Is It Possible To Defog America’s Corporate Financial Statements? by Knowledge@Wharton

Wharton’s Wayne Guay and Delphine Samuels discuss their research on corporate financial reports.

For anyone other than a highly dedicated professional, it’s virtually impossible to effectively parse a big company’s financial statements anymore. They’re absurdly dense, complex, jargon-filled, and longer than a Russian novel. More to the point, all of those issues have been getting worse for years. That part is obvious. Why it’s happening is not.

A recent paper by Wharton accounting professors Wayne Guay and Daniel J. Taylor, and doctoral candidate Delphine Samuels, “Guiding Through the Fog: Financial Statement Complexity and Voluntary Disclosure,” digs into the root cause, and suggests solutions that could get investors and regulators the information they need without burying it under a mountain of paper that they don’t. Guay and Samuels offer their views in this Knowledge@Wharton interview.

An edited transcript of the conversation appears below.

Knowledge@Wharton: Your paper is probably a real breath of fresh air for almost everyone who considers financial statements impenetrable. They seem to get more impenetrable every year — longer, more complicated. One example, which I see you’ve brought with you, is from Goldman Sachs, and this is 480 pages. What does this document represent?

Wayne Guay: This is the 10-K for Goldman Sachs from 2012. And you can see that it’s quite thick. It would be better as a doorstop than as an informative document. It’s amazing.

Knowledge@Wharton: It looks heavy — in weight and in content.

Guay: Yes.

Knowledge@Wharton: So the question is, financial statements: They’re getting longer. They’re getting more complicated. Does it have to be that way? Are they so complicated and long because companies are trying to hide bad news, in some cases? Or is it just, sometimes companies are so complicated, their business is so complex, that they need to explain it in a very long document? Or are there other reasons?

To start off, would you give a short summary of the basic ideas behind your research?

Guay: As you noted, financial statements have gotten more complicated. They’ve gotten longer. In part, that’s been due to regulations requiring firms to provide more information about certain transactions. But also, firms are getting more complex themselves. Global firms today are involved in lots of more complex transactions than they would have been involved in, say, 20 or 30 years ago, so they have just created more and more information, perhaps to the point where there’s information overload. In fact, evidence suggests that the average 10-K annual report is 50% bigger today than it was in 2005.

Knowledge@Wharton: That’s quite a big jump in 10 years.

Guay: It is a big jump, yes. And as we’ve seen, regulation over the last 15 years — Sarbanes-Oxley, some rules coming out of the financial crisis — firms are just required to provide more and more information. Some of it might be due to litigation concerns as well, that companies feel like they need to provide more information and cover themselves in the event that some of that information might be relevant.

What we try to do in this paper is assess whether companies that do have these complicated financial statements have ways that they can mitigate some of these transparency problems. Can they follow up — or pre-empt, perhaps — some of the complexity in the annual reports with additional disclosures like management forecasts or press releases and 8-Ks and those sorts of things?

“Evidence suggests that the average 10-K annual report is 50% bigger today than it was in 2005.”–Wayne Guay

Knowledge@Wharton: In other words, can they offer some kind of guidance that would simplify and be more straightforward and shorter?

Guay: And perhaps distill information. You could imagine an annual report that gets filed, and managers look at their investors, look at the market, and say, “I don’t think the market fully understood the implications of certain important disclosures we had this quarter, or this year. Let’s try to help them understand what we mean by that.”

Perhaps they could even give investors a forecast of next period’s earnings, to say, “You might not understand how this information maps into next period’s earnings. We’ll help you figure that out. We’ll give you our guess as to what next period’s earnings will be in response to that disclosure.”

Knowledge@Wharton: What would you say are the key takeaways from your research?

Delphine Samuels: I think that one of the key takeaways is certainly that managers seem to be aware of the informational problems that are caused by these overly-complex and very lengthy financial statements, because they seem to be providing additional management forecasts — forecasts of sales or earnings or other accounting numbers.

They also seem to be providing a lot more press releases, which contain all sorts of information that might help reduce the uncertainties that are caused by these complex financial statements. And they filed more frequent interim disclosures, in the forms of 8-Ks, which are much shorter and are filed whenever managers feel the need to disclose something that could be material.

Knowledge@Wharton: It sounds like companies are buried under regulation, and they’re forced to do this. Is it sometimes also though, they like to obfuscate? In some cases are they thinking, “If we make this more complicated, it might be harder for investors to see that this not-so-wonderful thing happened, and we can move on to the next quarter”?

Samuels: Yes, I think that certainly could be the case that in some instances. Managers would want to obfuscate information, for example, if they’re trying to hide poor performance, or if they’re trying to manage earnings, trying to paint their performance in a better light. In these cases, I think we would not expect to see managers provide more voluntary disclosure subsequently.

There are these two countervailing effects that could be going on. Overall in our study, we find that the predominant effect is this positive association between financial statement complexity and voluntary disclosure. In other words, managers are benevolent, so to speak, and are trying to really overall reduce the complexities and the uncertainties related to their finances.

Knowledge@Wharton: Could the market decide that they feel more comfortable with the companies that are trying to be more transparent? Might those companies benefit in some way, versus those that are maybe trying to hide things?

Guay: Yes. We try to estimate whether the market gets some degree of comfort when these new disclosures come out, and we find that when the managers put out these additional disclosures, that uncertainty of the market, liquidity in the market actually improves following them.

But just to follow up with what Delphine was saying: Although we do find, on average, that managers don’t appear to be trying to obfuscate information, we do try to look for managers who have greater incentives to obfuscate it. And in fact, we find that there are managers out there who do have incentives to obfuscate information. In those settings, we find that it’s less likely that managers are going to provide those supplemental disclosures.

“Although we do find, on average, that managers don’t appear to be trying to obfuscate information, we do try to look for managers who have greater incentives to obfuscate it.”–Wayne Guay

One of the nice

1, 23  - View Full Page