In December 2013, the Securities and Exchange Commission sent a report to Congress on Regulation S-K, the disclosure rules for public companies. Although its JOBS Act mandate was to investigate ways to simplify the registration process for so-called emerging growth companies, the SEC concluded its report by calling for a comprehensive review of the disclosure regime for all public companies.
Today, while the agency continues to review the disclosure requirements in Regulation S-K and Regulation S-X, which addresses financial statements, a growing number of companies are pursuing disclosure improvement on their own — with the encouragement of the SEC. General Electric, Target, Honeywell, Intel, and American Express are some of the more prominent firms that are making their 10-Ks clearer and more readable, using more charts and graphs to present financial and other information, whether on a printed page or a website.
“We have seen concrete progress by companies working to make disclosures clearer and more understandable, in particular by removing redundancies or unnecessary information,” SEC chairman Mary Jo White said in a December speech.
Such progress can come none too soon. In a study released last month, researchers at the University of North Carolina’s Kenan-Flagler Business School showed that the length of the median 10-K more than doubled from 1996 to 2013, from 23,000 words to more than 49,000 words — a tad longer than, say, The Great Gatsby.
New compliance requirements from the Financial Accounting Standards Board and the SEC drove most of the increase in length, with three topics — fair value, internal controls, and risk factors — accounting for “virtually all” of the increase. (See the study, “The Ever-Expanding 10-K: Why Are 10-Ks Getting So Much Longer (and Does It Matter)?” by Travis Dyer, Mark H. Lang, and Lorien Stice-Lawrence.)
At the same time, the annual reports studied by the researchers displayed rising levels of redundancy and complexity, or “Fog,” referring to a widely used index that measures the readability of text by analyzing sentence length and the frequency of complex words. According to the Fog index, readers needed 21.65 years of formal education to comprehend the median 10-K in 2013.
Top executives are just as frustrated as investors with the opacity of their reports. Leslie Seidman, a former chairman of FASB, moderated a panel during a forum on disclosure effectiveness last fall. “Many companies said that their own senior executives had got to the point where they didn’t understand what the key messages were in their own financial statements,” says Seidman, now executive director of the Center for Excellence in Financial Reporting at Pace University’s Lubin School of Business.
Now, many companies are working to clear the fog from their disclosures. “They are starting to experiment,” says Neri Bukspan, a partner in EY’s financial accounting advisory services practice and EY Americas Disclosure Leader. “They have made greater use of charts, graphs, and tables. Some have even changed the concept of the annual report altogether. They’ve made it a website with a link to their 10-K, and they’ve introduced summary annual reports that also show how the company has performed against key goals.”
“Companies describe [improving disclosure] as moving from a compliance mind-set to a communication mind-set,” says Seidman. “They have much more flexibility in their earnings releases and investor presentations, and I think they are finding there is more flexibility in the way they tell their stories in the 10-K and 10-Q as well.”
In 2015, EY and the Financial Executives Research Foundation surveyed more than 120 finance and accounting executives from companies in a range of industries. Three out of four (74%) respondents said their companies were taking action to improve disclosure effectiveness. More than half (53%) said the main reason for improving disclosures was the influence of the management team, while 22% said the SEC’s initiatives were the primary driver.
Efforts to improve financial reporting focused primarily on three areas: disclosing material information and eliminating immaterial information (cited by 80% of respondents), reducing redundancies (77%), and eliminating outdated information (70%). Forty-one percent of respondents said that reducing narrative disclosures in favor of charts, graphs, and infographics was an area of focus, while 19% said that making greater use of technology, such as a website or interactive display, was a priority.
The documents that companies improved most often during their disclosure initiatives were 10-Ks and 10-Qs, cited by three out of four respondents. Of those reports, the part companies improved the most was the Management’s Discussion and Analysis (named by 40% of respondents), followed by the notes to the financial statements (25%) and description of the business (18%).
Just over half (56%) of survey respondents reported that their companies’ disclosure effectiveness efforts had meaningfully improved financial communication, compared with 41% who reported marginal improvement and 3% who reported no improvement. And for nearly 4 out of 10 companies, better disclosure meant better process efficiency: 30% estimated they saved, or expected to save, one to three days in the preparation of their financial statements, while 9% saved four days or more.
Disclosure effectiveness, comments Bukspan, “is not just about improving the 10-Ks and 10-Qs. It’s about improving a company’s entire communications line with investors, from the periodic filings to the proxy statements, from the investor presentations to the investor relations web pages.”
One company that is striving to improve all aspects of its communication with investors is General Electric, the $117 billion industrial giant. “We’re passionate about disclosure reform,” says Christoph Pereira, chief corporate, securities, and finance counsel at GE. The company started its reform initiatives several years ago by revamping the proxy statement, and then moved on to earnings releases.
Last year, GE redesigned its annual report, adding an introduction and summary that places the company’s financial information in a strategic context, according to CFO Jeffrey Bornstein. The 14-page summary in the 2015 10-K contains information on, for example, major portfolio changes, performance against operating goals, business-segment summaries, industrial margins, and more — all summarized through concise text and a profusion of charts, graphs, and infographics.
GE’s latest 10-K and full annual report weigh in at 218 pages and 245 pages, respectively, but they are much easier to read and navigate than earlier versions. Pereira says the company has spent a lot of time improving the MD&A and discussion of risk factors, and for 2015, GE also simplified the presentation of three footnotes: postretirement benefits, stock-based compensation, and financial instruments.
What are GE’s guiding principles for compiling the summary report? Pereira mentions three. “First, we organize information around topics,” he says. An example is the page on capital allocation, which begins with a comment from CFO Bornstein. In a single page of charts, GE shows how much capital it expects to have available from 2015 to 2018; how much it spent over the past three years on dividends, buybacks, restructuring charges, growth funding, and acquisitions; and how capital allocation drives results in terms of organic revenue growth, free cash flow, operating profit margins, and returns. “It would take a fair amount of time for an investor to compile that information from the traditional 10-K,” says Pereira.
A second principle is to “tell investors what we think is the most critical information from an investment standpoint, using the lens of management,” says Pereira. Thus, for example, while the 2015 10-K lists 12 risk factors, the introduction zeros in on what GE sees as the four most critical enterprise risks: product quality, cybersecurity, liquidity through a crisis, and global compliance.
“If a company says there are 45 risks we worry about, there’s not much an investor can do with that,” comments Pereira. Meanwhile, in the 10-K, the 12 risk factors are organized by type of risk: strategic, operational, financial, and legal and compliance.
A third principle is to provide a strategic, forward-looking context for understanding the 10-K. “We are trying to articulate what GE’s investment thesis is,” says Pereira. The summary report helps answer the question. One page, for example, is devoted to the company’s new digital organization, which aims to capture and analyze GE product data through sensors, software, and analytics. “Internally, this is huge,” he says. “It may be the future of the company, and we’re putting enormous resources into it.” Yet, such new initiatives typically find little coverage in traditional 10-Ks, no matter how significant they may be.
In March, GE unveiled a new disclosure document: the annual integrated summary report. Combining critical information from the company’s annual report, proxy statement, and sustainability website, the 68-page report aims to give investors “a comprehensive and concise view of GE” by linking strategy, performance, governance, compensation, and sustainability. “When you go online, the fewer clicks you need, the more efficient you are. It’s the same with disclosures: The fewer steps it takes investors to get the necessary information, the better,” says Pereira.
Pereira says investor feedback on GE’s revamped disclosures has been “very positive,” including favorable comments on the summary reports from passive institutional investors. “They don’t really do a formal analysis of the company, and they don’t have time to go through hours of investor presentations. But they have to make voting decisions every year,” he says. The summary reports are “a good tool to quickly bring them up to speed on what’s been going on at the company, what’s the strategy.”
The improved annual report also serves an internal audience. GE has 333,000 employees in more than 180 countries, and it isn’t easy to keep everyone abreast of the company’s overall goals and strategy. Senior leadership has encouraged employees to read the summary reports, to make sure everyone is on the same page, says Pereira. “GE is a large, complicated company,” he says. “To the extent you can unify around clear themes, it’s always helpful.”
Edward Teach is editor-in-chief of CFO.