Are you frustrated by complex accounting jargon? In the July 2017 issue of The Accounting Review, the American Accounting Association (AAA) published findings from a study it conducted which suggest that using “plain English” to present financial results benefits public companies. This is especially true when companies have poor results.
Some business owners and managers mistakenly believe that they’re better off issuing less-readable disclosures when their financial performance is poor. The AAA study shows that such obfuscation is likely to backfire. “Overall, our findings suggest that issuing less readable disclosures limits managers’ ability to convince investors that performance will improve in the future,” the study concludes.
Written disclosures that are difficult to read may prevent investors from accepting managers’ assertions about the future. Hard-to-read disclosures may also encourage investors to place greater weight on outside information that doesn’t corroborate managers’ views.
The research was carried out by Scott Asay, an assistant professor of accounting at the University of Iowa; Brooke Elliott, professor of accounting at the University of Illinois at Urbana-Champaign; and Kristina Rennekamp, an assistant professor of accounting at Cornell University.
To examine investor behavior, the researchers conducted a controlled experiment with 203 participants who were provided an initial valuation about a company. Then they saw an earnings announcement indicating that, despite an increase in sales and net income, the company performed below expectations in the most recent quarter. Moreover, the disclosure indicated that management expected future performance to improve. Thus, the overall message was that company performance was mixed.
The researchers manipulated the disclosure to be more or less readable using suggestions provided in the Plain English Handbook published by the Securities and Exchange Commission (SEC) in 1998. After reading the disclosure, the participants gave judgments that indicated how comfortable they felt about evaluating the company. They were also given the option of looking at three sources of outside information:
- An individual analyst’s report,
- A report summarizing the consensus forecast of all analysts that follow the firm, and
- A Yahoo News story.
The researchers manipulated the outside information so that it was relatively supportive of managers’ claims that future performance would improve. Participants were then asked to indicate on an 11-point scale their assessment of the company’s value, with 1 being very low. They estimated their comfort level with the information provided from a seven-point scale, with 1 rated as low.
When management’s information was relatively low in readability and outside information gave low support for the company, participants gave the company a 6.1 investment rating on the 11-point scale. This rating was more than 10% below the rating for other combinations.
Keep it simple
While the AAA study focuses on public company disclosures, similar logic also may apply to investors and lenders who rely on financial statements provided by private companies. The findings suggest that presenting less readable information might undermine a company’s ability to convince investors that future performance is likely to improve. So, distressed companies should be open and honest when reporting lackluster results and explaining plans to turn around performance.
However, there’s a flip side: When disclosures are more readable, the findings suggest that investors might rely too heavily on the disclosures while discounting outside sources of information about a company. So, it’s important for investors and lenders to strike a balance between trusting a company’s financial statement disclosures and investigating external sources of financial information.
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