Is It Possible to Defog America’s Corporate Financial Reports?

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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 things about the paper is, we try to look at both groups of managers: the benevolent managers whom Delphine was talking about, and some managers who are not so benevolent. When they have incentives to obfuscate, they’re not providing those supplementary disclosures.

Knowledge@Wharton: The kinds of remedies you’re suggesting could have the market focused on the benevolent companies a little bit more. So that could have some effect on behavior also.

Guay: Yes, or penalize the ones that aren’t providing those supplemental disclosures.

Knowledge@Wharton: Which, if any, of the conclusions that you came to in the paper surprised you?

Guay: One of the things that I think people found most surprising was this: Within the academic literature to date, the complexity of financial statements has typically been believed to be a choice by managers. That managers are choosing to make financial statements — in the literature, it’s called “foggy.” And we have that in the title. Did managers choose to fog up the financial statements with complex language and additional words that don’t necessarily have to be there?

Up till now, the opinion among many academics — and even the public — has been that there is this pervasive fogginess in the financial statements. And one of the things we find is that no, it’s not the average effect. It’s not the pervasive effect.

The pervasive effect is that managers are trying to make things transparent. I think that was probably one of the more surprising things — one of the things we certainly had to convince our colleagues of when we were presenting and writing the paper.

Knowledge@Wharton: In other words, the companies are tied down like Gulliver by the regulations that say they have to provide all of this information?

Guay: Yes. It’s really a difficult balance, I think, for the companies, because the companies themselves are getting more complicated. Even in the absence of the regulations, they would have to say more to explain that complexity. Then you have the regulations that are being lumped on top of that. Then you have the litigation concerns that are being lumped on top of that. The companies are trying to play a very complex game, and on top of that, they’re trying to provide information to their customers.

Even when they’re well intentioned, things can get complicated.

Knowledge@Wharton: What are some of the practical implications of this? You’ve talked a little bit about some of these remedies. How do they work, and how much do they help?

“Companies themselves are getting more complicated. Even in the absence of the regulations, they would have to say more to explain that complexity.”–Wayne Guay

Samuels: Well, I think one of the practical implications for regulators is that there seems to be a real need to try to reduce the length of financial statements, and the complexity of their content. And regulators have recently launched a series of initiatives.

Specifically, the SEC launched the Disclosure Effectiveness Initiative, to try to find ways to work with firms to encourage them to reduce the length of financial statements, for example, by reducing redundancies, or by reducing the complexity of the accounting regulations themselves, and other things like that. I think there really is a continuous movement to try to reduce some of these uncertainty problems.

Knowledge@Wharton: Are there other misperceptions held by the public or the media or others that this study might dispel?

Guay: Well, you know, before we started the show, Delphine was talking about a General Electric annual report that’s … 110,000 words?

Samuels: Yes.

Guay: I think the general public looks at these really thick, complicated disclosures, and it’s become virtually impossible for anybody but the most sophisticated of investors to pick one of these things up and distill it. And even among the sophisticated investors, the analysts and people on Wall Street, it’s complicated. I think public perception, when they see all this extensive disclosure, is to think, “Well, why could this be happening?”

I think that the idea that regulators are over-regulating is something that a lot of people will conclude. Also, the idea that companies are trying to fog things up, that the managers that are trying to make things more complicated, is something that people will tend to think as well.

What gets missed there is that companies are just getting more and more complicated. We’re seeing that not only with disclosures. I work in corporate governance and executive compensation as well, and in these more complicated companies, you find much more complicated governance, compensation, business strategies, disclosures. The complexity of firms today as compared to 25 years ago has created a lot of misperceptions about the information that’s out there, and about how these businesses actually work. So hopefully, what we’ve provided is a little bit of insight as to how managers are trying to think about managing these very complicated situations.

Knowledge@Wharton: We also talked a little bit before the show about the costs for them to be doing this — huge teams, lots of money. Can you discuss that a little bit?

Samuels: Certainly companies spend a lot of money on these reports. They have to employ public accountants, auditors. They have to have general counsel, a legal team to try to address all the required disclosures that they have to provide in their 10-Ks and other filings. And they certainly have large teams of accountants to try to address that. The costs are tremendous, and have been increasing over the last decade or several decades, even.

Guay: And can easily run, for a large company, into the tens and millions of dollars. So it is a big expense for these large companies. And it’s perhaps an even bigger issue for the small companies.

For a company like Goldman Sachs, it’s a pain in the neck to have to write a 500-page annual report. But they’ve got the resources and the people to do it. The smaller firms are the ones that are really, I think, struggling and suffering, because they have to comply with most of the same rules, but they don’t have nearly the resources. There’s an economy of scale, if you will, involved with putting together some of this information. There are very complicated computer systems that need to be put in place, and people who need to be hired. For smaller firms, it can be a real strain on the resources to comply with some of this.

“Managers seem to be aware of the informational problems that are caused by these overly-complex and very lengthy financial statements.”–Delphine Samuels

Knowledge@Wharton: It sounds like that’s almost unavoidable, because of the complexity of the regulations and the complexity of the businesses. What you’re finding isn’t going to affect the cost of doing this. But that as far as the public and regulators and other interested parties are concerned, it can be made more clear. You can have clarity around these reports instead of fog.

Guay: Yes. Delphine and I were talking about this earlier. I think part of what might be helpful to the regulators is to think about, in a more holistic way, all of the different types of disclosures and information that are out there. Rather than regulating this medium, and then that medium, and then this medium, and this standard, to think about all the different ways the companies can provide disclosures, and think about it as a package of information. There may well be more cost-effective ways to provide that package of information.

Knowledge@Wharton: What will you look at next in this area? How would you follow up on this study? Are there plans to follow up on it?

Guay: Yes. Delphine’s a Ph.D. student, so she’ll have lots of plans to follow-up on everything.

Samuels: Yes, I think with the new regulatory initiatives that are launched by the SEC, but also FASB and other regulators, there’s a lot of room for improvement, to render financial statements less complex. Firms are definitely going in that direction — trying to come up with more executive summaries at the beginnings of their financial statements, trying to streamline them, eliminate redundancies, eliminate outdated items.

So I think there’s certainly a movement in that direction. And I think it would be interesting in the future to look at whether the complexity of these financial reports actually goes down. And when that happens, what the implications are for managers? Are there other ways of communicating this information? Will investors start using the financial statement more as a tool, rather than just it being a compliance mechanism? There’s a lot of interesting potential research.

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Is It Possible to Defog America’s Corporate Financial Reports?. Knowledge@Wharton (2016, April 19). Retrieved from http://knowledge.wharton.upenn.edu/article/possible-defog-americas-corporate-financial-reports/

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accessed February 19, 2017. http://knowledge.wharton.upenn.edu/article/possible-defog-americas-corporate-financial-reports/


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