'Let me explain': Corporate disclosures can take a circuitous route
The shortest distance between two points is a straight line, but sometimes taking the long way home can have advantages.
When a company is struggling but on the brink of recovery, its financial disclosures may take a circuitous route, sharing information in a non-linear fashion that can help paint a fuller picture of its prospects for investors, a new Cornell research suggests.
Assistant Professor Nicholas Guest, co-author of the study "Circuitousness in Disclosure Narratives," published in The Accounting Review, explained that CEOs should not aim for brevity in such cases, as a more detailed presentation, contextualized in multiple ways, could be beneficial for investors with the time and expertise to process the complex information.
This approach, known as "verbal circuitousness," has been a teaching method for decades, similar to the spiral curriculum where concepts are introduced, revisited and built upon at higher levels of complexity.
The researchers analyzed over 13,000 management discussion and analysis (MD&A) filings from annual reports submitted to the Securities and Exchange Commission (SEC) between 1997 and 2019, using natural language processing and machine learning techniques. They found that circuitousness is more prevalent in firms that are struggling but on the verge of recovery, as it allows them to present a wealth of information for analysts and market watchers to process.
This processing incurs costs such as cognitive effort or computational resources used to gather and digest the information.
To identify circuitousness, the researchers defined it as the ratio of the length of the path a text took to the length of the shortest path that could have covered all points. They compared this metric to three commonly used indices: the Fog index (linguistic complexity), document length, and repetition. The study revealed a positive correlation between circuitousness and subsequent earnings upturns among firms that were initially loss-making, but no such correlation was found for firms that were expected to face an impending downturn.
Additionally, higher MD&A circuitousness was associated with more downloads from the Electronic Data Gathering, Analysis and Retrieval (EDGAR) system, which investors use to access and process information.
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