Limitations of investors – get on the same page!

I came across an interesting academic study: “The effects of investors’ information processing limitations when incorporating return on assets into their investment decisions.”

The authors are Max Hewitt of the University of Arizona; and Jessica Watkins and Teri Lombardi Yohn of Indiana University. As with all such studies, I can’t claim to be capable of fully engaging with the methodology, but it’s interesting to consider it even on a relatively superficial level. Here’s a summary:

  • Return on assets is an important metric for forecasting and valuation…however, prior research finds that investors do not fully process changes in return on assets when making investment decisions due to their incomplete processing of asset turnover, an accounting signal that combines summary measures from both the income statement and the balance sheet…In this study, we provide an explanation based on investors’ information processing limitations for their failure to fully process changes in return on assets stemming from changes in asset turnover. First, we argue that investors’ fixation on the income statement increases the likelihood that investors will not fully process return on assets. Second, investors’ “split attention” impairs investors’ integration of summary measures from both the income statement and the balance sheet.

By “split attention,” the authors mean that just on a very basic psychological level, having related items of information in different locations, or even on adjacent pages of the same document, impedes a reader’s ability to integrate the information. They carried out some experiments to assess how these factors applied in practice:

  • In our first experiment, we manipulated between subjects (1) whether participants were presented with the income statement, the balance sheet, and an additional disclosure across separate pages or combined on a single page, and (2) the extent to which this financial statement information was integrated in the additional disclosure. We provide evidence suggesting that addressing investors’ fixation on the income statement and split attention leads to additive improvements in the extent to which investors incorporate return on assets into their investment decisions. Specifically, we find that investors are more likely to invest in the firm with higher return on assets if financial statement information is combined on a single page relative to when this information is presented across separate pages.

This pinpoints perhaps the most basic challenge in financial reporting – the risk that the volume and complexity of information will exceed the practical ability of users to do anything with it. If separating related pieces of information by a page or two can generate a measurable difference in the real-world effectiveness of that information, then what are we to do with the entirety of the annual report, the comprehensibility of which requires multiple leaps back and forth within the document. Technology can surely help in some of this (at least in an XBRL environment) – at its simplest, in automatically creating such an all-important single page, even if the reporting issuer doesn’t provide one. This leads into the next main finding:

  • We also show that investors are more likely to process return on assets if presented with an additional disclosure that fully integrates summary measures from both the income statement and the balance sheet by dividing each income statement item by average total assets. These findings suggest that combining and fully integrating relevant financial statement information decreases the adverse effects of investors’ fixation on the income statement and split attention.

Of course, when the authors talk about “processing” return on assets, they’re not saying that focusing on this item constitutes any kind of litmus test. As for any basic measure, the picture it appears to paint of the entity in isolation might be contradicted by other indicators – for example, the narrative information in the MD&A might suggest the historic measure of return on assets is unsustainable. Much might also depend on the sophistication of the calculation – for a company that made a single large asset acquisition near the beginning or end of the year, a simple average of opening and closing balances might generate a misleading result. But the point, I suppose, is that those and other complexities can’t even come into play, if certain key measures aren’t placed squarely on the investor’s analytical eye-line in the first place.

The authors conclude:

  • …even relatively sophisticated investors (as were the participants used in our experiments) fail to fully process information from multiple financial statements. In an increasingly ‘information-rich’ investing environment with ‘attention-poor’ investors, our study highlights the importance of standard setters considering presentation formats and disclosures that address investors’ attentional deficiencies (e.g., fixation on the income statement and split attention).

We know that disclosure effectiveness constitutes a current priority for the IASB, and this paper should be a timely contribution to that work. But of course, the challenges are manifest. The study only focuses on a single aspect in which investors are “attention-poor,” setting out some steps that might partly alleviate that. But is that just the tip of the attention-poverty iceberg…?

The opinions expressed are solely those of the author

One thought on “Limitations of investors – get on the same page!

  1. Enjoy reading your comments and observations.

    Few accountants will disagree that we need, on a continuing basis, to make improvements to the financial reporting process.
    Some of inherent limitations on the current ‘model’ include:
    -which user group should be targeted? The standard setters have selected Investors and Creditors, but there are many sub-groups within these categories-some with opposing perspectives.
    -which types of decisions?

    In addition, there is a need to make changes to the educational processes for the Investment professional.

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