In our recent paper, we study the textual meaning of the financial statement transition disclosures in firms’ filings with the Securities and Exchange Commission (SEC) explaining the likely effects of the adoption of Accounting Standards Codification (ASC) 842 on leases. Under President Franklin Delano Roosevelt, Congress established that the SEC’s backbone be based on a sufficient level of disclosure to maintain orderly equity and credit markets to protect the average investor from material omissions or misrepresentations. However, if you had flown in from Mars recently, you might have noticed that corporate balance sheets, income statements, and the other financial summaries in SEC annual filings comprise hundreds of pages of complexly worded notes and discussion to explain the financial data. If you had checked further, you would have found that these notes and discussion have expanded greatly in recent years. This emphasis on complex information raises the concern that the SEC may have veered significantly from its historical mission of disclosure and protection of the less sophisticated investor and public at large. Nowhere in the securities laws does it state that the SEC’s mission is to favor one class of investor over another.[1] Yet, according to considerable research, this is where we stand today.[2]
Our analysis of the textual content of firms’ transition disclosures following the adoption of the new standard on accounting for operating leases, implemented in 2019, draws the same conclusion. We base this conclusion on a large sample of ASC 842 transition disclosures in 2015–2018 meeting our search criteria. Specifically, we examine non-financial, non-utilities, and non-real estate US-headquartered firms with operating leases for fiscal years between the issuance of ASC 842 in February 2016 and its mandatory adoption beginning for fiscal years on or after December 15, 2018. For these firms, we search the 10-K filings on the SEC’s electronic web site (Edgar) and retain those whose text can be parsed and contains the keyword “2016-02” (which uniquely identifies ASC 842). This procedure generates 8,747 observations for 3,269 firms. We then remove filings for prior fiscal years filed during 2015–2018 (224 observations). We further remove firms with significant events such as mergers and acquisitions or spin-offs during the sample period (24 observations), those with missing accounting, market, audit, or readability data for the control variables (1,332 observations), and early adopters of ASC 842 (20 observations). This procedure results in a final sample of 7,157 firm-year observations for 2,710 firms.
To understand our sample of ASC 842 lease transition disclosures, we decode them into three meaningful dimensions of investor comprehension – based on their readability (the overuse of jargon, long sentences, heavy words, and acronyms), year-to-year dissimilarity (the change in wording from one year to the next), and extent of detail on materiality (the likely impact of the accounting change on assets and profits). We then use a machine-learning algorithm called latent Dirichlet allocation (LDA) to identify hidden (or latent) topics that most explain these textual dimensions. For example, if a firm’s transition disclosure readability is poor and worsens the closer to adoption date, LDA can identify what particular topic or aspect of readability best explains that outcome. Our study documents that firms’ lease transition disclosures become less readable, more dissimilar, and increasingly detailed on materiality the closer to adoption.
Our use of LDA analysis then reveals the topic with the most power to discriminate among the different levels of readability, year-to-year dissimilarity, and details on materiality, which is firms’ use of technical and complex language. This textual characteristic topic that LDA analysis links to the use of technical and complex words suggests a tension between the disclosure provisions of Topic 11.M and the SEC’s broader need for transition disclosures to communicate to investors in straightforward language. Other topics, which mostly reflect the use of everyday language, have much less discriminatory power.
Our study also indicates that firms’ use of technical and complex words in lease transition disclosures is associated with adverse market consequences. Specifically, we find that firms with more technical and complex lease transition disclosures experience a reduction in the timeliness of analysts’ forecast revisions (analysts take longer to update their forecasts) and an increase in market-related information uncertainty.
These economic outcomes support the view that the transition disclosures for ASC 842 are more likely to confuse than clarify by favoring those investors most able to benefit from technical and complex information over those who may prefer the use of more straightforward language to describe the transition. Technical and complex disclosures that favor sophisticated investors over unsophisticated investors may also hurt financial market liquidity by creating additional price risk for the unsophisticated investor. As such, in prescribing disclosure guidance under Topic 11.M, the SEC may have unwittingly favored one class of investor over another, contrary to its historical mission.
Luminita Enache is an Associate Professor and Future Fund Fellow at the University of Calgary Haskayne School of Business.
Paul A. Griffin is a Distinguished Professor of Accounting at the U.C. Davis Graduate School of Management.
Rucsandra Moldovan is an Associate Professor of Accounting at the Concordia University John Molson School of Business.
This post is adapted from their research, “Clarification or Confusion: A Textual Analysis of ASC 842 Lease Transition Disclosures,” available on SSRN.
[1] To the contrary, the Securities and Exchange Act of 1934 (Public Law 73-291, 73rd U.S. Congress) repeatedly states that the role of the Commission is to “prescribe rules necessary or appropriate in the public interest or for the protection of [all] investors.” The 1934 Act, nonetheless, does carve out additional protections for small businesses and small business investors for whom the rules could be more costly and complex compared to large businesses and large investors.
[2] https://doi.org/10.1111/1475-679X.12179; https://doi.org/10.1111/auar.12087; https://doi.org/10.1080/10291954.2021.1970450; https://doi.org/10.1016/j.jacceco.2016.09.001;https://doi.org/10.1080/00014788.2018.1470138; https://doi.org/10.1002/pam.20160; https://ssrn.com/abstract=4094133.
