TL;DR: We all need a reporting standard that is less repetitive and less pro-forma, but more meaningful through simplified reporting that ordinary mortals can digest. Because even “institutional investors” are human beings too.
On 13 April, the US Securities and Exchange Commission (SEC) released a concept paper seeking public comments on the business and financial disclosure requirements. The SEC is seeking comments on the specific reporting amendments that would maintain or reduce cost to a company while still providing important information to investors. To an analyst like me, this is a big deal. Here’s why:
The 10-K, 8-K and 20-F reports, not to mention all other filings, are onerous to read. They are long-winded, dry and repetitive, giving you the sense that legal departments are only filling in the boxes. Looking for relevant information in a 10-K is like looking for needles in a haystack, forcing you to do word searches instead of reading through the document to better understand the context of the disclosure. And did I say that some of the most important explanations are only footnotes?
The one-size fits all reporting standard does not allow for meaningful disclosures of risks and opportunities. The business description and risk sections of a company, arguably the most interesting part of the 10-K, are pro-forma, with companies reporting nearly similar risks to their business regardless of business models in the same tone and language. The most serious business challenge to a company can easily be buried in one of the pro-forma risk paragraphs or a footnote in the inside pages.
The ultimate goal of financial reporting is to ensure that investors are provided information that is “material” as defined by the Supreme Court and adapted by the SEC as follows:
Information is material “if there is a substantial likelihood that a reasonable investor would consider the information important in deciding how to vote or make an investment decision. The Court further explained that information is material if there is a substantial likelihood that disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the “total mix” of information available.” (SEC Concept Paper, p. 37)
The 10-K is possibly the most important disclosure tool for all types of investors, but it certainly does not make it to most retail investors’ weekend reading lists. And for this reason alone, the reporting standards should be amended. It is not enough that companies disclose, what is more important is that the intended audience understands the disclosure (intended audience is discussed below). Many companies release an annual report (AR) to supplement the 10-K. The AR is typically more reader-friendly with a chairman or CEO letter to shareholders that provides good insights into the company. The AR is the story-telling report, but it can also be used to spin fairy tales. The risk of relying on the AR is that it may only tell a good story with its glossy pictures, colorful graphs and interactive online versions, but the scary stuff remains hidden in the footnotes of the 10-K.
Some of the interesting points for which the SEC is seeking comments on:
General Development of Business Item:
25. How could we improve Item 101(a)(1)? For example, is the five-year time frame for this disclosure appropriate? Would a shorter or longer time frame be more appropriate? If so, what time frame would be appropriate and why?
26. Does this disclosure continue to be useful for registrants with a reporting history? Once a registrant has disclosed this information in a registration statement should we allow registrants to omit this disclosure from subsequent periodic reports unless material changes occur? Alternatively, should we require registrants to describe its business as currently conducted as well as any material changes that have occurred in the last five years?
My take: Yes, a five-year timeframe is more appropriate than the current one year because under normal circumstances, business models and strategies do not change year after year. Yearly reporting should be limited to material changes in the business (i.e. M&A, disposal of assets, reduction in workforce, new products and services, etc.), although disclosures on such changes should be comprehensive and holistic.
Principles-Based and Prescriptive Disclosure Requirements
6. Should we revise our principles-based rules to use a consistent disclosure threshold? If so, should a materiality standard be used or should a different standard, such as an “objectives-oriented” approach or any other approach, be used? If materiality should be used, should the current definition be retained? Should we consider a different definition of materiality for disclosure purposes? If so, how should it be defined?
7. Should we limit prescriptive disclosure requirements and emphasize a principles-based approach? If so, how? How can we most effectively balance the benefits of a principles-based approach while preserving the benefits of prescriptive requirements?
8. What are the advantages and disadvantages of a principles-based approach? Would a principles-based approach increase the usefulness of disclosures? What would be the costs and benefits of such an approach for investors and registrants?
9. Do registrants find it difficult to apply principles-based requirements? Why? If they are uncertain about whether information is to be disclosed, do registrants err on the side of including or omitting the disclosure? If registrants include disclosure beyond what is required, does the additional information obfuscate the information that is important to investors? Does it instead provide useful information to investors? (SEC Concept Paper p. 43)
My take: The concept paper summarized the comments received for both approaches from pages 38 to 43. There is merit in both arguments but my bias is for principles-based approach, where in companies disclose based on what is material to the company. While there is value in consistency and comparability that the prescriptive approach allows, at the end of the day value based decisions are based on a company’s own merit. Comparing financial ratios to peers are important for industry context, but only is only one part of the bigger story. The principles-based approach allows a company to tell its own story based on what makes sense to its business model, and helps investors understand the business itself.
Principles-Based and Prescriptive Disclosure Requirements (continuation)
10. Do registrants find quantitative thresholds helpful in preparing disclosure? Do such thresholds elicit information that is important to investors? Do they require registrants to provide some disclosure that investors do not need? To the extent our rules contain quantitative thresholds, how should we define them? Are specified dollar amounts more or less effective than amounts based on a registrant’s financial condition, such as a percentage of revenues or assets?
11. Should we develop qualitative thresholds for disclosure? Should there be a combination of quantitative and qualitative thresholds?
12. Do registrants find principles-based disclosure requirements helpful in preparing disclosure? Do such requirements elicit information that is important to investors?
13. Would principles-based disclosure affect corporate compliance and governance structures? If so, how?
My take: Quantitative thresholds are important but I find absolute dollar amounts less useful than amounts based on financial condition. Specified dollar amounts are always less useful when taken in isolation, but may take more significance when placed into context of a company’s revenues, assets, cashflow, operating income or other financial metrics. For example, a penalty of $100 million against a large or even a mid-size company may not mean much in itself, but if calculated against its cashflow, this penalty can be a redflag to investors. Moreover, quantitative disclosures are insufficient to gauge a company’s value because companies are much more than their financial ratios. A company has intangibles of high value such as people, its brand, intellectual property, and culture that are better discussed in a qualitative manner. My take is for a combination of quantitative and qualitative thresholds that are contextual rather than required in absolute form.
Audience for Disclosure
14. Should registrants assume some level of investor sophistication in preparing their disclosures? If so, what level or levels of sophistication? How should investor sophistication be measured? What are the risks or other disadvantages to investors if registrants either underestimate or overestimate the level of investor sophistication and resources when preparing their disclosures? Does disclosure protect all investors if it is tailored to a subset of the investor community?
15. Should we revise our rules to require disclosure that is formatted to provide information to various types of investors in a manner that will facilitate their use of disclosure for investment and voting decisions?
16. Commenters have suggested that disclosure should be written for a more sophisticated investor than current disclosure appears to contemplate, 164 and that tailoring disclosure to less sophisticated investors contributes to excessive disclosure.165 Should our disclosure requirements be revised to address these views? If so, how could we revise our disclosure requirements, and which requirements should we revise, to encourage more appropriately targeted of information required or whether the optimum should be achieved on a mandatory or voluntary basis. The Sommer Report also stated that market forces alone are insufficient to cause all material information to be disclosed. See Sommer Report at D-6. Other studies have noted the limitations of the efficient market theory. See, e.g., Robert J. Shiller, From Efficient Markets Theory to Behavioral Finance, J. Econ. Persp. 83, 83-104 (2003). 164 See CFA Institute. 165 See Shearman. 52 disclosure? If we revised our disclosure requirements to address these views, would there be any harm or costs to investors?
17. How do investors and other users of disclosure currently access and use this information? How does this vary across different subsets of the audience for the disclosure?
18. Should we use investor testing, such as focus groups or electronic surveys, to provide input on investors’ use of and access to disclosure?
19. To what extent should the reliance of certain investors on market prices or thirdparty analyses, rather than using disclosure directly, be a factor in determining the type of investor to which disclosures should be targeted?
20. To what extent should we consider the needs of other market participants, such as professional securities analysts and other third parties, in revising our disclosure requirements? What would be their needs?
My take: Who is a sophisticated investor? Are institutional investors automatically considered sophisticated investors? If they are, why were they roped into investing in mortgage backed securities and credit default swaps that cost many such investors to lose more than their shirts in the financial crisis? Were they not sophisticated enough? Why did so many institutional investors miss the fact that banks were drowning in their own debt and needed taxpayers’ money to survive? How will the SEC determine a sophistication threshold? There are many good arguments for making the 10-K a technical document but let me ask the question, who has the time and resources to allow an analyst to go through an entire 10-K? I say that when in doubt, simplify. Let’s not get lost in the weeds of who is a sophisticated investor and who is not because sophistication, like materiality is in the eye of the beholder. If the bigger, higher goal is to ensure that all investors are able to make reasonable decisions, a simplified, easier to read, but more meaningful disclosure standard is needed.
More later. BRB.