Guiding Through the Fog: Financial Statement Complexity and Voluntary Disclosure

“I am raising the question here and internally at the SEC as to whether investors need and are optimally served by the detailed and lengthy disclosures about all of the topics that companies currently provide in the reports they are required to prepare and file with us. […] In some cases, lengthy and complex disclosure may indeed be a direct result of the Commission’s rules.”

— SEC Chair Mary Jo White[1]

Regulators have long voiced concerns over the effectiveness of overly complex and lengthy financial statements in communicating information to investors. Detailed and lengthy disclosures can increase information processing costs and negatively impact financial statement users. Consistent with these concerns, existing academic studies show that complex financial statements can adversely affect individual investors, and increase uncertainty about the firm’s value even among large and sophisticated information intermediaries such as financial analysts and credit rating agencies.[2] Over the last several decades, regulators have launched a series of initiatives in an effort to mitigate financial statement complexity, such as the SEC’s “plain English” rule in 1998 and the FASB’s current Disclosure Framework project. Despite these efforts, however, financial statement complexity continues to grow.

In our study, we examine whether managers take action to mitigate the negative effects of complex financial statements by using alternative disclosure channels. We argue that voluntary disclosures, such as management forecasts and 8-K filings, represent alternative channels that allow managers to communicate information more efficiently to investors. As illustrated by the quote above, the rules surrounding financial statement disclosure impose constraints on managers that may necessitate the issuance of complex financial statements, particularly if the firm’s underlying economic activities are complex. For example, firms may engage in complex transactions or operating strategies which might be difficult for investors to understand. In this circumstance, we expect managers would provide additional disclosures following (and perhaps prior to) the release of complex financial statements in order to help investors understand the performance implications of these transactions or strategies. In this case, we expect a positive relation between financial statement complexity and voluntary disclosure.

On the other hand, a more cynical view is that complex financial statements reflect an intentional choice by managers to obfuscate and hide information from investors, for example poor performance.[3] In this circumstance, managers choose to accept the negative effects of financial statement complexity (as their personal benefits from a low quality information environment exceed the costs) and would not be expected to provide investors with supplemental information outside of the required financial statements. In this case, we expect no relation––or perhaps even a negative relation––between financial statement complexity and voluntary disclosure.

We find that managers tend to provide more voluntary disclosure when financial statements are complex. Specifically, complex annual reports, as measured by the Fog index (a proxy for the readability of written text) and the length of the report, are associated with more management forecasts and 8-K filings. Moreover, we find that this association is greater when the financial statements are accompanied by a greater reduction in the liquidity of the firm’s shares. These results suggest that managers actively attempt to mitigate the effects of complex financial statements by issuing more voluntary disclosure, particularity when they are associated with an increase in investors’ information processing costs.

We next examine the association between financial reporting complexity and voluntary disclosure in settings where managers may have different incentives to mitigate the effects of complex financial statements. First, we predict that managers under a high degree of scrutiny from external monitors have stronger incentives to maintain the quality of the information environment, and are more likely to increase voluntary disclosure in an effort to mitigate the negative informational effects of complex financial statements. Consistent with this prediction, we find that firms with a higher analyst following and more institutional investors tend to issue more management forecasts and 8-K filings when their financial statements are complex.

Second, we predict that managers have lower incentives to mitigate the effects of complex financial statements when performance is poor or when earnings are being managed. These situations can give rise to information-based agency problems between managers and shareholders, as managers who are performing poorly may benefit from a low quality information environment (e.g., a reduced likelihood of termination or reputational damage, or an inflated stock price), whereas shareholders bear the costs (e.g., reduced liquidity, greater cost of capital). Consistent with these predictions, we find that the positive relation between financial statement complexity and voluntary disclosure is weaker when the firm underperforms its industry peers, posts a loss, and has abnormally large accruals (non-cash earnings).

Our study provides evidence that managers increase efforts to communicate through alternative disclosure channels when their financial statements are complex, and that these efforts are more pronounced when the financial statements are associated with higher information processing costs and are a function of the firm’s external monitors and performance. Our results suggest a more nuanced view of how financial statement complexity affects the mosaic of public information about the firm––while prior research documents the negative effects of financial statement complexity, our results suggest that some firms attempt to mitigate these effects using voluntary disclosure.

ENDNOTES

[1] The Path Forward on Disclosure, National Association of Corporate Directors – Leadership Conference, 15 October 2013.

[2] See e.g., Miller, B., The effects of financial statement complexity on small and large investor trading, The Accounting Review 85: 2107–2143 (2010); Lawrence, A., Individual investors and financial disclosure, Journal of Accounting and Economics 56: 130–147 (2013); Lehavy, R., Li, F., and Merkley K., The effect of annual report readability on analyst following and the properties of their earnings forecasts, The Accounting Review 86: 1087–1115 (2011); Bonsall, S., and Miller, B., The impact of financial disclosure complexity on bond rating agency disagreement and the cost of debt capital, Working Paper (2013).

[3] See e.g., Li, F., Annual report readability, current earnings, and earnings persistence. Journal of Accounting and Economics 45, 221–247 (2008).

The preceding post comes to us from Wayne R. Guay, Yageo Professor of Accounting at the University of Pennsylvania, Wharton, Delphine Samuels, PhD Student at the University of Pennsylvania, Wharton, and Daniel J. Taylor, Harold C. Stott Assistant Professor of Accounting at the University of Pennsylvania, Wharton. The post is based on their recent paper, which is entitled “Guiding Through the Fog: Financial Statement Complexity and Voluntary Disclosure” and available here.