Heightened corporate reporting standards are meant to improve market fairness: better information should make it easier for outside investors to understand how a business is performing and value its shares, and stricter standards can reduce insider trading by improving transparency.

But new research suggests this positive effect may have an important caveat, hinging on how information is shared within large organisations comprising numerous divisions. Managers at the divisional level report information to executives at headquarters, who use it to prepare external corporate reports. Headquarters executives, if required to produce more detailed disclosures, may be more cautious in reporting that divisional information, not knowing or perhaps not trusting the information the divisional manager has.

This information gap can create insider-trading opportunities for the divisional manager if the conservative external report results in a temporary mismatch between the company’s share price and what the manager believes it should be.

In a new study, Internal information asymmetry, external reporting, and insider trading: Theory and evidence, Hanyang University Associate Professor Chang-Mo Kang, Chung-Ang University Associate Professor Donghyun Kim and UNSW Business School Associate Professor Youngdeok Lim examine what happened after the introduction of a US accounting standard that required diversified companies to provide more detailed information about their business segments.

The research, published in the Journal of Corporate Finance, showed that, after the new standard came into effect, divisional managers became more likely to buy shares in the company following the release of a corporate report. Their share purchases also became more profitable than those of headquarters executives.

“The key message is that improving external disclosure does not necessarily eliminate information advantages inside a company,” said A/Prof. Lim. “When divisional managers know more about their operations than headquarters, stronger reporting requirements can unintentionally create opportunities for those managers to trade on information that has not yet been fully reflected in the market.”

When information gets lost inside the company

Large companies typically operate through multiple divisions or business units, and the people who manage these units likely have a better view of how their part of the business is performing than do executives at corporate headquarters. This can give divisional managers early knowledge that is material to the company’s outlook, such as changes in demand or future prospects.

The paper refers to this as internal information asymmetry, which differs from the more familiar information gap between a company and outside investors. With internal information asymmetry, a company may produce detailed public reports while senior executives still lack a complete picture of what is happening across the business.

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If headquarters executives don’t know, or are hesitant to claim, that a division is performing better than expected, the company’s public disclosures may present a conservative picture of its prospects. A divisional manager who does have that knowledge may recognise that the company’s share price does not yet reflect the division’s true performance. They can then buy shares with the potential to profit when the market catches up.

“Information does not always flow perfectly from divisions to headquarters. Divisional managers may have incentives to present information strategically, while headquarters can find it difficult to verify information that is complex, qualitative or specific to a particular business unit,” A/Prof. Lim explained. “For investors, this matters because even detailed public reporting can only reflect the information that headquarters itself knows or can reliably verify.”

The accounting change that provided a natural test

The researchers examined the adoption of Statement of Financial Accounting Standards 131 (SFAS 131) in the United States. Previously, diversified companies had considerable flexibility in how they grouped their operations for reporting purposes and could report highly aggregated segments, giving investors only a broad view of the business.

"The key message is that improving external disclosure does not necessarily eliminate information advantages inside a company"

YOUNGDEOK LIM

SFAS 131, which took effect for financial years beginning after 15 December 1997, required companies to report segments based on the internal categories used by management to make operating decisions and assess performance. In practice, they generally had to provide more detailed information about their individual business segments.

The researchers compared companies that reported more business segments after the standard was introduced with similar conglomerates whose reported segment structure did not increase. This allowed them to test whether any change in insider trading was linked to the new reporting requirements, rather than simply reflecting broader market changes. They then examined the share purchases of divisional managers and headquarters executives.

Divisional managers started buying more shares

After SFAS 131 took effect, divisional managers at affected companies became more likely to buy their companies' shares, with an estimated increase in the probability of purchase of about 3.7 percentage points relative to the control group. There was no similar increase in share purchases by headquarters executives, and no comparable increase in share sales by divisional managers.

The researchers also found that divisional managers’ purchases were more profitable than those made by headquarters executives. “The pattern of results points to an information advantage rather than ordinary portfolio, liquidity or other non-information-related trading motives,” A/Prof. Lim said. “The increase is concentrated in non-cluster purchases by divisional managers, while purchases by headquarters executives do not significantly increase.

“Divisional managers’ sales also remain unchanged, and their non-cluster purchases become more profitable relative to those of headquarters executives,” he added. “Taken together, these patterns are consistent with divisional managers trading on favourable information that is not shared with headquarters.”

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They then divided the purchases into two groups. “Cluster purchases” – those made by a divisional manager and a headquarters executive on the same day or on nearby trading days – were more likely to reflect that both insiders shared the same knowledge.

“Non-cluster purchases” were made by divisional managers without a corresponding purchase by headquarters executives, more likely to reflect knowledge held by the divisional manager but not by headquarters.

The post-SFAS 131 increase occurred in the second category, with the probability of a non-cluster purchase rising by about 4.3 percentage points relative to the control group. There was no significant change in the likelihood of cluster purchases.

The researchers suggest that the new requirements also changed the way headquarters executives approached public disclosures, as the more detailed segment information required under SFAS 131 incentivised them to avoid overstating the performance of divisions they couldn’t confidently assess. This made their reporting more conservative.

Ultimately, the change may have improved the reliability of the information available to investors while also leaving room for a divisional manager with better knowledge to recognise that the company was undervalued.

A limit to what better disclosure can achieve

The researchers note that they are not suggesting SFAS 131 failed to improve corporate reporting. They point to earlier studies that found the standard led to more detailed segment disclosures, improved analysts’ forecasts, and helped investors understand companies’ future earnings.

However, the research suggests that better external reporting cannot fully address information gaps within the company. If a business discloses more information about its divisions but senior executives still lack all the knowledge held by the managers running them, outside investors may receive a better report without the whole picture.

The authors are also careful not to suggest that every purchase by a divisional manager represents illegal insider trading. Their analysis uses reported insider purchases and examines whether those purchases appear to be informed and profitable.

"For business leaders and boards, the lesson is that external transparency starts with internal transparency"

YOUNGDEOK LIM

The broader concern is whether outside investors are disadvantaged when material knowledge is held by one part of a company but is not reflected in its public disclosures. “These findings do not mean that SFAS 131 reduced transparency,” A/Prof. Lim said. 

“Previous research shows that the standard improved segment disclosure and the information environment for investors. Our findings identify a different effect: better external reporting can coexist with information gaps inside the firm. SFAS 131 did not necessarily increase those internal information gaps; rather, it allowed divisional managers to make greater use of information advantages that already existed.”

The effect was weaker in companies with higher institutional ownership. According to the researchers, this may be because large institutional investors are better placed to monitor management and push for stronger internal controls. 

Ultimately, the research suggests that more detailed financial reporting systems will not necessarily help investors if important knowledge remains with the people closest to individual divisions.

The same gaps may also affect decisions about capital allocation, performance evaluation, and strategy: a company that lacks a complete view of its operations may struggle to make sound decisions, regardless of how much information it ultimately discloses to the market. “For business leaders and boards, the lesson is that external transparency starts with internal transparency,” A/Prof. Lim said.

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“Improving disclosure rules is important, but firms also need effective systems for information to move from divisions to headquarters. For regulators, our findings suggest that the effectiveness of reporting standards may depend partly on the quality of information sharing and internal controls within the organisation.”

Improving public disclosure may help narrow the gap between companies and investors. This research suggests companies also need to pay attention to the gaps inside the organisation.

Five recommendations for industry professionals

1. Boards and senior executives should assess whether material knowledge from business divisions reaches the people responsible for external reporting.
2. Reporting and finance teams should review whether internal reporting systems capture material divisional information that might otherwise not reach headquarters.
3. Business-unit leaders should consider whether internal competition for resources or concerns about verification are discouraging managers from sharing important information with headquarters.
4. Risk and compliance teams should examine whether gaps in internal information-sharing could affect public disclosures or create opportunities for informed trading.
5. Institutional investors should consider the quality of a company’s internal reporting and control systems alongside the information it discloses publicly.