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More than helpful to investors, presenting financial results readably pays off for companies too, study suggests
"Failing to make that extra effort is likely to prove costly"
Next year will mark the 20th anniversary of a notable SEC initiative – the issuance of its "plain English handbook," a self-described 83-page guide to "writing disclosure documents in a language investors can understand." In arguing for the need of such a guide, none other than Warren Buffett prefaced it with the complaint that in 40 years of studying company documents "too often I’ve been unable to decipher just what is being said or, worse yet, had to conclude that nothing was being said."
Now some new research finds that readability is not only helpful to Warren Buffett and his fellow investors but is of tangible benefit to companies that are able to manage it.
According to the study in the July issue of an American Accounting Association journal 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. In addition...[even] when participants do not access any of the outside sources of information, we find that valuation judgment is lower overall when a firm provides a less readable disclosure."
A probable reason for this more negative judgment, the study adds, is that 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, which has gained currency in financial management, that poor readability can be advantageous in reporting bad results. In the words of 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, "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."
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 this limited respect, 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 recruited through a crowd-sourcing Internet marketplace extensively used in accounting and social-science research. Participants' mean age was about 34 years, and their education had included an average of about one course each in accounting and finance.
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 a simulated press release summarizing the firm's sales and earnings for its most recent quarter. 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 quarterly results a year earlier.
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. This rating was more than 10% below the investment rating for each of the experiment's three other combinations – a highly readable press releases 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).
What accounts for these findings, given that both releases consisted of the same mixed bag of positive and negative financial results? 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. In the words of the study, "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."
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. In its words, "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."
In sum, when financial results are mixed, readability can carry the day, whether an investor seeks outside opinions or not.
Given this considerable benefit and the fact that the SEC has been providing readability lessons for almost two decades, why is it 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," comments Iowa's Prof. 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 study, entitled "Disclosure Readability and the Sensitivity of Investors’ Valuation Judgments to Outside Information," is in the July issue of The Accounting Review, published six times yearly by the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. Other journals published by the AAA and its specialty sections include Accounting Horizons, Auditing: A Journal of Practice and Theory, Issues in Accounting Education, Behavioral Research in Accounting, Journal of Management Accounting Research, Journal of Information Systems, Journal of Financial Reporting, The Journal of the American Taxation Association, and Journal of Forensic Accounting Research.