Annual Report Information Overload: Five Reasons 10-Ks Continue to Expand
In a recent Wall Street Journal article (“The 109,894-Word Annual Report,” June 2, 2015), the fact that corporate annual reports on Form 10-K have expanded by some 40% over just the four-year interval 2010-2013, to an average count of 42,000 words, was bemoaned, with General Electric’s headlined filing cited as perhaps a record-setting example. This is the most recent in a long series of concerns voiced over so-called “information overload,” a topic that has received sporadic academic attention over several decades. Past experience offers scant hope for actually accomplishing either a reduction in the size of filings under the securities laws or advancing the art of structuring these filings in a way to more effectively communicate with their users.
The author, who as an accounting expert and author of leading accounting reference books has spent thousands of hours interpreting financial statements reported in Forms 10-K, offers five reasons why Form 10-Ks will continue to grow in length.
Some have suggested that expanded disclosures have been used deliberately to conceal, rather than to reveal. Most auditors know from experience that managements seeking to veil suspect transactions may well bury them within a mass of bookkeeping minutia, and presumably this same tactic could be attempted in financial reports. However, for publicly-held companies at least, this would have to first survive scrutiny by a platoon of attorneys and accountants. Absent their complicity in such a plan, the odds of success are probably slight, and proving that this took place would be very difficult absent a “smoking gun,” such as incriminating e-mails. Thus, this is not thought to be the predominant reason for increasingly voluminous filings.
Fear of litigation is almost certainly a motivation for erring on the side of more, rather than less, disclosure. Suits against preparers and also, sometimes, auditors for failure to make adequate disclosures are not uncommon, but successful suits for excessive disclosures are virtually unknown. Arguably, a higher threshold for certain types of litigation, such as securities class actions (already somewhat constrained by the PSLRA of 1995), might encourage financial reporting that is less cluttered by disclosures that are now made (or mandated) for defensive purposes, although this posited relationship has not been firmly demonstrated.
The actual most likely cause for expanded disclosures is the simple fact that the complexities of business have exponentially increased over time. As businesses have become more complicated – e.g., with conglomerate forms of business and the consequent demand (and requirement) for “segment” reporting – it is inevitable that reports have gotten not only longer but more technically convoluted, and thus less digestible by lay investors. Additionally, the natures of everyday business transactions, even by relatively simple enterprises operating within only a single segment, have grown more complex. This is perhaps best exemplified by the widespread use of so-called derivative financial instruments, with even the “plain vanilla” examples, such as currency forwards and interest rate swaps, being subject to extensive narrative and tabular footnote explanations. Although these risk-management tools are widely, and appropriately, employed by all manner of businesses, the average – perhaps mythical – small investor has great difficulty in parsing this information, and is more likely to view it as obfuscatory than illuminating.
One challenge to streamlining financial reports by limiting them to “important” or “relevant” disclosures is that varying users inevitably have differing perspectives on what is most important or relevant. For one obvious example, shareholders’ concerns are with longer-term profitability of the investments they make, although nearer-term solvency concerns are also of interest; creditors are much more concerned with solvency and the ability to generate cash flows over the terms of the outstanding debts. These diverse points of view could well affect which disclosures might be seen as candidates for elimination or streamlining by each of these classes of stakeholders.
Financial statements cannot be aimed solely at “average” investors. General purpose financial statements (i.e., the ones governed by U.S. GAAP or IFRS) must serve a wide audience of users, from professional analysts to prospective employees, customers and suppliers. It is highly unlikely, even if massive research were first undertaken, that the accounting standard-setters and regulators would deign to define a narrowly limited set of informational “cues” that should be needed by users. In this regard, it seems that expansion of information requirements is all but inevitable, as new, presumptively useful disclosures are added to the existing ones.
Quality vs. Quantity
Perhaps, rather than continuing to pursue the “holy grail” of optimal disclosure quantity, it might prove more beneficial to focus attention on the (perhaps equally challenging) matter of disclosure quality. The SEC’s vaunted “Plain English” initiative of the late 1990s, including its promulgation of A Plain English Handbook: How to create clear SEC disclosure documents, with a foreword by Warren Buffett – in which even he acknowledges occasional challenges in reading financial reports, had some success in changing report drafting behavior. This has been reinforced by the Division of Corporate Finance’s (“Corp Fin”) comments on preparer submissions, which are reviewed at least once every three years. The Handbook cited as key deficiencies the excessive use of long sentences, the passive voice, weak verbs, superfluous words, legal and financial jargon, numerous defined terms, abstract words, unnecessary details, and unreadable design and layout, and it provided copious examples of how to avoid these mistakes. The challenge, of course, lies with the need to address inherently complex, technical business and accounting matters precisely enough to escape the risk of legal liability in an era of widespread litigiousness, while still “making it simple” for readers with decreasing attention spans.
Research and Proposals for Simplification of Financial Reporting
Disclosure simplification and possible elimination has been debated for years, with both FASB and its international equivalent, IASB, formally attempting to review existing requirements with eyes toward simplification. A number of such efforts have been made by standard setters and suggested by academicians over the decades, with virtually no results apart from limiting less than a handful of extant requirements to publicly-held preparers, thus giving to private companies almost-trivial relief from these presumed burdens.
A number of academic and quasi-academic writings, many dating from the 1990s, have raised the specter of communicating less with more – i.e., either deliberately or inadvertently obfuscating important information by burying it in a clutter of often trivial detail. Some have cited a possible “inverted U-shaped utility function” that might be understood as being somewhat analogous to the famous “Laffer Curve” suggesting a net decrease in tax revenues once an inflection point tax rate has been exceeded. In the information overload hypothesis, the quality of the user’s decision making regarding a reporting entity’s financial position and results of operations actually declines once some threshold is crossed, be it defined in terms of numbers of words or pages, complexity, language usage, or other yet-to-be determined criteria. It does not appear, however, that the accounting profession, and specifically its standard-setting bodies, has perceived this as a call to action. Further research by academic accountants and/or behavioral scientists would seemingly be of great potential importance.
One comprehensive review of the literature bearing on this (and other) matters was provided by law professor (and later SEC commissioner) Troy Paredes (“Blinded By The Light: Information Overload and Its Consequences For Securities Regulation,” Washington University Law Quarterly, 2003). He addressed information overload in the context of imperfect information, limited cognitive capabilities, and cognitive biases, as well as the presumption that the so-called weak form of the efficient capital market hypothesis (EMH) relieves individual investors of even the need to digest annual reports. He seemingly accepts the fundamental logic of the “inverted U-shaped curve of information overload,” but speculates that the curve might turn downward beginning at a higher quantity of information, and then decline at a less-steep rate, in the case of experts. This supposition, if correct and coupled with the EMH, would tend to imply that concerns over information overload might be unwarranted, since “experts” digest complex financial filings and then make judgments that are shared, implicitly, with individual or less cognitively capable investors via the efficient workings of the market.
On the other hand, substantial research has found that experts and non-experts alike make use of relatively few “cues” when making decisions. If this observation is accurate, then the deleterious consequences of information overload, if they exist, would equally apply to all users of financial statements, neophytes and professionals alike.
According to another Wall Street Journal article (“To Be Clear, SEC Reviewers Want Filings in Plain English, Period,” September 12, 2014), Corp Fin in 2013 alone sent 8,800 comment letters containing 66,000 questions to 4,600 companies, demanding clarifications and changes to expositions made in their filings. Although most of the comments were of a more substantive nature, some pertained to such minute matters as type size and punctuation, but many more demanded rewrites to simplify narratives and to eliminate or define jargon used.
Nevertheless, it appears that preparers’ efforts to meet the SEC’s Plain English challenge remain a work in progress. It is not clear that the accounting establishment, comprised of technicians, would be the ideal candidate to pursue research on the effectiveness of communications, but this nonetheless is probably an important avenue for further attention.
Summary
In conclusion, further research, by appropriately trained professionals and academicians, into both information overload/decision making efficacy and communication effectiveness might finally bring about improvements in general purpose financial reporting. The profession should begin to support those efforts.