If companies’ annual reports get easier to use, investors just might have a group of graduate students to thank.
Four two-person teams at The George Washington University School of Business each spent the summer poring over hundreds of forms 10-K, looking for ways to make the documents more clear, concise and user-friendly. More specifically, they were aiming to streamline disclosures.
The project had a dual purpose. First, the teams were involved in a competition that was part of the “Initiative on Rethinking Financial Disclosure,” a partnership between the university’s Institute for Corporate Responsibility (ICR) and the Center for Audit Quality (CAQ). Second, the students’ recommendations are currently being compiled into a report the school plans to submit to the Securities and Exchange Commission, which last December asked for comments to help further its ongoing disclosure effectiveness project.
“We were thinking about what might be an innovative way to look at this,” says Cindy Fornelli, executive director of the CAQ, “and we thought young people might have some fresh points of view about how to modernize the disclosure regime.”
The members of the winning team — MBA student Elizabeth Moehlenbrock and Liyuan Su, who’s in the school’s master of science in finance program — didn’t think they had the right stuff. “We were surprised to win, because we thought our recommendations were the simplest,” says Moehlenbrock. “But the reasoning given [for the decision] was their simplicity and, therefore, their feasibility.”
Each team was tasked with making two recommendations. The winners proposed, first, to stratify annual reports’ risk factors into two groups. They offered two methods for making the division. One was segregating company-specific risks from those applicable to the company’s industry generally and other non-company-specific risks. The other method was sorting risk factors based on their potential impact on company performance and probability of occurrence.
Both methods were aimed at allowing 10-K users to more easily identify risk factors that changed since the filer’s previous annual report. “There are definitely too many risk factors in many 10-Ks, but that’s not really the issue,” says Moehlenbrock. “The real issue is suggested by a basic economic concept: value is determined by scarcity. By the same token, with risk factors, a lack of uniqueness among them implies limited utility for investors. We found that for [an average] company across five fiscal years, only two risks ever changed, even if 20 or more were listed.”
Company-specific risk factors, and those that are more likely to come into play and stand to have a bigger impact on company performance if they do, are proxies for a greater likelihood that something about them will change from year to year, the winning team’s thinking went. There may be some gray area in determining whether a particular risk is company-specific, but under the proposal companies would decide for themselves which category a risk factor belongs in.
The team’s second recommendation was to add executive summaries for 10-K items 1 (Business), 1A (Risk Factors), 7 (Management’s Discussion and Analysis of Financial Condition and Results of Operations) and 10 (Directors, Executive Officers and Corporate Governance).
Moehlenbrock notes the irony in the fact that while one of the SEC’s stated goals is to make annual reports more concise, having executive summaries would actually add verbiage. But, she says, “We were tasked with keeping in mind the different needs of sophisticated and less-sophisticated investors. The purpose of the executive summaries is to meet those disparate needs. Many institutional investors open a 10-K knowing exactly what they want to see and where it is, and if changes from the prior year are popped into an executive summary, that task becomes even easier and clearer. And the less-sophisticated investors may not be interested in reading the [whole] 10-K.”
Her characterization of her team’s proposal as “simple” was underscored by that of another team, composed of Elizabeth Halford and Chu Xu, who are in George Washington’s MBA and master of accountancy programs, respectively. They also zeroed in on the problem of spotting new content in the risk-factors section and proposed an executive summary pointing out changes. But they suggested it be in the form of a table, which would show risks for the company and its industry and also classify each risk as either ongoing, emerging or retired. Similar tables were also recommended for items 7 and 7A (Quantitative and Qualitative Disclosures About Market Risk).
Each piece of information in the table would be hyperlinked to the portion of the annual report discussing that topic. “This dovetails into a bigger idea about how 10-Ks look,” says Halford. “We think the document at a minimum should be full of hyperlinks, like a Wikipedia page, so you can [navigate] around the document.”
The team’s second recommendation was out of the box but perhaps natural, coming from a team competing in a contest aimed at drumming up new ideas for annual reports. Halford and Chu proposed that the SEC practice crowdsourcing by holding its own, broader competition.
Halford — who spent 20 years in the Army and is getting an MBA to learn about how to run a business, as she plans to open a sustainability consultancy — rails against the manner in which 10-Ks are typically written. “The sections we focused on look like complete legalese. They look like someone is trying to cover their butt,” she says. “We made a key assumption about the 10-K: it is for investors’ needs, not a document that lawyers need to write in order to protect management from being sued.”
The Brain Trust
Meanwhile, the students had some help, in the form of an advisory committee that included Fornelli; former SEC chairman Harvey Pitt; ICR senior research scholar Cynthia Glassman, a one-time SEC commissioner; Troy Paredes, another ex-commissioner; David Martin, a former director of the commission’s Division of Corporate Finance; and Susan Phillips, a former Federal Reserve Board governor and George Washington finance professor, among several other finance and investment luminaries. Each student team met with each advisory committee member twice.
“It was like having your ideas in an Etch-a-Sketch,” says Halford about the process of interacting with the advisers. “Every time you thought you had it, you met with a new advisory board member who brought in a different angle, and you decided to shake the Etch-a-Sketch and start over. It was a very involved learning experience, much more so than we’ve had in any of our classes.”
The students applied for the project and were interviewed for selection. “We aimed to have a small team to facilitate effective discussions within the group and with the advisory board,” says Susan Kulp, associate professor of accounting and faculty adviser for the initiative. “We wanted to instill collaboration and competitiveness and felt that we would have the best results and most innovative solutions if the group was large enough to subdivide into pairs, but small enough to work effectively as one group of eight.”
Judges for the competition were former SEC chairman Mary Schapiro; Catherine Odelbo, head of corporate strategy and partnerships at investment-research firm Morningstar; and Andy Cross, chief investment officer at The Motley Fool, a provider of multimedia financial services for investors.