۱- Introduction

۲- Literature review and hypothesis development

۳- Research design

۴- Sample selection, descriptive statistics, and main results

۵- Additional analysis

۶- Robustness tests

۷- Conclusion

References

Abstract

Concerns about the complexity of firm disclosures have prompted regulators to initiate projects to improve the readability of annual reports. We investigate business strategy as a determinant of annual report readability. As business strategy fundamentally determines a firm’s product and market domain, technology, and organizational structure, it influences a firm’s operating complexity, environmental uncertainty and information asymmetry. Consequently, business strategy frames the level, wording, and complexity of disclosures. We capture a firm’s business strategy based on the Miles and Snow (1978) strategic typology and measure 10-K readability with Li’s (2008) Fog index. We find that firms pursuing an innovation-oriented prospector strategy have less readable 10-Ks relative to firms pursuing an efficiency-oriented defender strategy. We also find that prospectors display more negative and uncertainty tones while defenders exhibit more litigious tone in their 10-Ks. Our study provides useful insights to policy makers as it suggests that efforts to improve annual report readability may be limited for some firms given that business strategy is a fundamental determinant of readability and pronouncements accommodating different strategic orientations are not feasible.

Introduction

As the scope of reporting requirements has widened to a broader narrative including corporate governance, sustainability and responsibility, remuneration, enhanced disclosure regimes and long form audit reports, the complexity and materiality of information in annual reports is being questioned. This has prompted the international financial reporting community to initiate projects on streamlining annual reports to improve their readability. Responses in the US include the Securities and Exchange Commission (SEC)’s 1998 Plain English Mandate (SEC Rule 421 (d)) and the Financial Accounting Standards Board (FASB)’s ongoing Disclosure Framework project, initiated in 2009, with the objective of making financial statement disclosures more effective, coordinated and less redundant. Disclosure reform is also on the agenda of the International Accounting Standards Board (IASB) and the UK Financial Reporting Council (FRC). 1 Form 10-Ks report accounting numbers prepared in accordance with accounting standards, as well as unstructured textual narratives disclosing accounting policies and describing business operations and financial performance. When preparing annual reports, including the financial reports and accompanying notes, and the management discussion and analysis (MD &A) sections, managers have discretion over the content emphasized, and the language and writing style used in their narratives (Henry and Leone, 2016; Loughran and McDonald, 2014). Li (2010) argues that unstructured textual narratives in annual reports exhibit irregularities, ambiguities, and managerial opportunism. Form 10-K volume of pages and footnote disclosures has also increased, up 16 percent and 28 percent respectively over the six-year period 2004–۲۰۱۰, with evidence of disclosure repetition and redundancy (Iannoconi and Sinnett, 2011). Investors rely on information in 10-Ks to infer trading and pricing decisions (Cazier and Pfeiffer, 2016; Griffin, 2003; Huddart et al., 2007) and complex disclosures, including less readable annual reports, can impair users’ ability to process information, and hence affect their judgment and decision making (Li, 2008; Miller, 2010; You and Zhang, 2009). Consequently, policy makers and various capital market participants are increasingly concerned about the readability of 10-Ks that underpins the understandability and decision usefulness of information contained therein.