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Where Do Investors Prefer to Find

Nonfinancial Information?

BY VICKY ARNOLD, PH.D., JEAN C. BEDARD, CPA, PH.D., JILLIAN PHILLIPS, CPA, PH.D. AND STEVE G. SUTTON, CPA, PH.D.

AUGUST 23, 2010

Its 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 requireddisclosures accompanying financial reports makes it difficult to decipher a companys performance andidentify factors that drive performance.

We recently tracked the information used by professional and retail investors to examine how they copewith this complex information environment. In this article, we use the data to provide answers to some keyquestions. How much of the information in an annual report do investors use in making their investmentdecisions? How do investment professionals such as financial analysts differ from retail investors? If theyhave 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 simplifyfinancial reporting and to enhance the relevance of business reporting through improved disclosure viaimportant channels beyond the face of the financial statements themselves, such as ManagementDiscussion & Analysis (MD&A).

INFORMATION COMPLEXITY AND THE FINANCIAL MARKETSThese issues are important for two reasons. First, U.S. corporations that prepare financial reports havelong expressed concern about the growing complexity of required disclosures. Essentially, many in thebusiness community who support simplification of financial statements and related disclosures areconcerned about the increasing costs of preparing required disclosures and the effects of the resultinginformation overload on investor decision quality.

The SEC recognized the importance of this issue during the proceedings of the Advisory Committee onImprovements to Financial Reporting. This committees charge focused on ways to reduce unnecessarycomplexity, 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with a new disclosure framework project to address the disclosureoverload and to help eliminate redundancy or otherwise outdated GAAP disclosure requirements.However, there is little evidence on how investors actually do use information in their investmentdecisions. This article addresses that issue.

Second, nonprofessional investors form a significant proportion of the market. While the era of the day

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trader may have passed, many individuals manage their own retirement accounts and make buy/selldecisions. While many nonprofessional investors have years of experience in trading stocks, most lackthe education of financial professionals. Does the information they acquire when reviewing an annualreport imply differences in the ways in which they make investment decisions? Do any differences ininformation use suggest disadvantages that might inhibit the performance of their portfolios, relative toinvestment professionals? We address these questions by comparing information use between the twogroups.

OUR PROCEDURES FOR MEASURING INVESTORS' USE OF INFORMATION

Our study on these issues involved data from 73 investment professionals and 118 nonprofessionalinvestors, who were provided with an annual report (Form 10-K) adapted from the annual report of apublic U.S.-domiciled high-tech company, and asked to make investment decisions using their normalpractices.

The investment professionals came from a variety of financial advisory roles, including both buy-side andsell-side analysts. Our criteria for professionals included experience in evaluating information for equityvaluation; 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 ofnonprofessionals 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 companys identity(that is, its name and the names of personnel and products) to prevent participants from looking up theactual 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 andpredicting its future stock price. The information categories were listed in a table-of-contents fashion downthe left side of the web page, providing a format very similar to that provided in a PDF format 10-Kdocument. Software tracked the information they accessed.

As with an actual annual report, company information included the following major categories: FinancialStatements, Financial Statement Footnotes, the Independent Auditors Opinion, MD&A, Business Dataand 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 andtrends from the actual companys website as most investors are likely to have a baseline knowledge of acompanys 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 investorgroups, and what type of information they prefer to examine. Table 1 shows the percentages ofprofessional and nonprofessional investors who viewed at least one item in the category (Column A), andhow many times they viewed individual components of the category (Column B). Several trends areevident. First, while virtually all investors viewed some annual report information prior to making theirpredictions, the extent of use varies across categories. Most heavily used are Business Data and RiskFactors (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

companys website, which is outside of the annual report.

Second, use of all categories of information is lower among retail than professional investors. This impliesthat nonprofessionals make their investment decisions with less knowledge about the companysperformance, and that the quality of their decisions could be impaired. Differences are particularly large inthe financial statement and footnotes categories. Because these are the audited parts of the annualreport, they are perhaps the most reliable, although also likely the most difficult to understand withoutbusiness training.

A third key conclusion to be drawn from investors information use is that there is great variability in use of

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individual items within information categories and that investors do not use footnote informationextensively. For example, Table 1 shows what information the different types of investors view whenevaluating a company. It shows that 68% of professionals viewed at least one of the 21 footnotes, butonly 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 than20% of professional analysts. The highest percentage of professionals viewing any single footnote was37% (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 nonprofessionalparticipants. These results imply little agreement among our investor groups about which footnotes aremost important, which does not provide a good roadmap to policy groups trying to reduce disclosurecomplexity.

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, theymay 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 theopportunity 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 thecompanys independent audit firm.

Table 2 lists some items that are contained in more than one section of our subject companys annualreport. The table shows what percentage of professional and retail investors chose to view theinformation in the footnotes, or in an alternative location. For most items, the predominant choice is toview the information outside of the footnotes. For example, 1.5% of professionals viewed information oncorporate 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 morethan 35% examined that information in the MD&A. These comparisons suggest a preference for obtainingcompany information in the MD&A over the same information in the financial statement footnotes. This isimportant in light of the SECs 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 resultswith a much smaller set of information than professionals. Further, professional and nonprofessionalinvestors 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 detailon account activity and financial reporting methods. This implies that nonprofessional investors are at adisadvantage in making investment choices, as they are less informed about results of operations at adetailed level and about earnings quality.

Our results also show that within both professional and nonprofessional investor groups, financialstatement 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 differentimplications. One explanation is that investors may perceive that the footnotes are too complex. If so, thatwould support calls to reduce the extent of required footnote disclosures. However, our investorparticipants do not show a consensus on which footnotes are most important, providing little guidance tothe simplification effort. Alternatively, they may prefer to consider information items within the context orstory that management portrays about the company in the MD&A. This implies that investors prefer touse information that has a lower level of assurance. While footnotes are audited under currentrequirements, the MD&A has only review-level assurance. Extension of the audit to the MD&A and other

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sections of the annual report may be desirable in light of the information usage patterns observed in thisstudy.

Source: http://www.journalofaccountancy.com/Web/20102682.htm downloaded 08/26/2010