The study examines the impact of financial disclosure policies on companies’ innovation strategies.

If pharmaceutical and technology companies could keep early failures private, would that encourage greater innovation and long-term success?

Researchers from the University of Zurich and Carnegie Mellon University investigated this question and found that the way companies share financial information can significantly affect their willingness to innovate. Using a widely used bandit problem designed to model innovation choices, they found that when companies can keep early failures a secret, they are encouraged to experiment, leading to greater long-term success.

The study was published in Journal of Accounting Research.

“Our findings suggest that firms are more likely to innovate when they can manage the timing of their disclosures,” said Pierre Jinghong Liang, a co-author of the study and a professor of accounting at Carnegie Mellon’s Tepper School of Business. “This knowledge is crucial for both managers and policymakers who want to foster a more innovative business environment.”

Companies face a strategic choice between using existing technologies that are reliable and exploring new methods that are riskier but may yield greater long-term rewards. Understanding how disclosure rules affect these choices can help create better regulations and business practices that encourage innovation.

The researchers focused on companies faced with early trial innovation and then later full-scale product launch for this study. They analyzed how managers’ innovation decisions were affected by when they had to disclose financial results. The results showed that companies operating in an environment with voluntary early disclosure and mandatory later disclosure were more likely to experiment with new methods, leading to greater long-term success.

For example, imagine that a company has two ways of producing a product: one it has used before and knows works well; and a new, untested way that might be better but might also fail. In the first period, the company tries the new method on a small scale. If it works, it uses it for a larger launch in the second period; if it fails, it goes back to the old way. In this way, the company learns and decides whether to stick with the safe option or take a risk for potentially better results.

“Our research suggests that early mandatory disclosure may actually hinder innovation by forcing managers to avoid risky but potentially profitable new approaches,” said Yevgeny Petrov, a co-author of the study and a professor of accounting at the University of Zurich.

“This was a surprising finding that challenged traditional views on transparency,” added Professor Hui Chen, another co-author, also from the University of Zurich.

The study’s authors make the following theoretical predictions: Private startups planning to go public (e.g., through an IPO) are more likely to innovate compared to those that remain private. On the other hand, public firms planning to go public are less likely to innovate than those that remain public. This is important because it shows how different financial disclosure policies can affect a firm’s willingness to try new things and be creative.

Understanding when financial disclosures occur can help investors, regulators and business leaders make better decisions about how to support innovation.