How Material Are Disclosures in Annual Reports?

The Financial Accounting Standards Board (FASB) and the Securities Exchange Commission (SEC) (collectively, “regulators”) have expressed concern over “disclosure overload,” or the concern that the sheer volume of disclosure in annual reports makes it difficult for investors to identify and incorporate relevant information into their decisions (White 2013). While academic research finds that annual reports have become longer and less readable (e.g., Dyer et al. 2017), regulators attribute disclosure overload in part to high levels of immaterial disclosure that make it difficult for investors to recognize the material, or relevant, information in these reports.

Interestingly, firms are not required to disclose immaterial information (that is, information that would fail to change the mind of a current or prospective stakeholder). The FASB and the SEC make it clear that their disclosure requirements apply only to the extent the information is material – leading one to question why firms choose to provide immaterial disclosure in their annual reports. In a new paper, I seek to provide insight on this issue by examining the relative materiality levels of firms’ quantitative annual report disclosures.

Determining whether an item is material, and therefore should be disclosed in the annual report, is an often ambiguous process. Part of this ambiguity stems from the fact that firm managers must assess not whether they personally consider an item material, but whether an item could be considered material by current or potential investors. Managers must assess whether a piece of information has the potential to influence investors’ decisions. Furthermore, accounting standards and financial reporting regulation typically don’t provide bright-line guidance for assessing an item’s materiality because materiality has both quantitative and qualitative components. In particular, while we generally expect smaller dollar amount items to be less material and therefore less influential in investors’ decisions, it may very well be that some small dollar amount items have important implications for firm value (and by extension for investors’ decisions). Further complicating these assessments is the risk that an item that appears immaterial in today’s business conditions (and therefore would not need to be disclosed) may be considered material in the future if conditions change.

As a researcher, I cannot definitively determine whether each disclosure in each firm’s annual report is material or not. However, to provide some insight into regulators’ concerns, I examine the relative materiality of firms’ quantitative annual report disclosures: What is the magnitude of the dollar amounts disclosed, relative to the firm’s total assets? I first calculate the ratio of each dollar amount disclosed in a firm’s Form 10-K annual report relative to the firm’s total assets. I include dollar amounts from both the text and the tables in the report. For example, if a firm has total assets of $10 million, and discloses capital expenditures of $800,000, the ratio is 0.08. I then calculate the median value of these ratios for each firm’s annual report. Higher values of this measure indicate higher materiality disclosures. If a firm’s materiality measure is 0.02, then the median value of its quantitative disclosures is 2 percent of total assets. While this measure does not tell us whether the firm is disclosing immaterial information, it provides insight into whether the firm is disclosing generally larger or smaller dollar amounts, relative to its size (i.e., total assets). On average, I expect relatively smaller dollar amounts are less material (i.e., less likely to influence an investor’s decisions) than relatively larger dollar amounts.

I create this measure for all Form 10-Ks filed with the SEC for fiscal years ending during 1997–2017. My final sample has 36,655 annual reports. I find the median materiality of firms’ annual report disclosures has decreased 34 percent over the sample period — that is, firms are disclosing relatively smaller dollar amounts in their annual reports over time. In 1997, the median dollar amount disclosed in the average Form 10-K was almost 2 percent of total assets; in 2017, this amount was down to 1.3 percent of assets.

To provide insight beyond these descriptive results, I also estimate formal regressions to better understand why firms disclose relatively more or less material dollar amounts. Several interesting results emerge. First, I find firms disclose significantly smaller dollar amounts (i.e., provide lower materiality disclosure) when macroeconomic uncertainty is higher, likely in response to higher investor demand for information. Second, I examine the association with a firm’s ex-ante litigation risk. Firms can be sued for failing to disclose information that a manager may have deemed immaterial ex-ante but was considered material by investors ex-post. Accordingly, I find that firms with higher litigation risk tend to disclose lower materiality information (i.e., smaller dollar amounts) in their annual reports. Finally, I also find that more innately risk-averse managers choose to provide lower materiality disclosure, presumably because these managers are less tolerant of the potential risks of nondisclosure (e.g., litigation; reputational damage). Together, these results suggest that managers choose to disclose smaller dollar amount items to protect themselves and their firms from the risk of failing to disclose an item they incorrectly deemed immaterial. Furthermore, it is important to note that these results are incremental to the effects of annual report disclosure length and firms’ operating complexity on their disclosure practices (e.g., firms with derivatives; pensions; multiple geographic segments; recent acquisitions; etc.).

I also conduct preliminary analyses to examine whether annual reports with lower materiality disclosures are more difficult for investors to process. While I find some evidence that such reports are associated with higher measures of investor uncertainty, the results are mixed. Importantly, however, I do not find any evidence to suggest that annual reports with lower materiality disclosure (i.e., annual reports that disclose smaller dollar amounts) provide investors with more useful information. These preliminary results lend some credence to regulators’ concerns about annual report disclosure overload but require additional consideration by future research.

These results may be informative to regulators and standard setters as they create more effective financial reporting. If regulators want firms to disclose less immaterial information, my results suggest they consider (1) reducing one-size-fits-all disclosure regulations and (2) providing more legal (i.e., safe harbor) protection for managers that opt not to disclose information because they believe the information to be immaterial at the time of the disclosure.

REFERENCES

Dyer, T., M. Lang, and L. Stice-Lawrence. 2017. The evolution of 10-K textual disclosure: Evidence from Latent Dirichlet Allocation. Journal of Accounting and Economics 64: 221–245.

White, M.J. 2013. The Path Forward on Disclosure. National Harbor, MD.

This post comes to us from Professor Jenna D’Adduzio at the University of British Columbia’s Sauder School of Business. It is based on her recent paper, “The Materiality of Quantitative Disclosure in Annual Reports,” available here.

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