The lease standard has changed, and firms’ transition disclosures confuse more than they clarify

Posted by ARC Commitee - Aug 10, 2023
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In a paper recently published in the European Accounting Review, we study the text of the transition disclosures in firms’ financial statements explaining the likely effects of a new standard. For a sample of almost all affected firms, we extract the text that refers to how firms plan to transition to the new lease standard. The text runs from a couple of dozen to sometimes over 500 words per disclosure. We then quantify this text on three dimensions of investor comprehension: readability (the use of jargon, long sentences, heavy words, and acronyms), year-to-year dissimilarity (the change in wording from one year to the next), and extent of detail on materiality (the likely impact of the accounting change on assets, profits, and internal controls). Our study documents that firms’ lease transition disclosures become less readable, more dissimilar, and increasingly detailed on materiality the closer to adoption.

 

We then use a machine-learning algorithm to identify the underlying topics that best explain the three textual dimensions. For example, if a firm’s transition disclosure readability is poor and worsens the closer to adoption date, the algorithm can identify what particular topic or aspect of readability best explains that outcome.

 

The algorithm tells that the textual dimensions of readability, year-to-year dissimilarity, and details on materiality all increase because of firms’ higher use of technical and complex language. The other topics identified by the algorithm, which reflect descriptive and everyday language, do not explain the trends in the three textual dimensions.

 

Investors also treat lease transition disclosures as technical and complex. Financial analysts take longer to update their earnings forecasts and the level of uncertainty in stock market prices increases as a result of firms’ lease transition disclosures.

 

Our conclusion is that the transition disclosures for the new lease standard are likelier to have been confusing rather than clarifying for the average investor by favoring those investors most able to benefit from technical and complex information such as large asset managers like BlackRock.

 

Contrary to the SEC’s historical mission, the transition disclosures that the SEC requires to make the markets fair for all may have ended up favoring one class of investors over another.

 

The published version of our study titled “Clarification or Confusion: A Textual Analysis of ASC 842 Lease Transition Disclosures” is available at the following link: https://doi.org/10.1080/09638180.2023.2244990.

Luminita Enache is Associate Professor and Future Fund Fellow at Haskayne School of Business, University of Calgary, Calgary, Canada.

Paul A. Griffin is Distinguished Professor of Management at the Graduate School of Management, University of California, Davis, USA.

Rucsandra Moldovan is Associate Professor of Accounting at John Molson School of Business, Concordia University, Montreal, Canada.

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