It’s
no secret to investors that annual reports filed by U.S. companies
are becoming increasingly complex. Many reports in the business
press over the past decade cite concern that the proliferation of
required disclosures accompanying financial reports makes it
difficult to decipher a company’s performance and identify factors
that drive performance.
We recently tracked the information used by professional and
retail investors to examine how they cope with this complex
information environment. In this article, we use the data to provide
answers to some key questions. How much of the information in an
annual report do investors use in making their investment decisions?
How do investment professionals such as financial analysts differ
from retail investors? If they have a choice about where to find
specific types of information (that is, in the financial statement
footnotes or in other sections of the annual report), which location
do they prefer?
Our findings have implications for investor decision-making,
as well as for current efforts to simplify financial reporting and
to enhance the relevance of business reporting through improved
disclosure via important channels beyond the face of the financial
statements themselves, such as Management Discussion & Analysis
(MD&A).
INFORMATION COMPLEXITY AND THE FINANCIAL MARKETS
These
issues are important for two reasons. First, U.S. corporations that
prepare financial reports have long expressed concern about the
growing complexity of required disclosures. Essentially, many in the
business community who support simplification of financial
statements and related disclosures are concerned about the
increasing costs of preparing required disclosures and the effects
of the resulting “information overload” on investor decision
quality.
The SEC recognized the importance of this issue during the
proceedings of the Advisory Committee on Improvements to Financial
Reporting. This committee’s charge focused on ways to reduce
unnecessary complexity, making information more useful and
understandable to investors. FASB announced on July 8, 2009, that it
was following up with a new disclosure framework project to address
the “disclosure overload” and to “help eliminate redundancy or
otherwise outdated GAAP disclosure requirements.” However, there is
little evidence on how investors actually do use
information in their investment decisions. This article addresses
that issue.
Second, nonprofessional investors form a significant
proportion of the market. While the era of the “day trader” may have
passed, many individuals manage their own retirement accounts and
make buy/sell decisions. While many nonprofessional investors have
years of experience in trading stocks, most lack the education of
financial professionals. Does the information they acquire when
reviewing an annual report imply differences in the ways in which
they make investment decisions? Do any differences in information
use suggest disadvantages that might inhibit the performance of
their portfolios, relative to investment professionals? We address
these questions by comparing information use between the two
groups.
OUR PROCEDURES FOR MEASURING INVESTORS' USE OF INFORMATION
Our
study on these issues involved data from 73 investment professionals
and 118 nonprofessional investors, who were provided with an annual
report (Form 10-K) adapted from the annual report of a public
U.S.-domiciled high-tech company, and asked to make investment
decisions using their normal practices.
The investment professionals came from a variety of
financial advisory roles, including both buy-side and sell-side
analysts. Our criteria for professionals included experience in
evaluating information for equity valuation; thus, the sample
includes financial analysts, venture capitalists, brokers and
financial advisers.
The retail investors had on average 10 years of personal
investing experience. Criteria for inclusion of nonprofessionals
included income greater than $75,000 and availability of assets
greater than $50,000 for investing.
While we based case materials on an actual company for
realism, we disguised the company’s identity (that is, its name and
the names of personnel and products) to prevent participants from
looking up the actual stock price from public sources. Participants
responded to the case using a dedicated website, clicking on links
to access information they wanted to consider in judging the risk of
the company and predicting its future stock price. The information
categories were listed in a table-of-contents fashion down the left
side of the web page, providing a format very similar to that
provided in a PDF format 10-K document. Software tracked the
information they accessed.
As with an actual annual report, company information included
the following major categories: Financial Statements, Financial
Statement Footnotes, the Independent Auditor’s Opinion, MD&A,
Business Data and Risk Factors, and Other Required Information.
Within each category were individual components (for example, there
were 21 footnotes). In addition, we included summary information
regarding ratios and trends from the actual company’s website as
most investors are likely to have a baseline knowledge of a
company’s past performance when evaluating an annual report.
WHAT
INFORMATION DO INVESTORS USE?
We
first consider the annual report as a whole, and ask how much
information is used by our investor groups, and what type of
information they prefer to examine. Table
1 shows the percentages of professional and nonprofessional
investors who viewed at least one item in the category (Column A),
and how many times they viewed individual components of the category
(Column B). Several trends are evident. First, while virtually all
investors viewed some annual report information prior to making
their predictions, the extent of use varies across categories. Most
heavily used are Business Data and Risk Factors (for example, 97% of
professionals), Financial Statements (94%), and the MD&A (85%).
Interestingly, virtually all professionals viewed summary ratio and
trend information taken from the actual company’s website, which is
outside of the annual report.
Second, use of all categories of information is lower among
retail than professional investors. This implies that
nonprofessionals make their investment decisions with less knowledge
about the company’s performance, and that the quality of their
decisions could be impaired. Differences are particularly large in
the financial statement and footnotes categories. Because these are
the audited parts of the annual report, they are perhaps the most
reliable, although also likely the most difficult to understand
without business training.
A third key conclusion to be drawn from investors’ information
use is that there is great variability in use of individual items within information categories and that investors do
not use footnote information extensively. For example, Table
1 shows what information the different types of investors view
when evaluating a company. It shows that 68%
of professionals viewed at least one of the 21 footnotes, but only
30% of nonprofessionals viewed at least one.
Further analysis not included in Table
1 indicates that 12 of the 21 footnotes were viewed by fewer
than 20% of professional analysts. The highest percentage of
professionals viewing any single footnote was 37% (the disclosure of
“subsequent events”). Nonprofessionals used even less footnote
information. Fourteen of the 21 individual footnotes were viewed by
fewer than 20% of the nonprofessional participants. These results
imply little agreement among our investor groups about which
footnotes are most important, which does not provide a good roadmap
to policy groups trying to reduce disclosure complexity.
WHERE
DO INVESTORS LOOK FOR INFORMATION WHEN THEY HAVE A CHOICE?
Our
discussion in the previous section suggests that if investors do not
view particular information, they may miss elements of company
performance that could be useful in making investment decisions.
However, a good deal of information is contained in multiple
sections of the annual report, providing the opportunity to examine
investors’ choices. When similar information is available in
alternative locations, what location do investors choose, and does
this vary between professional and nonprofessional groups? One
reason this is an important and interesting question is that some
sections of the annual report are audited (the financial statements
and related footnotes), while other sections are only reviewed by
the company’s independent audit firm.
Table
2 lists some items that are contained in more than one section
of our subject company’s annual report. The table shows what
percentage of professional and retail investors chose to view the
information in the footnotes, or in an alternative location. For
most items, the predominant choice is to view the information
outside of the footnotes. For example, 1.5% of professionals viewed
information on corporate acquisitions in the footnotes, but 56.7%
viewed that information in the MD&A.
Similarly, no nonprofessional investors viewed footnote information on corporate acquisitions, but more than 35% examined that information in the MD&A. These comparisons suggest a preference for obtaining company information in the MD&A over the same information in the financial statement footnotes. This is important in light of the SEC’s ongoing deliberations as to whether disclosures in the MD&A should be extended.
CONCLUSIONS AND IMPLICATIONS
Our
results indicate that on average, retail investors come to the task
of predicting future company results with a much smaller set of
information than professionals. Further, professional and
nonprofessional investors differ substantially in their extent of
using specific categories of the annual report information. This
trend is especially evident for financial statements and the related
footnotes, which provide key detail on account activity and
financial reporting methods. This implies that nonprofessional
investors are at a disadvantage in making investment choices, as
they are less informed about results of operations at a detailed
level and about earnings quality.
Our results also show that within both professional and
nonprofessional investor groups, financial statement footnotes are
accessed less than other information categories in the annual
report, even when the same information is provided in both sections.
There are several possible explanations that our data cannot distinguish, which have different implications. One explanation is that investors may perceive that the footnotes are too complex. If so, that would support calls to reduce the extent of required footnote disclosures. However, our investor participants do not show a consensus on which footnotes are most important, providing little guidance to the simplification effort. Alternatively, they may prefer to consider information items within the context or “story” that management portrays about the company in the MD&A. This implies that investors prefer to use information that has a lower level of assurance. While footnotes are audited under current requirements, the MD&A has only review-level assurance. Extension of the audit to the MD&A and other sections of the annual report may be desirable in light of the information usage patterns observed in this study.
TABLES
Acknowledgements: This research was made possible by a grant from the FINRA Investor Education Foundation. The authors are also grateful for the Enhanced Business Reporting Consortium members’ feedback on the design and support of the research activities, the financial institutions that provided professional participants, and to the professional and nonprofessional investors who gave their time in support of our research.
More from the JofA:
Find us on Facebook
| 
Follow us on Twitter
