decisions in terms of real activity manipulations, Ernstberger et al. (2017) arrived at the conclusion that interim reports have a negative impact. Even though real activity manipulations increase with frequent reporting, their long-term effect is harmful. In particular, Ernstberger et al. (2017) demonstrated that interim management statements are associated with a long-term decline in the operating performance of firms. Additionally, the high frequency of financial reporting puts managers under greater pressure which leads to risk-aversion behaviours (Roychowdhury et al. 2019). Such behaviour often leads to decreased innovation which reduces the effectiveness and efficiency of management long-term (Roychowdhury et al. 2019).

References

Kajüter, P., Lessenich, A., Nienhaus, M. and van Gemmern, F. 2021. Consequences of Interim Reporting: a literature review and future research directions.European Accounting Review pp.1-31. Web.

Please note, that since this was published online, it does not have an issue or a volume number.

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