Over the last two decades, publicly traded firms’ financial statements have become longer and less readable. Studies show that investors and sophisticated market participants, including analysts and credit rating agencies, struggle to process these complex reports.

The Securities and Exchange Commission, which mandates these reports and what they contain, itself has recognized that their increasing complexity is a problem. For example, the SEC recently revised the rules for the management discussion and analysis section in financial statements so that if the risk factor section exceeds 15 pages, firms must provide a summary of no more than two pages.

Nonetheless, the SEC is now proposing to further increase the complexity of these statements by requiring firms to report the carbon emissions of their operations and their suppliers. Such a rule would degrade the value of financial statements and impose a higher cost of capital on public corporations.

Research has shown that firms take actions to mitigate the costly consequences of financial statement complexity, including issuing voluntary disclosure and increasing expertise within boards of directors. Both are costly, although neither shows up in the SEC’s cost–benefit calculus that accompanies the proposed emissions disclosure rule.

The complexity of a financial statement also affects the source and cost of financing. In a recent Accounting Review article, my co-authors and I document that higher financial statement complexity correlates with firms’ increasing reliance on bank financing. Also, banks ameliorate information frictions using loan contractual terms that depend on the source of the complexity. Ordinary investors are shying away from buying the firms’ bonds, and firms are increasingly resorting to borrowing money from banks at a higher cost than if they had issued a bond.

In the context of the proposed carbon disclosure rule, the complexity of the task that firms face in reporting emissions is considerable. For instance, evaluating a firm’s own emissions, let alone its suppliers’, is far from elementary. It would require the firm—or a consulting firm it hires for the task—to make various modeling assumptions that the SEC will be hard-pressed to specify. If some firms make aggressive assumptions while others make conservative ones, the rule may reduce the ability of investors and consumers to differentiate between the firms, which would be an example of the classic game theoretic strategy of signal jamming. In such a case, the inaccuracies likely to be contained in emission disclosures would significantly diminish any value the SEC hopes to pass along to investors. While the SEC insists that its rule will help standardize the reporting of emissions caused by public firms, that is altogether different from standardizing how emissions are estimated by those firms.

The actual value to investors of the proposed rule remains unclear. If it lowers their ability to process firm-level information, then it will increase the cost and change the terms of financing of firms. In turn, these higher capital costs will reduce shareholder returns and employee wages because higher capital costs will diminish investment, productivity growth, and wages. As for any environmental effects of the rule, it is easy to imagine a situation where capital flows toward heavy emitters that are artful in their disclosures and away from environmentally conscious firms that disclose earnestly.

Financial statements should serve solely to convey the information needed by investors to make rational decisions about the fiscal health of a company. Requiring the reporting of carbon emissions threatens to make the financial statement an ideological bulletin board, with the costs of doing so borne by investors and workers alike.

Readings

  • “Complexity of Financial Reporting Standards and Accounting Expertise,” by Roman Chychyla, Andrew J. Leone, and Miguel Minutti-Meza. Journal of Accounting and Economics, 67(1): 226–253 (2019).
  • “Financial Statement Complexity and Bank Lending,” by Indraneel Chakraborty, Andrew J. Leone, Miguel Minutti-Meza, and Matthew A. Phillips. Accounting Review 97(3): 155–178 (2022).
  • “Guiding through the Fog: Financial Statement Complexity and Voluntary Disclosure,” by Wayne Guay, Delphine Samuels, and Daniel Taylor. Journal of Accounting and Economics, 62(2): 234–269 (2016).
  • “Measuring Readability in Financial Disclosures,” by Tim Loughran and Bill McDonald. Journal of Finance, 69(4): 1643–1671 (2014).
  • “The Impact of Narrative Disclosure Readability on Bond Ratings and the Cost of Debt,” by Samuel B. Bonsall and Brian P. Miller. Review of Accounting Studies, 22(2): 608–643 (2017).