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Mason researcher helps the SEC walk the talk

Marianne Klinker — Tue, 31 Jan 2023 14:37:09 +0000

Mason researcher helps the SEC walk the talk Marianne Klinker Tue, 01/31/2023 - 09:37

Research by Mason Accounting Professor Bret Johnson, a former SEC staff accountant and academic fellow, shows how seemingly mundane intra-agency policies can have unintended effects that benefit Wall Street over Main Street.

The U.S. Securities and Exchange Commission (SEC) has long seen itself as a friend to the retail investor, doing everything it can to ensure that financial markets offer both large and small players roughly equal opportunity to succeed. Most recently, that mandate provided the rationale for a slate of sweeping rule changes that would, among other things, shine a light on the opaque business arrangements between wholesale brokers and trading apps such as Robinhood. It adds up to what some industry insiders are calling the largest-scale SEC intervention in nearly 20 years.

Bret Johnson

To its credit, the SEC is just as committed to promoting fairness and transparency in-house as it is to ambitious industry reforms. The agency even invites accounting academics to research its inner workings via the SEC Academic Fellowship Program. �� School of Business accounting professor and former SEC staff accountant Bret Johnson was selected for the year-long program starting in August 2020.

Johnson says, "My role was to be a liaison between the SEC and the academic community…Often, my research uncovers some problem or something they can improve on, some inefficiencies. And I found they are very open to embracing this type of research."

For example, Johnson's recent research paper in Review of Accounting Studies co-authored by Michael Iselin of the University of Minnesota, Jacob Ott of the London School of Economics, and Jacob Raleigh of Monash University, finds that while the SEC's monitoring arm – the Division of Corporation Finance (DCF), where he worked for six years – seems to focus less on firms with a high percentage of retail ownership, the Division of Enforcement (DOE) appears to take a harder line with these firms. In other words, irregularities are less likely to be spotted early and addressed through non-punitive means when the firm in question has a larger proportion of retail investors.

"My role was to be a liaison between the SEC and the academic community…Often, my research uncovers some problem or something they can improve on, some inefficiencies. And I found they are very open to embracing this type of research." - Bret Johnson

The SEC's enforcement-heavy approach may disadvantage retail investors because once the enforcement action becomes common knowledge, the "Main Street" investors who hold disproportionate stock in the target company will lose out when the share price falls. In this way, the SEC does not seem to be acting in accordance with its stated mission to protect mom and pop investors.

Johnson can only guess at what's going on here. He speculates that firms that attract retail investors may share other characteristics that cause the SEC to flag them for enforcement rather than monitoring. For instance, the paper finds that retail ownership was positively associated with firm visibility and performance volatility, and negatively associated with external monitoring and structural complexity. The discrepancy may also have to do with how resources are distributed between the DOE and DCF.

In other cases, the agency's good-faith attempts to increase market transparency on behalf of less savvy investors can backfire. Based on analytics from the publicly available filings database on the SEC website, Johnson's 2020 paper in The Accounting Review, co-authored by Michael S. Drake and Jacob R. Thornock of Brigham Young University, and Darren T. Roulstone of The Ohio State University, concluded that institutional users (e.g. investment banks, hedge funds, asset managers, and financial institutions) were profiting handsomely from their search activities on the online resource, while retail investors saw little to no benefit. Abnormal search volume from Wall Street was associated with future returns for the focal firms of up to 10.5 percent. No such pattern was seen on Main Street.

In addition, how the SEC balances the need for transparency against its relationships with companies can have unintentional knock-on effects. Johnson’s 2022 paper in Management Science, co-authored by Marshall A. Geiger and Abdullah Kumas of the University of Richmond, and Keith L. Jones of the University of Kansas, found that for companies that had just received an SEC comment letter, there was a sizeable uptick in sell-offs among mutual funds and other major players during the short period (initially 45 days, then shortened to 20 days) before the letter went public. The best explanation was that high-ranking executives were sharing non-public information with investors close to the company concerned.

The 20-day privacy window is meant to prevent companies’ confidential information from being accidentally released through an over-hasty process. But it may also create information asymmetry that benefits industry insiders at the expense of retail investors – the very favoritism that the agency intends to combat.

There are no simple answers to the questions posed by Johnson’s research. Even seemingly mundane intra-agency decisions, such as resource allocations and the length of the confidentiality window for comment letters, can have complicated ripple effects. Sometimes, it takes an informed outsider to trace these ripple effects and draw evidence-based conclusions. "I am happy to see that the SEC continues to solicit – and take seriously – academic research into its policies and practices," Johnson says. After all, sweeping industry reforms may make headlines, but fine-tuning how the agency itself functions is a quieter but no less material way of promoting fairness and transparency in financial markets.

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In This Story

Bret Johnson

Unpacking the Graphic Content of Annual Reports

Jennifer Anzaldi — Thu, 28 Apr 2022 14:46:07 +0000

Unpacking the Graphic Content of Annual Reports Jennifer Anzaldi Thu, 04/28/2022 - 10:46

In This Story

Lei Gao

Bo Hu

Lei Gao and Bo Hu

Viewed one way, the corporate annual report is redundant, merely repeating information in publicly available 10-K filings, as well as on Bloomberg, Yahoo! Finance, etc. Still, most companies that issue stock publish annual reports for the general public, despite the SEC not requiring them to do so.

Part of the reason may be that with the annual report, companies are in complete control of the presentation. They can use graphic elements to capture and direct investor attention. Visuals can also convey suggestive messages that, though non-explicit, can exert subtle influence. Color choices, for example, carry emotional associations that can transfer over to the firm; pleasant or exciting illustrations can affect how readers interpret information. These graphic effects can help managers hint at hidden strengths or intangible assets not yet reflected in the firm’s financials.

According to a recent working paper co-authored by Mason finance professors Lei Gao and Bo Hu, more than 80 percent of U.S. public firms use graphics in their annual reports. Further, visual presentation has market benefits as well as aesthetic ones.

Lei and Bo, and their co-authors Wesley Deng of University of New South Wales and Guofu Zhou of Washington University in St. Louis, analyzed the annual reports of 1,322 companies from 1994-2019 alongside their financial performance. They focused particularly on reports that, from one year to the next, exhibited a sudden increase in “graphicity”—a construct invented by the researchers to measure the ratio of visual to verbal information contained in a report. Graphicity was calculated with the help of a machine learning algorithm capable of detecting, among other things, the relative size, color, and number of graphic elements in a document.

The researchers discovered that firms that went in a more graphical direction received an average abnormal return of 3.5 percent over the three-to-six-month period following the release of their report. The bump in stock returns could not be explained through other characteristics such as institutional ownership, analyst coverage and short selling constraints.

The three-to-six-month delay represents the time it takes for the subtle information in graphic reports to permeate the market. “Numbers can be picked up in no time by algorithms and factored into the stock price,” Lei said. “But graphic information takes time to consume, it’s harder to pick up this kind of information.”

The researchers also looked at the firms’ business activities to determine whether going graphic could be construed as signaling an intention. They found a pattern of increased R&D investment in the three years following a pivot to visual communications in the annual report.

“An optimistic take on this correlation would be that firms are using visuals to telegraph their soon-to-be-realized potential to investors,” Bo said. In other words, graphicity could function as a kind of “Watch out, here I come” announcement to the market. Visual cues can also give a non-specific sense of what’s being planned in terms of innovation and tech adoption. For example, a manufacturing firm can display its aspirations through an image of a futuristic factory.

On the other hand, graphicity can sometimes be misleading. “Not every R&D initiative will be value-adding,” Lei reminds us. Firms could be using images to paint a risky investment with a rosier tint. “These firms are doing something serious, but it’s hard to deliver. They might face more uncertainty. So, they use soft information to make claims, because if you put in hard numbers you’re liable for the risks.”

Lei and Bo say that theirs is the first paper to quantify the market impact of the tacit messaging conveyed by the graphic design of annual reports. Their findings imply that regulators should perhaps pay attention, since the visual content of corporate documents are absorbed by investors as information, not decoration. Moreover, the signals embedded within visual cues are not wholly ambiguous but consistently predictive of future firm activity, i.e. R&D investment. You could say that high-graphicity reports are communicating with investors on two dimensions at once— visual and verbal—while regulators now are probably concerned only with the latter.

If the government were to monitor the graphic content of annual reports, Lei and Bo’s methodology gives some clues about how it might be done fairly and with minimal human labor. Primed with a construct such as graphicity, an algorithm could crawl through annual reports (usually found within the “Investor Relations” section of a corporate website) and trigger an alert whenever it spotted abrupt and sizeable shifts—50 percent was the threshold the researchers used—from verbal to visual presentation.

“Consistent with our model, this work provides evidence of a new anomaly in financial markets,” Bo said. “If it is not recognized, it must be novel and needs more attention from market participants.”

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