Have We Created Financial Statement Disclosure Overload?

By Arthur J. Radin

E-mail Story Print Story

We now have accountants and lawyers all over the country writing massive disclosures for filings with the SEC. I sincerely question whether anyone can or does read all of that information. Much of what is written is so long and so opaque that its usefulness is questionable. If this was an exercise in opacity, it would be an amazing success. What comes to mind is the old saying: “I wrote a long letter, as I did not have time to write a short one.” I have sampled twenty-five 10-K reports; they average 150 pages. No one seems to have time for a short report. There is much significant information to be found in a long financial report. But as an investor looking at the number of pages that are boilerplate, redundant, immaterial, irrelevant, or overly fact-packed, I immediately suffer from MEGO—my eyes glaze over.

There are several reasons why the profession should be worried about excessively long financial statement disclosures:

• The length of the reports turns off reasonable readers;
• Important information is hidden;
• The expense is excessive for the result.

The Length of the Reports Turns Off Reasonable Readers

There is significant anecdotal evidence that the footnotes to a company’s financial statements are read only by the registrants’ drafters, accountants, the SEC staff, and, maybe, company counsel. I know from personal experience that knowledgeable securities lawyers avoid the footnotes to financial statements because “that’s accountants’ stuff.” If securities lawyers do not read what we produce, who will?

The most poignant case of unread footnotes is, of course, Enron. At the time, a newspaper did report that a representative of one of the large investment institutions said, “We were not into the footnotes.” If they had been interested, they would have read notes such as:

• “Enron recognized revenues of approximately $500 (million) related to the subsequent change in the market value of these derivatives.”
• “At December 31, 2000 Enron had derivative instruments … on 54.8 million shares of Enron common stock … an average price of $67.92 per share on which Enron was a fixed price payer.”

They would have also read references to many related-party gains and other guarantees.

We all remember how “shocked” we were when all of this “came out.” Had anyone previously read the footnotes? I know I did not. Before the exhibits, Enron’s 10-K filing ran 79 pages on EDGAR, far too much for investors in a $60 billion company to read (Enron Corp. 10-K, fiscal year ended December 31, 2000).

Of course, there is the question of whether, in the six years since Enron’s collapse, things have changed. And the answer is yes, they have; they have gotten worse. Reports continue to grow longer. I cannot remember an accounting pronouncement that reduced disclosure. My random sampling of reports of published 10-Ks reveals that some run to 200 pages. Why?

• Compensation disclosures have grown.
• Risk disclosures have grown.
• Pension accounting disclosures have grown.
• Stock option disclosures have grown.
• Income tax disclosures are about to grow.
• Auditors’ reports have more than doubled.
• Disclosures such as future accounting changes have multiplied.

I have to admit that while I am paid to read the 10-Ks of the public companies my firm audits, and it is my main responsibility, it ain’t easy. They are boring. Just imagine being the CEO of a public company with a 176-page 10-K to read. Hmmm. I have worked on many 10-Ks during my career and I will admit that the notes, even mine, are not written to be read. They are written to comply with a lot of rules.

Of course, this problem doesn’t apply only to annual reports. Quarterly filings can run 30 pages, and, as most investors will agree, merger proxy statements are even worse than financial statements. As I write this, there is one on my desk that runs over 400 pages. And that length is not unusual.

Important Information Is Hidden

If a company today wanted to hide information, but technically be protected, what better place to hide it than in the footnotes to the financial statements or in the risk factor and operations sections of the 10-K? This is exactly what happened in the case of Enron. I have seen risk factor sections running 10 pages and management’s discussion and analysis (MD&A) sections totaling over 50 pages.

There is no distinction between the critical and the obvious in many of these reports. Information of interest, or even of potential concern, to investors can be hiding in plain sight.

The Expense Is Excessive for the Result

Then there is the cost. In a recent article in the Wall Street Journal, a CFO of a public company complained about the cost of the audits. What he failed to mention is the increasing length of the footnote disclosures. All of those disclosures require the registrant’s staff to compute and draft, the independent auditors to check and review, the audit committee to read, and management to understand. All of that is expensive, and no one I know reads the product.

There is great debate about the costs. I have read articles indicating that the increases in the fees of the Big Four are not up significantly since the implementation of SOX. What these articles do not compute is the cost of the work that has been outsourced to other firms, frequently the same Big Four. One CFO of a New York Stock Exchange–listed company, when asked whether I could refer a tax question to his auditors, exclaimed: “Any firm but them. If I use them I must explain it to the audit committee. Anyone else but them.”

Why Has This Happened?

Today there is no constituency for reducing disclosure. While I have heard representatives of the SEC staff request in speeches that duplication be reduced and that obsolete disclosure be eliminated, the staff is not consistent in this area. In SEC comment letters I have received many requests for information in more than one place but never a comment requesting disclosures be eliminated. Nor can I recall any significant reduction in disclosure requirements from FASB. To be fair, there are occasional disclosure reductions from the SEC (e.g., the small business disclosure forms).

This is a classic problem with either no one, or everyone, at fault. The latest cause celebre is “transparency.” What use is increased transparency when no one took advantage of less-voluminous transparency available during the Enron era? The latest example is FIN 48, which requires a table on income tax uncertainty. I think the only people FIN 48 will help are securities lawyers and government tax auditors (full disclosure: I have had FIN 48 billings). A recent article favorably viewed the disclosures of some of the large companies; it did not mention that those significant disclosures had already been in the footnotes.

There is, however, some blame to be distributed:

• The SEC, a government agency, writes rules. The SEC staff focuses on what is missing; it’s their job. There is little incentive to eliminate disclosures.
• FASB also writes rules requiring disclosure. There seems to be no incentive for FASB to reduce disclosure.
• The auditing firms, including mine, look upon disclosure as protection. There is no financial incentive for us to reduce disclosure.
• While lawyers are generally not paid by the word, if one reviews the disclosures they recommend, one would believe that they are.
• I have never seen an article by a member of the investment community asking for thinner annual reports.
• Congress, in the Private Securities Litigation Reform Act of 1995, gave companies a legal protection from litigation relating to disclosures of estimates of future financial information if there was an appropriate caveat. The SEC said that the caveat could not be boilerplate. Therefore, on every 10-K, and many press releases, there is this pseudo-boilerplate paragraph that states that the future is not assured. Lawyers struggle to say the same thing slightly differently.

Some of the disclosures are politically correct, but probably useless. All of the corporate governance material in the proxy statement is fairly useless. Disclosures such as the audit committee charter, a description of how board of directors members are chosen, qualification of board members, board voting policies, and board independence standards are, in fact, neither useful nor interesting.

What Will Reduce Disclosure Overload?

What is the solution? First, we need to readdress the concept of materiality. Declaring something immaterial has become a sin, but things don’t need to be this way. In today’s climate, auditors know better than to suggest to an SEC reviewer that something is immaterial. To do so has the opposite effect: The matter immediately becomes essential or even suspicious. Personally, I believe that most of the disclosures in a 10-K are immaterial to an investor. For example, I do not believe that the disclosures about auditors’ compensation are at all useful for an investor; the disclosures are useful only to an auditor thinking of bidding on the audit. I think the executive compensation information is most useful for people considering their salaries and whether to ask for a raise. While interesting, do these disclosures impact investment decisions?

Next, we need “sunset” rules on disclosures. Once written, they almost never go away. We need to find a way to evaluate user demand and disclosure effectiveness. For example, corporate managers will sometimes stop distributing a monthly report. If no one asks for it in a week, the report is killed and an interested user has to go through the process of requesting a new report, which requires significant effort. I do not know how this would work in our current financial reporting system, although one could eliminate a disclosure and see if it is missed.

My suggestions of areas for where disclosure could be reduced are the following:

• Lengthy disclosures of risk factors, such as “If our customers stop buying our product, sales may decrease,” “Technological changes could make our product obsolete,” “If our financing is inadequate,” and so on.
• Interminable discussions in MD&A about operations. After about 10 pages, I think anyone would go to sleep.
• Disclosures in MD&A and the footnotes regarding changes in accounting principles. The vast majority say that the new principle will “not have a material effect”; the rest generally say that “management is evaluating the effect.”
• Pension disclosures have become immense. I appreciate that this is a sensitive area where many companies face significant exposure, but the notes I have read are too lengthy for a reader.
• Critical accounting policy in the MD&A seemed like a wonderful idea when the SEC adopted it. It has become filler for a company that is evaluating goodwill; why it has an allowance for deferred tax assets; how its bad debt allowance is determined; or how it evaluates inventory obsolescence, none of which is particularly useful.
• Information easily found on the Internet, such as quarterly earnings, recent prices, repetition of the prior year’s MD&A, and views on the overall securities market. All of this information used to be difficult to find other than in the annual report. Now its inclusion is redundant.
• There is lots of boilerplate: auditors’ opinions, warnings about disclosures of future trends, many accounting-principle disclosures (e.g., we value our inventories at the lower of cost or market), the footnote on estimates, and so on.
• The details of stock options have become overwhelming.
• The expanded disclosure of executive compensation has left readers of financial statements—at least the ones I’ve spoken to—aghast. It’s too much.

Any change will require some effort on the part of the accounting establishment. Certain steps could be taken by the following bodies:

• Simplifying and condensing the audit report: the PCAOB
• Eliminating all of the required CEO and CFO attestations: Congress
• Dropping immaterial footnotes and boilerplate: the SEC and FASB
• Changing the “necessary” future information disclosure: Congress
• Reducing the disclosure of “risk factors”: the SEC and the legal profession
• Eliminating descriptions of recent accounting changes for pronouncements having no effect: the SEC and the auditing profession.

The ‘Homegrown’ Approach

Interestingly enough, published reports that are “homegrown” and not simply a mechanical copy of the required 10-K do a much better job of communicating financial results efficiently. This approach is expensive, however, because management needs to involve public relations staff to help to write the report, it needs to have lawyers evaluate all of that boilerplate and duplication, and it needs to have auditors evaluate all of that immaterial information. When one considers the effort, it is understandable that so many companies opt to copy the 10-K and add a president’s letter and a picture of the board of directors.

We need to create a method of creating financial reporting that is user-friendly. Our society has created many ways of communicating that are highly effective. The advertising industry has done a spectacular job communicating a branding message in under 30 seconds. Cartoonists are expert at communicating complex thoughts with a little sketch and a few words. Those of us in accounting and financial reporting have created lengthy disclosures, but have fallen short in communicating financial information.

©2009 The New York State Society of CPAs. Legal Notices