Next year will mark the 20th anniversary of a notable Securities and Exchange Commission initiative — the issuance of its “plain English handbook,” a self-described 83-page guide to “writing disclosure documents in a language investors can understand.”
While disclosure readability, particularly when it comes to earnings, is presumed to benefit investors, a new study says it can be of tangible benefit to issuers also, especially when their earnings results are less than stellar.
According to the study published in the July issue of The Accounting Review, “When a firm provides a less readable disclosure, participants feel less comfortable evaluating the firm, and their judgments … are more sensitive to outside sources of information about the firm,” such as sell-side analysts. “In addition…[even] when participants do not access any of the outside sources of information, … valuation judgment is lower overall when a firm provides a less readable disclosure.”
The study, “Disclosure Readability and the Sensitivity of Investors’ Valuation Judgments to Outside Information,” cites a probable reason for this more negative judgment: lower readability “might undermine managers’ ability to convince investors that future performance is likely to improve… When the causal narrative is difficult to read, investors are likely to either discount managers’ positive assertions about the future or place greater weight on outside information sources that may conflict with the managers’ assertions.”
The paper calls into question the notion that poor readability can be advantageous in reporting bad results.
“If managers strategically issue less readable disclosures to obfuscate poor performance, our results suggest investors will respond by increasing their reliance on outside information, at least partially negating this strategic obfuscation,” write co-authors H. Scott Asay of the University of Iowa, W. Brooke Elliott of the University of Illinois at Urbana-Champaign, and Kristina M. Rennekamp of Cornell University.
At the same time, the study uncovers a likely unintended consequence of issuing readable disclosures – namely, that they “may lead investors to over-rely on firm disclosures by reducing their propensity to incorporate outside information into their judgments.” In other words, readability may prove more advantageous to the companies reporting results than to the investors digesting them.
The paper’s findings derive from an experiment involving 203 individuals that were directed to assume the role of a prospective investor in a hypothetical company similar to an actual firm in the sporting-goods field. Participants were presented with simulated press releases summarizing the firm’s sales and earnings for its most recent quarter. The press releases detailed what amounted to a mixed bag of results: for example, the company’s earnings fell short of the original guidance it had provided, but its net sales were up 6.6% and its net income was up 5.8% from the year-ago quarter.
Although all releases contained the same data, they were equally divided between adopting or not adopting formatting and linguistic features suggested by the SEC — such as using descriptive heads and subheads to break the text into bite-sized pieces and writing short sentences in active voice.
In addition, each of the two groups of participants had available to it three media or analyst reactions to the quarterly results that expressed either a uniformly positive or uniformly negative view of the company’s potential as an investment.
Subjects were asked 1) to indicate on an 11-point scale (with 1 equaling very low, 11 very high) their assessment of the company’s value and 2) to estimate on a seven-point scale (1/low, 7/high) their comfort with the release — a measure of their confidence in its reliability and in their own evaluation of the company. In addition, the researchers monitored to what extent participants referred to the three uniformly positive or uniformly negative outside opinions they had received.
Participants gave the company a 6.10 investment rating on an 11-point scale when the press release they read was relatively low in readability and the outside sources they received gave meager support to the company as an investment. That rating was more than 10% below the score for each of the experiment’s three other combinations — a highly readable press release combined with either high or low company support from outsiders (6.90 and 6.80 respectively) and a less readable press release combined with high support from outsiders (6.91).
Among the 75 participants who conferred an investment rating solely on the basis of the press release without bothering to read outsiders’ assessments, a readable document simply impressed them significantly more favorably than a less readable one did.
“When participants do not access any of the outside sources of information, we find that valuation judgments are lower overall when a firm provides a less readable disclosure,” the authors write.
As for the 128 participants who took the trouble to read one or more of the outside sources, a highly readable release overcame negative outsider opinions, while a less readable one did not.
Without the impression of clarity that a good press release conveys, readers are increasingly subject to influence from outside sources, the study concludes. “When a firm provides a less readable disclosure, participants feel less comfortable evaluating the firm, and their judgments about the firm are more sensitive to the content of outside sources of information about the firm,” write the authors.
In sum, when financial results are mixed, readability can carry the day, whether an investor seeks outside opinions or not.
Why is readability still absent in many corporate financial documents? “Scholars have assumed a major reason is that managers intentionally prepare less readable disclosures when company performance is poor,” says Iowa’s Professor Asay.
“In general, though, poor readability probably has less to do with deliberate obfuscation than with the inherent difficulty of producing readable narratives of any kind and the much greater effort required when performance leaves something to be desired. In any event, what our study makes clear is that failing to make that extra effort is likely to prove costly.”
The Accounting Review is published six times yearly by the American Accounting Association, a worldwide organization devoted to accounting education, research, and practice.