Firms with Hard-to-Read Annual Reports Have Lower Earnings
Profits of companies with annual reports that are difficult to read are less persistent in the following one-to-four years.
ANN ARBOR, Mich.—There's a reason why some annual reports are difficult to read—they're hiding something, says a University of Michigan business professor.
A new study by Feng Li, assistant professor of accounting at the U-M's Stephen M. Ross School of Business, shows that annual reports of firms with lower earnings are harder to read.
"Consistent with the motivation behind the plain English disclosure regulation of the Securities and Exchange Commission, managers may be opportunistically choosing the readability of annual reports to hide adverse information from investors," Li said. "Firms with lower earnings not only tend to file annual reports that are more difficult to read, but a decrease in earnings from the previous year also results in annual reports that are harder to read, compared with the previous year's reports."
Using a sample of more than 55,000 firm-years since 1994, Li measured annual report readability by examining syllables per word and words per sentence in companies' 10-K filings. He used two statistical readability measures: the Fog Index, which indicates the number of years of formal education a reader of average intelligence would need to read and understand the text; and the Kincaid Index, which rates text on a U.S. grade-school level.
According to the study, profits of firms with annual reports that are more difficult to read are less persistent in the next one-to-four years. In fact, companies use more complex language in their annual reports even when presenting good news—if it is only fleeting. On the other hand, Li found no significant evidence that firms make their annual reports harder to read to hide more persistent bad news.
Li's research also found that larger companies and growth firms (those with higher market-to-book ratios) tend to have annual reports that are more difficult to read. In addition, annual reports with more negative special items are harder to read.
Industries with annual reports most difficult to read include insurance, health services and electric, gas and sanitary services. Those that are easier to read belong to the airlines and the stone, clay, glass and concrete products industry.
Although the study found a correlation between earnings and annual report readability, Li says none exists between readability and future stock returns.
"Contrary to the SEC's concerns, small investors may not be affected by the lack of readability, since the stock market seems to impound the implication of annual report readability into prices," he said.
Overall, annual reports of public companies, in general, are difficult to read, Li says. The average Fog Index for all annual reports is 19.4 (a score of 12-14 is ideal and higher than 18 is unreadable). Likewise, the annual report readability score on the Kincaid Index is 15.2—about twice as high as the optimal score of 7-8.
"Interestingly, there is an obvious drop in the indices in the years immediately after 1999, suggesting that the SEC's plain English disclosure regulation of 1998 did make companies take efforts to make their annual reports more readable," Li said. "However, this trend reversed dramatically after 2002 and the annual reports filed by public firms seem to have become even more difficult to read, compared with the pre-1998 years."
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