Readability of Narrative Disclosures in 10-K Reports: Does Managerial Ability Matter?

Abstract

This study examines the association between managerial ability and the readability of narrative disclosures in 10-K reports. Using a large US sample from 1994 to 2015, we find that managerial ability is significantly positively associated with the readability of narrative disclosures in 10-K reports. We also find that this association is more pronounced for firms with high levels of profitability. In addition, firms’ financial performance mediates the association between managerial ability and the readability of 10-K reports. Further analysis shows that the association was more pronounced before the implementation of the plain English disclosure rules. These results are robust to alternative specifications of managerial ability, 10-K report readability, and the endogeneity concern. Overall, findings from this study suggest that managerial ability matters for improving the readability of corporate disclosures.

Keywords:

• Managerial ability
• 10-K reports
• Readability

JEL classifications:

• G14
• G38
• M12

Acknowledgments

We are indebted to Reuven Lehavy and Florin Vasvari (guest editors of the special issue on textual analysis) and two anonymous reviewers for their insightful suggestions which have significantly improved the paper. We are also grateful for the helpful comments from Panayiotis C. Andreou, Ahsan Habib, Bohui Zhang, Adrian Cheung, Robert Durand, and Grantley Taylor. We also thank Greg Shailer (discussant) and the participants at the SIRCA's 7th Young Researcher's Workshop held in the University of Melbourne for their comments and suggestions. Moreover, we thank Brian P. Miller for providing the Bog readability scores. Special thanks are due to Bill McDonald for providing the file size and number of 10-K words data. We also thank Feng Li for his generosity in providing Fog and Flesch Index data. Finally, we thank Peter Demerjian for making managerial ability data publicly available.

Notes

1 For example, Demerjian et al. (2012, p. 1242) show that ‘a one-standard deviation increase in the relative ability of a CEO is associated with a 37.0% higher stock return and 3.2% higher ROA over the next three years’.

2 http://faculty.washington.edu/pdemerj/data.html.

3 We thank Brian P. Miller for making Bog Index data publicly available at https://kelley.iu.edu/bpm/activities/bogindex.html.

4 For a detailed discussion of the Bog Index, see Bonsall, Leone, et al. (2017).

5 The data for the file size is obtained from http://www3.nd.edu/~mcdonald/Word_Lists.html#File_Summaries.

6 Our inferences from the analysis remain similar when we use the natural log of the number of words in 10-K documents (WORDS) as an alternative measure of financial statement readability (results untabulated).

7 Untabulated analyses show that results are qualitatively similar using the continuous managerial ability score.

8 We acknowledge that the economic significance of managerial ability on the Bog Index appears to be relatively less meaningful. A close look reveals that the interquartile range for the Bog Index is only 10, indicating that there is very little variation in the Bog Index metric. In addition, firms belonging to both the 25th and 75th percentile figures are classified as ‘Poor’ readability groups. Thus, the lack of variation in the Bog Index, results in a relatively lesser economic significance for managerial ability in reducing the Bog Index. Therefore, we emphasize the file size measure of readability in explaining the economic significance of managerial ability.

9 We also explore whether more able managers, compared with their less capable counterparts, are associated with more readable annual reports at a given level of firm performance. Given that firms with the same level of performance can be managed by managers with various abilities, this setting will allow us to isolate the managerial ability from the general firm performance and identify whether the association between managerial ability and the readability of annual reports is conditional on a given level of firm performance. Our analysis show that higher managerial ability is associated with more readable annual reports and that this association is not confined to any performance group (results untabulated).

10 Following prior studies (Cheung, 2016; Hasan & Habib, 2017), we use different sets of controls for equations (2) and (3). In particular, equation (2) includes controls that prior studies show to affect readability (Li, 2008; Lo et al., 2017). Moreover, since equation (3) shows how managerial ability (MA) is associated with readability through the firm performance channel, we include controls that prior studies suggest to affect firm performance (Baños-Caballero, García-Teruel, & Martínez-Solano, 2014; Unsal, Hassan, & Zirek, 2016). Note that our results (untabulated) remain qualitatively similar even if we include similar sets of controls for the two equations.

11 One may argue that the managerial ability of the current year will have an impact on the organizational performance in the next year. Therefore, in the sensitivity analysis, we use one-year-ahead profitability in the regression and obtain qualitatively similar results (untabulated).

12 As an additional robustness test, we use CEO tenure as a proxy for managerial ability. Milbourn (2003) argues that longer CEO tenure indicates the market's perception of the CEO's ability and the board's willingness to retain this executive. Our empirical results show that CEO tenure is insignificantly associated with the Bog Index. However, the association of CEO tenure with FILESIZE is negative and significant (p<0.01). This mixed evidence is not surprising given that Demerjian et al. (2012) also note that CEO tenure is a weak proxy for managerial ability.

13 As a further sensitivity analysis, following Muslu, Radhakrishnan, Subramanyam, and Lim (2015), we use the natural log of the number of sentences in the management discussion and analysis (MD&A) section of the annual report (MD&A_SENT) and the natural log of the number of forward-looking sentences in the MD&A section of the annual report (MD&A_FWLS). Untabulated results show that managerial ability is negatively associated with both MD&A_SENT and MD&A_FWLS, corroborating the conclusions from our main analyses.

14 Note that we tabulate two sets of first-stage regressions. In Column (1), the first-stage regression is estimated for a sample of 56,318 firm-years spanning from 1994 to 2015. On the other hand, in Column (2), the first-stage regression is estimated for a sample of 50,287 firm-years during the period 1994–2014. This is because data for the Bog Index are available for 1994–2015, whereas data for the file size and number of words are available for 1994–2014, justifying the need for two sets of first-stage regressions.

15 We exclude firm-year observations in 1998 to remove the intervention effect.