The Costs of (Greater) Complexity.

• Author: Chakraborty, Indraneel

Over the last two decades, publicly traded firms' financial statements have become longer and less readable. Studies show that investors and sophisticated market participants, including analysts and credit rating agencies, struggle to process these complex reports.

The Securities and Exchange Commission, which mandates these reports and what they contain, itself has recognized that their increasing complexity is a problem. For example, the SEC recently revised the rules for the management discussion and analysis section in financial statements so that if the risk factor section exceeds 15 pages, firms must provide a summary of no more than two pages.

Nonetheless, the SEC is now proposing to further increase the complexity of these statements by requiring firms to report the carbon emissions of their operations and their suppliers. Such a rule would degrade the value of financial statements and impose a higher cost of capital on public corporations.

Research has shown that firms take actions to mitigate the costly consequences of financial statement complexity, including issuing voluntary disclosure and increasing expertise within boards of directors. Both are costly, although neither shows up in the SEC's cost-benefit calculus that accompanies the proposed emissions disclosure rule.

The complexity of a financial statement also affects the source and cost of financing. In a recent Accounting Review article, my co-authors and I document that higher financial statement complexity correlates with firms' increasing reliance on bank financing. Also, banks ameliorate information frictions using loan contractual terms that depend on the source of the complexity. Ordinary investors are shying away from buying the firms' bonds, and firms are increasingly resorting to borrowing money from banks at a higher cost than if they had issued a bond.

In the context of the proposed carbon disclosure rule, the complexity of the task that firms face in reporting emissions is considerable. For instance, evaluating a firm's own emissions, let alone its suppliers', is far from elementary It would require the firm--or a consulting firm it hires for the task--to make various modeling assumptions that the SEC will be hard-pressed to specify. If some firms make aggressive assumptions while others make conservative ones, the rule may reduce the ability of investors and consumers to differentiate between the firms, which would be an example of the classic game theoretic...