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Low readability of corporate reports is as much a headache for stock analysts as it is for average investors, study suggests

Less readable documents spur demand for analysts' forecasts but diminish their accuracy

"The SEC is waging an all-out war on complexity."

With those words a few years ago, the commission's chairman at the time, Christopher Cox, entered the lists in a decades-old debate about the readability of documents that companies issue to investors. It is an argument that pits advocates of plain English, like Mr. Cox, against skeptics who contend that corporate business is too complex for simple prose and that company communications should be targeted exclusively to financial sophisticates.

In the words of one skeptic, who notes that "the intended audience of disclosure has been one of the most vehemently debated subjects of securities regulation since Congress enacted the '33 [Securities] Act," the SEC ought simply to "accept the fact that disclosure should be geared toward the sophisticated investor and amend [its mandate for] plain English accordingly."

Now new research suggests that the debate may well be beside the point. Convoluted corporate prose turns out to be a problem not only for average investors but for financial professionals as well.

The study in the current issue of the American Accounting Association journal The Accounting Review tests the readability of tens of thousands of company filings over 12 years and finds that analysts' earnings forecasts for firms with less readable reports "have greater dispersion, are less accurate, and are associated with greater overall analyst uncertainty."

Ironically, though, the syntactic and linguistic complexity of these reports generates greater demand from investors for analysts' commentary and greater reliance on their forecasts.

Says Feng Li of the University of Michigan who carried out the study with Michigan colleagues Reuven Lehavy and Kenneth Merkley, "The less readable these documents are, the more pressure it creates from clients for analysts to provide commentary and forecasts. This increases the number of analysts who weigh in on these stocks and enhances their influence on investors, even while it reduces the analysts' collective accuracy.

"In sum, " he adds, "corporate reports that are difficult to read stymie not just average investors but analysts as well. And, by the same token, plain English is good for amateurs and professionals alike."

Prof. Li and his colleagues arrive at this conclusion through an analysis of some 33,000 corporate 10-K filings, annual reports required by the SEC that provide a comprehensive summary of public companies' performance. To gauge the reports' readability, the professors employ the Fog Index, a standard instrument that captures the linguistic and synaptic complexity of a document as a function of the number of syllables per word and the number of words per sentence. The index provides an estimate of the number of years of formal education required for a person of average intelligence to read the document once and understand it.

The mean FOG score for the entire sample was 19.53. This ranged from 18.58 for 10-Ks at the 25th percentile of complexity to 20.29 for those at the 75th percentile. Health care and insurance companies had the highest mean scores (20.22 and 20.16 respectively) while precious metals had the lowest at 18.43. Possibly reflecting the folksiness of its CEO, Berkshire Hathaway weighed in at 17.23, putting it among firms with the lowest scores and highest readability.

Yet, even that is well above the level that would be considered plain English. The FOG score for Reader's Digest, for example, is 8, and that of The Wall Street Journal is 12.

The professors analyze the relationship between FOG scores and a whole variety of analyst variables. They find that higher scores (meaning lower readability) translate into coverage by more analysts but that the increase in coverage slows down at high levels of complexity, suggesting, Prof. Li says, that "the analysts give up." Unsurprisingly, analysts take 10 to 15% longer to issue reports on 10-Ks with above-average FOGS than they do for those with low FOGS, something, the study notes, that is "likely to be economically important given the rapid pace at which markets impound new information." Forecasts based on 10-Ks in the highest FOG quartile also have about 10% more influence on investors than those on documents in the lowest FOG quartile, as determined by movement of stocks on the days the forecasts are issued. This is the case notwithstanding the fact that "less readable disclosures are associated with more dispersed and less accurate analyst earnings forecasts."

Despite this fall-off in accuracy, Prof. Li allows that investors may benefit from the increased coverage that less readable reports elicit. "With more analysts reporting, investors may stand an increased chance of getting some useful nugget of information," he comments. "But, on the whole, low readability is the enemy of accuracy."

The study, entitled "The Effect of Annual Report Readability on Analyst Following and the Properties of Their Earnings Forecasts," is in the May/June issue of The Accounting Review, published six times a year by the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. Other journals published by the AAA or its specialty sections include Accounting Horizons, Issues in Accounting Education, AUDITING: A Journal of Practice and Theory, Behavioral Research in Accounting, The Journal of the American Taxation.

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