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Do financial reports matter?

Do financial reports matter?
Do financial reports matter?

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Yes, it does, and more so than we think! We usually view investors as the primary users of information disclosed in financial reports. The information buck does however not stop at investors. In my study “Corporate Investments: Learning from restatements” published in the Journal of Accounting Research, I find that a firm’s financial reports are useful for other companies in its industry (i.e., its competitors). Competitors rely on the information from a firm’s financial reports to make investment decisions, such as what factories to build or what R&D projects to sponsor. This insight has considerable implications when information in financial reports turns out to have been wrong. Competitors of a firm that publishes information later shown to be erroneous have de facto based their investment decisions on faulty inputs. A case in point is WorldCom. In 2001 and 2002, WorldCom restated its financial reports and decreased its reported net income by 3.8 billion U.S. dollars. This restatement was caused by line costs incorrectly reported as too low. If other telecommunication companies relied on WorldCom’s initial financial reports, they may well have underestimated the costs of obtaining customers, and, as a result, overinvested in acquiring new customers. Consistent with this argument, Sprint’s former CEO William Esrey said that WorldCom’s overstated net income had a substantial effect on industry investment. How do a firm’s competitors react when errors in its financial reports are discovered? They adjust their investment policy and either boost or cut down their investments, depending on the errors. Most errors in financial reports result in downward corrections to reported income. In my study, I find that when a firm restates its financial reports downwards, its competitors decrease their investments between 3% and 16% in each of the three years following the restatement. Financial reports thus represent a source of strategic information for managers who make investment decisions. If financial reports are faulty, investment decisions are affected: companies over-invest, and correct their investments downwards later on once the mistakes in financial reports have been uncovered. Getting information in financial reports right matters, not just for Wall Street but also for Main Street.

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