Annual Report Readability and Analyst Following
A recent paper published in The Accounting Review caught my attention. The paper is entitled, “The effect of annual report readability on analyst following and the properties of their earnings forecasts,” and is written by University of Michigan researchers Reuven Lehavy, Feng Li, and Kenneth Merkley. Readability is measured using the Fog index, which is a function of the average number of words in a sentence and the percent of complex words (defined as words with three or more syllables). So, the authors are talking literally about how easy the 10-K is to read, after controlling for business complexity and a host of other variables.
My first thought when I saw this title was that the more readable the financial reports and disclosures, the more analysts would want to follow the firm. But on second thought (and as the paper’s results bear out), I wondered whether analysts choose to follow firms whose financial reports are less readable because that is where they can add value. It turns out that, even though analysts take a longer time to revise their forecasts for firms with poor readability (suggesting that low readability is tough on analysts too, not just your average investors), there are more analysts following such firms than firms with high readability. Apparently, demand for interpretive services is sufficient to pay for more analysts when financial statement readability is relatively low.
After reading this paper, I wondered what a financial reporting standard setter would conclude. If the readability of financial reports is somehow the result of standard setting, perhaps the FASB, the IASB, and/or the SEC should focus more on making disclosures more readable. But then I had a more sinister thought occur to me. When standard setters ask for input from sophisticated users of financial reports (such as analysts), should they take the input with a grain of salt? If analysts have an incentive to seek out companies or industries where they can add value by interpreting the low-readability reports, perhaps analysts have little incentive to seek for better disclosures (let alone readability). If you made lots of money helping people interpret financial reports because those reports are hard to understand, would you want standard setters and regulators to make financial reports more readable?
Of course, this paper is not specifically about standards and regulations that cause low readability, nor is it about standard setters reliance on input from analysts. So you should take my comments here with a grain of salt too. But if readability of disclosures somehow varies across different disclosure topics (for example, if pension disclosures tend to have lower Fog index scores than stock compensation disclosures), and standard setters are wondering what sophisticated investors think about a particular disclosure, they may want to think twice about the input they get from analysts.
By the way, I should add this caveat in defense of analysts—every analyst I ever met with in my work at the FASB seemed earnest in their desire to improve financial reporting. So, I do not mean to call into question the integrity of analysts. I am only drawing attention to the incentives some analysts may face when their bread and butter comes from interpreting hard to read financial reports.
One final thought: I wonder if the readability of my posts is associated with people’s willingness to comment on my posts. Hmmmm…