The Dark Side of Corporate Transparency in Developing Countries

A scene from a mafia movie could go like this.  Big Tuna the collector goes to Frankie the shopkeeper to collect ‘protection fees’. Frankie demurs, ‘Boss, time is tough, please cut me some slack.’ Big Tuna doesn’t skip a beat, ‘Frankie, don’t be stupid! We know how much you pulled in this month.’ Haplessly, Frankie opens a drawer and hands over a roll of cash.  Big Tuna taps Frankie’s shoulder twice, ‘Good boy,’ and walks towards a bakery across the street.

In developing countries with weak institutions, rent-seeking bureaucrats behave like the Big Tunas. They gather and utilize available information to optimize their bribe demands. Cadot (1987) shows that corrupt behaviors are directly linked to players’ information sets. He further shows that high-ranking bureaucrats are able to extract more bribes due to their more complete information sets, thus ‘to embezzle according to one’s rank’ (Cadot, 1987, p 240). 

While the literature largely focuses on the benefits of disclosure by listed firms in developed economies, our paper focuses on the costs associated with disclosure by private firms in the developing world. When a private business produces audited financial statements (AFS), the detailed financial information contained is readily available to government bureaucrats, via such channels as state-owned banks (when applying for loans) or government agencies (when applying for licenses).  We proxy the costs by the level of corruption obstacles a firm faces.

In this study, we employ the World Bank Enterprise Survey (WBES) data from 2006-2014 for over 70,000 firms in 121 developing countries to examine the costs associated with the production of AFS. We document that AFS-firms experience significantly higher level of corruption obstacles than the non-AFS firms. To shed light on the specific channels through which corruption obstacles could visit upon a firm, we investigate three specific interactions between the firm and bureaucrats: tax collections, business permit applications, and customs and trade. We find that AFS-firms encounter significantly more obstacles than non-AFS firms when dealing with bureaucrats in these three areas. These results are consistent with the notion that rent-seeing behavior arises with access to more financial information.

To investigate how the effects of AFS vary cross countries, we examine the role of institutional developments. We find a stronger (weaker) relation between corruption obstacle and AFS in countries with weak (strong) corruption control mechanism. These results provide further evidence of the costs associated with increased transparency, especially in countries where institutions are underdeveloped and bureaucrats are less constrained.

Our paper makes useful contributes to the literature. First, our analysis of private firms complements the literature that has largely been derived from listed firms in developed countries. Issues related to disclosure by private firms are under-explored yet important, because non-listed sector still overwhelmingly dominates the economic landscapes in the developing world.  Furthermore, non-listed firms and listed firms face vastly different market and regulatory forces that shape their respective financial reporting practices. Our study contributes to the small but growing literature on financial reporting practices by private firms. Second, and most importantly, our novel finding that AFS is linked to more corruption obstacles demonstrates that corporate transparency bears important costs in exposing the firm to government expropriation. Third, we document that a country’s institutional quality plays an important role in moderating the costs associated with corporate transparency.

In conclusion, our paper offers a vivid illustration that an important hindrance to improving corporate governance, here in the form of increased financial transparency via the production of detailed and credible financial information, is the risk of government expropriation. As firm financial information becomes more readily available, the risk of expropriation becomes more severe, especially in countries with weak institutions. Our findings are thus supportive of Acemoglu and Johnson (2005) on the overwhelming importance of constraining government expropriation in facilitating economic development.

Tingting Liu is an Assistant Professor in the Department of Economics & Finance at Creighton University.

Barkat Ullah is an Assistant Professor of Finance at Rhode Island College.

Zuobao Wei is a Professor of Finance in the Economics and Finance Department at University of Texas at El Paso.

Lixin Colin Xu is a Lead Economist in the Development Research Group of the World Bank.