A new academic study leveraging XBRL-produced financial data suggests there’s a measurable link between accounting disclosure complexity and financial reporting quality. The more complex a company’s filing becomes, the more quality suffers, according to the research.
In their research report, authors Rani Hoitash of Bentley University and Udi Hoitash of Northeastern University say that measuring accounting complexity has been elusive in the past, but now the existence of XBRL, or eXtensible Business Reporting Language, provides new insight. The more GAAP Taxonomy tags a company requires, and the more it must produce custom extensions to explain elements that can’t be found in the Taxonomy, the more complex the filing becomes, they say.
The research found a clear connection between the number of tags and extensions a company employs in its filing, and the likelihood of issuing financial restatements and disclosing material weaknesses in internal controls over financial reporting. Higher numbers of tags and extensions also correlate with higher abnormal accruals and higher audit fees, which reflect a higher level of audit effort or adjustments to the audit for risk, according to the authors. “These results overwhelmingly demonstrate that accounting disclosure complexity can undermine the quality of company financial reports,” the authors wrote.
The researchers concede that there could be other explanations for why a company might use a high number of tax or extensions. It could reflect the learning curve for preparers in getting up to speed in using the GAAP Taxonomy. It could also reflect weaknesses in the Taxonomy that leave companies with no option but to create extensions for tags that don’t exist. “Notwithstanding, the link between the complexity measures we propose and various proxies for reporting quality suggest that these measures do not simply capture white noise,” they wrote.
Hoitash and Hoitash say the research can be useful both for companies and for users of financial statements. “We suggest that these measures can be used by companies when deciding on internal resource allocation to the accounting function or by external stakeholders who wish to assess financial reporting risk,” they wrote.