The Informational Role of Exhibits as ‘Source Files’ in Form 10-K
When it comes to investing in a US publicly traded company, it’s important to understand the Form 10-K — a comprehensive yearly document filed with the Securities and Exchange Commission (SEC). Rivalling the oftentimes colourful and glossy annual reports put out by firms, the Form 10-K provides detailed insights into a company’s financial condition, performance, and management outlook for the previous fiscal year.
For all its importance, attempting to decipher a Form 10-K can be a daunting challenge, as it involves navigating a labyrinth of dense language and convoluted disclosures.
And besides the main Form 10-K file, there are additional documents called exhibits that are bundled in with the submission of the report. Exhibits — which include materials such as contracts and other legal documents — can provide more in-depth information on specific aspects of a company's operations or financials. These files can often be even more difficult to interpret than the main file but are no less essential, and in fact, are frequently referred to by investors to supplement their understanding of the main report.
In 2023, SMU Assistant Professor of Accounting Lin Pengkai took a closer look at the Form 10-K and how exhibits play a role in helping investors make informed decisions in his paper "The Informational Role of Exhibits as ‘Source Files’ in Form 10-K". We chat more with Prof Lin — whose research interests include corporate disclosures, capital markets, and auditing — on why such exhibits required by the SEC provide useful information to investors; and the mechanism underlying how exhibits are used to facilitate users’ processing of the main file within the 10-K bundle.
Understanding how exhibits help users process the 10-K report
While there are accounting practitioners and researchers who collect useful information from certain 10-K exhibits, there has not been much study into how these exhibits are useful to users in understanding the 10-K file. However, this gap in research sparked the curiosity of Prof Lin, leading him to embark on the study.
“Exhibits tend to enclose documents that use plenty of jargon and, more often than not, are more difficult to read than the highly summarised 10-K main file,” explains Prof Lin.
“This, together with the time and capacity constraints, often means that investors might prioritise processing key information from the main file.”
Why then, given the difficulty in attempting to understand the information presented, are exhibits still referred to as the user processes the 10-K main file? Well, according to Prof Lin’s research findings, exhibits often contain source documents that preserve transaction-level details that are less subject to managers’ discretion. As such, exhibits are especially accessed when the user comes across a 10-K main file that is vaguer, or when the main file reveals negative financial news.
“This shows that investors access the exhibits mainly to help with their understanding of the activity discussed in the main file,” says Prof Lin.
To put it simply, companies sometimes provide limited disclosure in their 10-K main files, for example, when they try to obfuscate certain negative news. However, this can have the opposite effect of driving investors to dig deeper and scrutinize the 10-K file more closely, much like the Streisand effect on a smaller scale. In other words, by not being fully transparent in their main file, companies may inadvertently pique the interest of investors and analysts who seek to uncover any hidden risks or potential red flags.
Moreover, Prof Lin’s research found that short-term access to exhibits is limited mostly because of the costs and time needed to process this information.
“What results is that we often see exhibits receive more access gradually. This value-relevant information then reflects in stock market activity progressively,” he states.
Using the findings to improve 10-K document requirements
Prof Lin suggests that by considering how users interact with exhibits as a source of information, we can take steps to improve the presentation and regulation of these documents. This would be a positive step forward in ensuring that users can access the information they need in a clear and useful format.
In its current state, there are often large swings in reporting requirements of exhibits across the years.
“Our evidence shows that exhibits are important in helping users process the main file with more clarity,” he adds.
“Exhibits may also help to protect investors from the often-strategic exclusions or watered-down disclosures of the main file.”
While regulation is changing over time, Prof Lin does have some suggestions for companies who are looking to take steps to improve their users’ experience when processing the 10-K report exhibits.
“Correct labelling of files with appropriate titles is a low-hanging fruit,” he reveals.
“Consistently doing so can help ease the users’ difficulty in browsing relevant files. Companies may also want to consider including references to the exhibits to make cross-referencing easier.”
To enhance useability, Prof Lin reckons that technology such as natural language processing algorithms can help investors to glean the key points of exhibits without having to wade through heavy jargon. Of course, this is not a perfect solution. While AI-generated summaries still need a discerning eye, they can still help simplify the processing of information for users.
At the end of the day, the evidence is clear—the absence of sufficient detail only serves to drive users to dig through supporting documents to find what they are looking for. With that in mind, it is in everyone’s interest to make accessing this information a little more user-friendly.
Prof Lin's research sheds light on the benefits of leveraging exhibits as a source of information, and how they can be used to identify potential risks and opportunities in a company's financial reporting. By recognising the informational role of exhibits, regulators and companies can work together to ensure that users can access the information they need in a clear and useful format, ultimately promoting transparency and accountability in financial reporting.
