Firms make investments to increase their future profits because they help reduce production costs, increase capacity, or upgrade their products or services. However, firms do not always make investments to improve production efficiency or customer demand. They often make investments to strategically influence competitors’ behavior. Due to their costly-to-reverse and time-bound nature, investments signal credible commitments to future strategies that alter competitors’ decisions. For example, a firm’s purchase of large inventory can be viewed by its competitors as bad news about their profitability and may deter them from competing. This is because purchasing inventory, which is costly to remove if it goes unsold, credibly signals a plan to produce and sell a large quantity. Therefore, investments not only have an internal profit-increasing value, but also have an important strategic value.
This insight that firms strategically change investments to alter future competitive conditions—referred to as strategic investments—is one of the most fundamental ideas in industrial organization. When firms are required to publicly report their investments, one can suspect that firms will take into consideration the fact that its disclosure of investments is viewed by its competitors. Hence my research question: does financial reporting facilitate the strategic role of firms’ investments? This question is motivated by the idea that investments are more likely to affect competitors’ behavior when they are more observable to them, and financial reporting increases this observability. This idea is intuitive because if a firm wants to scare away its competitors by increasing investments in production and advertising, it will be more efficient if its competitors learn about it quickly and accurately. To answer my research question, I explore whether publicly traded firms changed investments after the U.S. Securities and Exchange Commission (SEC) in 2003 required them to disclose more of their investments to outsiders, which include competitors.
In 2003, the SEC required firms to disclose in their annual financial statements, Form 10-K, their off-balance sheet contractual obligations. A key feature of the regulation is that it required firms to provide tabular information in a single location in the Management Discussion and Analysis (MD&A) section about their purchase obligations. Purchase obligations are defined as executory agreements to purchase goods or services that specify significant terms, such as quantities and prices and the approximate timing of the transaction. These reflect a broad set of future investments, such as inventory purchases, capital expenditure (CAPEX), research & development (R&D), royalty/licensing, advertising/marketing and strategic alliances. These purchase obligations are irreversible as they reflect legally binding (e.g., non-cancellable) and audited amounts of purchase commitments. Also, they are time-bound as firms typically need to enter into purchase obligations well in advance, in time for future production and/or sales. Because the irreversible and timely nature of purchase obligations makes them effective at signaling commitments to future product market strategies, this 2003 regulation is well suited to study firms’ strategic investments.
I find that the amounts of purchase obligations reported after the 2003 regulation are economically significant. During 5 years after the regulation, approximately 60% of public firms, excluding those in finance and utilities, reported purchase obligations in their 10-Ks. Among firms that reported purchase obligations, the average amount of total purchase obligations was $193.02 million or 11.12% of total assets. This suggests that the regulation requiring disclosure of purchase obligations likely caused a meaningful increase in the information about a firm’s future strategies that is observable to competitors.
Intuitively, the specific investment strategy that firms choose after the 2003 regulation likely depends on how they interact with other firms. Accordingly, my predictions for how firms respond to the 2003 regulation depend on their mode of competition. To guide my predictions, I rely on classical theory on strategic investments developed in the industrial organization literature, which classifies competition into two types: competition with strategic substitutes and competition with strategic complements.
Firms are considered to be in competition with strategic substitutes (e.g., Cournot competition) when more aggressive strategies, such as increasing quantity, induce competitors to adopt less aggressive strategies by reducing competitors’ marginal profits. For example, suppose Coca-Cola signals that it intends to flood the market with soft drinks by making large investments in distribution centers. Coca-Cola would be classified as having strategic substitutes if these investments induced smaller competitors, such as Shasta, to reduce the quantity of production in anticipation of a reduction in the prices consumers are willing to pay for their products. Thus, in competition with strategic substitutes, firms’ choices have negative correlations.
Firms are considered to be in competition with strategic complements (e.g., Bertrand competition) when more aggressive strategies, such as lowering price or increasing quality, induce competitors to similarly adopt more aggressive strategies by increasing competitors’ marginal profits. For example, suppose Boeing signals that it intends to increase the quality of its aircraft by investing in energy efficiency. Boeing would be classified as having strategic complements if these investments induced smaller competitors, such as General Dynamics, to also improve the quality of their aircraft to avoid losing market share. Hence, in competition with strategic complements, firms’ choices have positive correlations. Another example of such competition is the one with price leadership, where competing firms follow the prices chosen by leading firms.
I develop a two-way prediction that after an increase in observability of investments, firms in competition with strategic substitutes increase investments, and those in competition with strategic complements reduce investments. In the examples above, Coca-Cola increases investments in distribution centers, and Boeing reduces investments in energy efficiency. The intuition is that greater observability of investments increases firms’ ability to use investments as a signal to induce desired responses from competitors. To induce less aggressive strategies from competitors (e.g., sell less), which helps increase firms’ own profits, firms with strategic substitutes signal commitments to more aggressive strategies, whereas firms with strategic complements signal commitments to less aggressive strategies.
The predictions from classical models of strategic investments center on firms with a first-mover advantage. Accordingly, my predictions center on dominant firms (i.e., firms with large market share), which have the capacity to exert a significant influence on the quantity and price of products in the industry and hence on the subsequent actions of other firms. Following Bloomfield (2021), I define dominant firms as those with market shares between 10-65% excluding monopolistic firms.
To test my predictions, I employ difference-in-differences tests around the regulation on dominant firms. I examine whether dominant firms with a greater increase in investment observability (i.e., a greater degree of “treatment”) change investments by a greater amount. Because the regulation increases disclosure of contractual investments, firms that rely more on investment contracts likely experience a greater increase in observability of their investments. For instance, firms engaging in R&D with third parties are affected by the regulation to a greater extent than firms relying on in-house departments. For this reason, to estimate the degree of “treatment,” I count investment contracts as manifested in 10-K/Q and 8-K exhibits before the regulation. To partition firms into different competition types, I use the measure used by Kedia (2006), which estimates whether more aggressive strategies by competitors increase or decrease a firm’s marginal profits using their sales and net income data.
Consistent with my predictions, I find that dominant firms with strategic substitutes are more likely to increase their investments if the 2003 regulation makes their investments more observable. In terms of economic magnitudes, a one-standard-deviation increase in the exposure to the regulation leads to an approximately 6% increase in the 5-year investments for an average firm. In contrast, dominant firms with strategic complements display a similar change in the 5-year investments of 7%, but of opposite sign. These results are consistent with dominant firms changing investments in directions that induce competitors to adopt less aggressive product market strategies, which is what industrial organization theory predicts if firms were strategically changing investments to increase their own future profits.
To understand the consequences of the strategic actions taken by dominant firms, I also study the behavior of non-dominant firms. I find that they decrease investments after the 2003 regulation across both types of competition. Continuing with the above illustrations, the decrease in investments by non-dominant firms with strategic substitutes is consistent with Shasta rationally reducing its investments in production when Coca-Cola’s increased investments signal an intention to flood the market. In contrast, the decrease in investments by non-dominant firms with strategic complements is consistent with General Dynamics optimally engaging in less aggressive investments in technology when Boeing’s reduced investments signal reduced commitments to improving energy efficiency.
Furthermore, I examine whether dominant firms’ strategic investments have real effects on product market outcomes. I show that, in competition with strategic substitutes, dominant firms increase sales and non-dominant firms reduce sales. This suggests that dominant firms captured larger market share. I also show that, in competition with strategic complements, both dominant and non-dominant firms increase profit margins, consistent with less aggressive competition. These findings suggest dominant firms’ strategic investments impact competition.
Altogether, I provide novel evidence that financial reporting increases the extent to which large firms strategically engage in investments, and that this has real effects on firms’ competitive dynamics. A central contribution of my paper is showing that financial reporting can allow large firms to make strategic gains through investments. In doing so, my paper seeks to expand our limited understanding of the role of mandatory corporate disclosures in firms’ strategic investments and their implications.
Finally, my findings have important implications for regulators. The primary objective of the regulation was to provide investors with information about firms’ obligations from off-balance sheet arrangements. Although they do not speak to the net effect of the regulation, my finding that firms use the strategic effect of disclosures about their investments to their advantage sheds light on a potential unintended effect of the regulation and an unexplored role of financial reporting.
Suzie Noh is an Assistant Professor of Accounting at the Stanford Graduate School of Business.
This post is adapted from her paper, “The Effect of Financial Reporting on Strategic Investments: Evidence from Purchase Obligations,” available on SSRN.