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IIMB-WP N0. 486
WORKING PAPER NO: 486
Narrative analysis of annual reports – A study of communication
efficiency
Padmini Srinivasan
Assistant Professor,
Finance & Control
Indian Institute of Management Bangalore
Bannerghatta Road, Bangalore – 5600 76
Ph: 080-26993318
[email protected]
Srinivasan R
Associate Professor
Corporate Strategy and Policy
Indian Institute of Management Bangalore
Bannerghatta Road, Bangalore – 5600 76
Ph: 080-2699 3143
[email protected]
Year of Publication –April 2015
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Narrative analysis of annual reports – A study of communication efficiency
Abstract
Content analysis of annual reports has been a strong research theme in the fields of business
communication and corporate governance. We examine the quality and efficiency of corporate annual
report disclosures in malevolent environments. We study Indian automobile industry annual reports
encompassing the global recession period, viz., 2007-08 through 2011-12.
We content analyze the Management Discussion and Analysis sections of annual reports. We choose the
Indian automobile and auto-components industry as the context of our study for three reasons – there
exists variety in (a) the forms of firms in the industry (domestic firms and MNE subsidiaries); (b) size
(small to large); and (c) level of global integration (export intensity). The Indian automobile and autocomponents industry has sufficiently integrated with the global economy with the creation of global
supply chains and India becoming an important sourcing hub as well as a fast maturing consumer
market.
We study the relationship between textual complexity and firm performance in munificent
environments. We use content analysis as a primary tool for studying textual complexity. Using the
Flesch Reading Ease formula, we find that the reading ease of annual report texts vary significantly
across years. The other variables that influence reading ease are proportion of market capitalization
(size), promoter ownership and the extent of internationalization. In other words, bigger the size of
companies, higher the promoter ownership and higher the extent of internationalization, the texts are
easier to read. Other control variables including firm performance, age and diversification do not
contribute to textual complexity.
We contribute to organizational communication literature by adding environmental malevolence as a
factor in determining textual complexity. We demonstrate that in years when the environment is
difficult (such as a global recession), firms obfuscate their texts, irrespective of their financial
performance. We demonstrate the relative importance of external variables (business recession,
international exposure and stakeholder diversity) in influencing textual complexity than variables
internal to the firm.
Keywords: Corporate Annual Reports, Business Communications, Corporate Governance, Indian
automobile Industry, Content Analysis
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1.0 Introduction
Narrative analysis of annual reports has been of interest to accounting and finance literature. Of late,
with the emergence of corporate governance and disclosure norms across the world, and the
emergence of norms such as the International Integrated Reporting (or <ir> as it is known, for more
details, see www.theiirc.org), it has become important to study not just what is being communicated
but how it is being communicated as well. In other words, apart from the content of the communication,
the form of communication is also of interest. Worldwide, regulators are also emphasizing on improving
the quality of corporate reporting through various norms, including focus on the textual narratives in the
annual reports.
In this paper, we study the readability of corporate annual report disclosures in malevolent
environments. By separating the effects of environmental malevolence and organizational performance
on organizational communication, we demonstrate that environmental malevolence is a stronger
determinant of communication efficiency than organizational performance.
The impact of external environmental crises on organizational communication has been studied
primarily to discover self-serving biases in attributing positive or negative performances. Studies on
direction and strength of such attribution have yielded ambivalent results. For instance, it was found
that managers blame negative performance outcomes on the external crisis, while taking credit for
positive outcomes (Bradley, 1978). On the other hand, Salancik & Meindl (1984) found that managers
own up even unfavorable outcomes in unstable environments to demonstrate the extent of their
control over the environment. Similarly, D’Aveni & McMillan (1990) found differences between survivors
and bankrupt firms’ communication: firms that survived a crisis would emphasize on the crisis more
than those that went bankrupt. Keusch, Bollen & Hassink (2012) studied the recent macro-economic
recession (2008 onwards) and focused on studying the existence of self-serving bias in European firms.
They choose two years – 2006, to represent a non-crisis year, and 2008 to represent a crisis year – for
comparison. In this paper, we use five years of data beginning 2008 to include years of recovery from
recession.
The rest of the paper is structured as follows. We present a brief review of the literature in the next
section, followed by our research design. We present our methodology and data subsequently, followed
by the results section. We conclude with sections on discussion and conclusions.
2.0 Literature review
Content analysis of annual reports has been a strong research theme in the fields of business
communication and corporate governance. Studies on organizational communication have for a long
time, focused on the effect of organizational performance on the quality and efficiency of organizational
communication (Abrahamson & Amir, 1996; Abrahamson & Park, 1994). Jameson (2000) extolled the
virtues of linguistic narrative studies and demonstrated it using an analysis of shareholder reports of
equity mutual funds. There are five genres of narrative analyses around annual report texts: subjective
analyst ratings, disclosure index studies, thematic content analysis, readability studies, and linguistic
studies (Beattie, et al., 2004). While subjective analyst ratings focus on ratings by the analysts on
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disclosure information sufficiency and quality; disclosure index studies (also known as partial content
analysis) focus on studying the presence (or absence) of only those themes that are defined ex ante.
Thematic content analysis focuses on uncovering the underlying themes while analyzing the whole text;
readability studies focus on the clarity of communication using readability indices; whereas linguistic
studies focus on the subtleties of the language used in the communication rather than an onedimensional evaluation of readability (Beattie, et al. , 2004).
Studies on attribution of communication have demonstrated relationships between financial
performance and annual report texts (Abrahamson & Park, 1994). Also known as the “good news, bad
news” hypotheses or “accounting bias”, researchers argue that good performance is attributed to the
firm and managerial choices, whereas the reason for bad performance is externalized (Aerts, 1994;
Aerts, 2001; Bettman & Weitz, 1983; Bradley, 1978; Clatworthy & Jones, 2003; Ingram & Frazier, 1983).
For instance, Jones (1988) demonstrated that firms obfuscate their textual communication in years of
poor performance, relative to those years when their performances have been better. Firms have also
been found to conceal negative organizational outcomes from stockholders willfully, by either lower
disclosures or through obfuscating their texts (Abrahamson & Park, 1994). Clapham & Schwenk (1991)
found that such self-serving attributions may not be entirely willful actions by managers, and they may
be present because of poor choice of niches or domains by firms; and the managers’ own cognitive
biases. Given the negative effects of such self-serving attributions on resource providers (Schwenk,
1990), there can be no explanation for willful attribution to conceal outcomes from shareholders.
Salancik and Meindl (1984) study the relationship between causal attributions of firm performance with
stability of outcomes (as a proxy for management control). While they found support for the attribution
in positive outcomes, management also takes the blame for negative outcomes if their outcomes are
unstable, thereby signaling high management control over the external environment.
Narrative analysis studies have focused on either the breadth and depth of disclosures (quality), or the
efficiency of disclosures. The focus of quality studies (when the texts supplement the financial and other
quantitative information in the company annual reports) is “what is being communicated”. Beattie, et al.
(2004) defined quality as including two dimensions – the amount of disclosure and the spread of
disclosure. The measures proposed in their study include “the actual amount of disclosure, relative to
the amount expected”, spread of disclosure across topics using concentration measures across main
topics, sub-topics, and non-empty sub-topics (Beattie, et al., 2004: 21). Beretta and Bozzolan (2008)
distinguish between quality and quantity of communication. They defined richness of communication as
including the width of disclosures, plus the depth of disclosures. They evolve a composite index that
considers quantity of disclosure and richness of its content. Content analysis of mandatory and
voluntary disclosures is the dominant tool of these studies (Abrahamson & Amir, 1996; D’Aveni &
McMillian, 1990; McConnell, Haslem, & Gibson, 1986; Patelli & Pedrini, 2013; Tennyson, Ingram &
Dugan, 1990; Smith & Taffler, 1995; Smith & Taffler, 2000; Swales, 1988).
We define efficiency of communication as the relative ease of reading (textual complexity), or in other
words, “how something is being communicated”. For instance, Courtis & Hassan (2002) studied
differences in readabilities of annual reports in different languages (English and Chinese versions in
Hong Kong; and English and Malay in Malaysia), and found that indigenous language versions were
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relatively easier to read than their English counterparts. Such studies on the ease of reading use one of
the several indices to evaluate textual complexity, the most popular of them being the Flesch Reading
Ease scale (Flesch, 1948).
2.1 Readability studies
Crow (1988) extolled the virtues of “plain English” in organizational communication, as it signals honest
and responsive communication. Jones and Shoemaker (1994) reviewed the then literature on content
analysis in accounting research, and highlighted the importance of readability research. Their review
summarized five basic questions in readability studies: readability of annual reports, differences in
readability across sections, differences in readability across types of reports, differences in readability
over time, and association of readability with other variables (Jones and Shoemaker, 1994). Table 1
summarizes the major reading ease studies.
Table 1: Summary of major readability studies
Study
Barnett &
Leoffler (1979)
Texts
Footnotes to
accounting
statements and
audit reports
Method/tool
Flesch Reading
Ease formula
Jones (1988)
Chairman’s
letters
Flesch Reading
Ease formula
Subramaniam,
Insley &
Blackwell
(2003)
Letter to
shareholders
Flesch–Kincaid
index;
RightWriter
jargon index
Courtis &
Hassan (2002)
Chairman’s
address
Hrasky, Mason,
& Wills (2009)
Chairpersons’
letters
Flesch Reading
Ease (English
texts); Yang
formula
(Chinese texts);
Yunus
readability
formula (Malay
texts)
Flesch Reading
Ease score
Result
Footnote texts in 1975
had lower readability
scores than 1969 texts;
audit report readability
is low, and varies
significantly among
independent auditors
Reducing readability
over time; increasing
size & complexity; and
listing
Good performers’
annual reports are
easier to read than
poor performers’
reports; and use less
jargon
Readability levels are
different across
languages; texts in
indigenous texts are
relatively easier to read
than their English
counterparts
Readability of better
performing companies’
texts are better than
Implications
Reduction in
readability scores can
be attributed to both
management and
auditors to these firms
Readability is a
function of firm
complexity – the need
to reach a wider
variety of stakeholders
Managers use annual
report as a marketing
tool, that is amenable
to manipulation as it
reaches multiple
stakeholders
Differences in
readabilities can have
potential resource
allocation decisions
Conscious impression
management by
managers in poor5
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Li (2006)
Annual reports
(10-K filings)
Fog index +
length of the
report
Rutherford
(2003)
OFR (MD&A
texts, as they
are known in
UK)
Flesch Reading
Ease index
those reporting poor
performance
Negative association
between readability
and firm performance
(current earnings and
earnings persistence)
Obfuscation of OFR
texts may not be just
related to poor
performance; and
complexity of the
content could also play
a role
performing firms to
obfuscate texts
Managers may be
opportunistically
structuring annual
reports to hide
adverse information
from investors
Textual complexity in
OFRs may be an
unintended
consequence of
procedures and habits
learnt from best
practices
As seen in Table 1, the major focus of readability studies have been towards understanding the
relationship between reading ease and firm performance, with size and complexity as control variables.
In our study, we study differences in readability in the context of environmental malevolence (economic
recession) using a longitudinal sample for firms in the Indian auto and auto-components industry.
2.2 Environmental malevolence
Khandwalla (1972) was one of the earliest studies on organizational responses to environmental
malevolence. He enumerated various organizational responses to environmental uncertainty,
heterogeneity and malevolence. He defines environmental malevolence (or hostility) as “a condition of
perceived threat to the organization’s primary goals” (Khandwalla, 1972: 307). Schmitt, Probst, &
Tushman (2010) elucidate how organizations develop ambidexterity in times of economic crisis, in the
context of the 2008 global recession, through a case example of Samsung Electronics Corporation. Such
economic crises could also have an impact on the content and form of organizational communication
with its stakeholders. D’Aveni & MacMillan (1990) contrasted the contents of letters to shareholders
between matched samples of failing and surviving firms, and found support for normative strategy:
successful firms focused more on the output environment, whereas failing firms focused more on the
internal and input environments, denying the crisis and focusing on the short-term issues. Keusch, et al.
(2012) found extensive use of self-serving behavior in times of environmental crisis.
2.3. Inertia in communication
Aerts (2001) conducted a longitudinal analysis of annual report texts to study the inertia in attributional
behavior, and found significant consistency across years. Firm reporting practices could have been unadaptive, either due to embedded routines or formalized procedures; and stability in attributional
content was due to listing status and performance history (Aerts, 2001). Given the inertia in changing
the content over years, an environmental crisis is likely to challenge the routines and procedures, and
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lead to significant changes in the communication styles. Therefore, we hypothesize that as the industry
emerges out of recession, the textual complexity of the annual report texts would reduce.
H1: Readability of MD&A narratives would continuously improve over the years from
2008-12 as the recession tapers off.
2.4. Firm performance and other control variables
Annual report texts of better performing companies are likely to be easier to read than those that
performed poorly (Hrasky, Mason & Wills, 2009; Subramaniam, et al., 2003). In addition to firm
performance, we also control for firm growth, shareholder diversity, firm complexity, and
internationalization. Firms with concentrated ownership, with low shareholder diversity (large share of
promoter ownership) have no incentives to obfuscate their texts, as these promoters would most likely
also hold operating roles in the firm as senior managers or members of the board. Similarly, firms that
operate in multiple industries could spread their performance risk over a variety of products, and
therefore have little incentive to communicate in complex terms (Jones, 1988). Likewise, firms operating
in international markets have a wide stakeholder base to communicate to, and therefore would be
better off communicating in easier language (Courtis & Hassan, 2002). Therefore, we hypothesize that
the readability of annual report texts would be better for firms that are (a) relatively highly profitable,
(b) larger; (c) older; (d) enjoying higher share of promoter ownership, (e) highly diversified, and (f)
having higher proportion of exports.
H2a: Readability of MD&A narratives of high-performing firms will be better than
those of low-performing firms.
H2b: Readability of MD&A narratives of larger firms will be better than those of
smaller firms.
H2c: Readability of MD&A narratives of older firms will be better than those of
younger firms.
H2d: Readability of MD&A narratives of firms with highly concentrated ownership will
be better than those firms with dispersed ownership
H2e: Readability of MD&A narratives of highly diversified firms will be better than
those of low-diversification firms
H2f: Readability of MD&A narratives of highly internationalized firms will be better
than those of low-internationalization firms
3.0 Research Design
3.1. Longitudinal design
Schmitt, Probst, & Tushman (2010) call for studying the impact of environmental crises using
longitudinal case studies. Since we are interested in separating the effects of environmental
malevolence and firm performance on efficiency of communication, we choose to study texts over
years. We choose a specific timeframe that includes global recession (2008-12) that affected the
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performance of most firms in the sample to reflect environmental malevolence. D’Aveni & McMillan
(1990) and Keusch et al. (2012) had introduced environmental crisis in their studies of annual report
contents. Both these studies use two points of data to reflect a normal year and a crisis year and
contrast between the two. We expand on these study designs to examine five years of texts to include
gradual and consistent changes in the texts. Furthermore, while these two studies focused on the
content of the texts, this study focuses on the efficiency of communication (textual complexity) across
years.
3.2. Choice of MD&A texts
Studies on quality of communication have focused on the texts including Chairman’s letter to
stockholders (Abrahamson & Amir (1996); Subramanian, et al. (1993); Courtis, 2004) and the
Management Discussion & Analysis (MD&A) texts (Bowman, 1978; Bowman, 1984; Bryan, 1997). We
preferred to use the MD&A section of the annual reports over Chairman’s letters to stockholders. In the
Indian context, the structure and broad contents of the MD&A is mandated by the listing regulation, and
every annual report ought to include one as compared to the Chairman’s statement that is voluntary.
The MD&A texts are required to include both an analysis of the external environment and internal
context of the firm such as industry structure and trends, opportunities and threats, segment
performance, analysis of financial performance, future outlook, and risks and concerns (Rajagopalan and
Zhang 2008).
3.3. Single industry context
Since our primary purpose is to separate the effects of environmental malevolence from performance in
explaining reading ease of the annual reports texts, we choose to study firms from a single industry. We
choose the Indian automotive pndustry (that includes automobile manufacturers and auto-component
manufactures) to represent uniformity of environmental forces. The Indian automotive industry is fairly
exposed to the global economic context, as the industry comprises a variety of firms: domestic
competitors; JVs with foreign automotive majors (Japanese, American, and European); and MNC
subsidiaries. The industry also comprises firms that produce products for the domestic market, use India
as an export hub, as well as a combination of both. The industry is open to global competition with both
inward foreign direct investments into India, and with Indian firms beginning to invest in assets and
operations abroad.
Choosing a single industry context ensures that the internal business environment is also consistent
across firms in terms of asset intensity, performance parameters, and organizational forms. This industry
also provides us access to sufficient number of publicly listed firms to make a usable sample.
3.4 Choice of years
D’Avenni & McMillan (1990) and Keusch (2012) studied the effect of environmental crisis using two
benchmark years – one to represent a “normal” year and another to represent a “crisis” year. In order to
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study the sustained effects of the environmental crisis on firm communication, we use a longitudinal
design to include years when the global recession was at its peak in 2008, and the recession tapered off
through the next few years (IMF, 2011). Therefore, we choose to study firm annual reports including the
five fiscal years 2007-08 through 2011-12.
3.5 Sample and data
We draw our sample from the Center for Monitoring Indian Economy (CMIE) Prowess Database.
PROWESS, is a widely used and well-validated database for research on Indian companies (Elango and
Pattnaik, 2007; Khanna and Palepu, 2000; Khanna and Rivkin, 2001; Vissa et al., 2010). Our sample
consists of all the listed automobile and auto-component companies in the National Stock Exchange. In
all, there were 139 firms listed in the database. From this, we eliminated companies that did not have
data for the full five years. Further, to ensure comparability of the annual reports, we choose companies
with a year-end date of March 31. The final sample consisted of 89 firms for 5-year period between
2008 and 2012. This resulted in 445 firm years. The sample consists of domestic firms as well as
companies that were subsidiary of multinational firms (and listed in the NSE). Table 2 provides the
sample description of firms in terms of ownership.
Table 2: Sample description (ownership)
Ownership
Domestic
Foreign
TOTAL
Number
76
13
89
Product
Automobiles
Auto-components
TOTAL
Number
8
81
89
4.0 Data and Methodology
We use the Flesch readability index to assess the readability of texts. The Flesch Reading Ease Scale
(FLRE) is a widely used measure in research to study the complexity of text (Courtis 1995, Courtis 1998,
Beattie, 2004, Courtis, 2004, Prasad, et al., 2009). The readability index or the score measuring the
textual complexity is derived from the number of words in a sentence and the number of syllables in
each word that form the narrative. The reading ease is classified from “very easy” to “very difficult”
based on the scores (ranging from 1 to 100). Scores from 0–30 are described as scientific writing and are
the most difficult to read; whereas scores from 30–50 are described as academic writing. At the other
end, scores closer to zero are the easiest to read (Courtis, 1995). Even though there have been questions
on the use of FLRE as a measure to study textual complexity, as it only measures readability rather than
understandability or completeness of the text (Hrasky & Smith, 2008), it continues to be the best
available measure to study textual complexity in terms of difficulty and obfuscation (Courtis, 2004;
Rutherford, 2003).
Firm financial performance may influence the way in which the companies write their MD&A. Prior
literature suggests that companies that are not performing well may want to hide the poor results and
thus may follow a difficult to read style of writing (Jones, 1988; Subramanian et al., 1993; Courtis, 2004).
Earlier studies have used absolute measure of profitability (for instance, Subramanian et al., 1993), while
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a few other studies use percentage change in reported profits (for instance, Courtis, 2004; Clatworthy &
Jones, 2001). Using either an absolute measure or change in the profit is unidirectional and does not
fully capture the resources employed by the firm. We therefore use return on equity (ROE) as a measure
of financial performance of the company. ROE is a more relevant measure for investors and better
represents the earnings due to the shareholders (for instance, studies including Smith 2005; and Hrasky,
et al., 2009 use ROE to measure performance).
Size and complexity of firms are other control variables that may affect the textual complexity of
communication by listed firms (Hrasky, et al., 2009). Larger firms are under increased scrutiny by the
analysts as well as retail investors, and it would be expected that these companies are more
forthcoming in providing information, as well as presenting the data in a simple and transparent style
(Rutherford, 2003). Similarly, companies that are highly diversified (manufacture multiple products and
services) need to disclose segment information and address more complex issues which may make
MD&A more difficult to read. Companies exposed to diverse stakeholders are under higher pressure to
make their texts easy to read. For instance, firms that export a large proportion of their production may
want to address stakeholders across different countries, and therefore may resort to easy to read texts.
We use market capitalization as a measure of size to represent the value of the firm (rather than asset
size or turnover); number of products to measure the extent of diversification and therefore complexity
of the firm performance reporting; and exports as a proportion of sales as a measure of export intensity.
Mature firms are more experienced and are likely to use specialized teams or outsource the preparation
of the annual reports (Courtis, 2004). We measure the maturity of the firm by the age of the firm
(calculating the difference between the year of incorporation and the year of the annual reports). Firms
that are largely owned by promoters enjoy significant advantages than those that are held by more
dispersed ownership. For instance, firms with concentrated ownership have their promoters and large
shareowners as operating managers as well, as in the case of most family-owned businesses. Such firms
have very little incentive to obfuscate their texts, as their majority owners (significant stakeholders) are
in complete cognizance of the firm performance and outcomes; in comparison with firms that have
dispersed ownership structures. Jones (1988) found that texts became increasingly difficult to read as
firms went public. We measure concentration of ownership using proportion of promoter ownership in
the firm.
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Exp_sales: refers to the complexity of the firm, measured by the proportion of exports to total sales
DIVER: refers to the complexity of the firm, measured by the number of products
PROWN: refers to the concentration of ownership of the firm, measured by the proportion of promoter ownership
Age: refers to the maturity of the firm, measured by age of the firm
MCAP: refers to the size of the firm, measured by market capitalization
ROE: refers to the firm performance, measured by return on equity
FLRE: refers to the textual complexity, measured by the Flesch Reading Ease (FLRE) index
where:
Table 3 presents the summary statistics of the variables
+ β1 * ROE + β2 * logMCAP + β3 * logAge + β4 * PROWN + β5 * logDIVER + β6 * exp_sales + Year,
Year
Mean
2008
2009
2010
2011
2012
Maximum
2008
2009
2010
2011
2012
Minimum
2008
2009
2010
2011
2012
FLRE
ROE
MCAP
Age
28.91
28.37
27.88
26.64
27.06
10.53%
1.51%
12.64%
13.30%
13.78%
11750.68
7592.68
20969.83
27840.26
29211.21
28.91
28.37
27.88
26.64
27.06
45.60
47.00
45.20
42.90
53.40
50.85%
120.98%
58.06%
78.90%
72.10%
240342.44
223934.19
409139.98
671494.67
742077.83
14.2
9.6
14.7
14.5
13.5
-158.02%
-452.76%
-35.34%
-205.92%
-63.58%
35.37
35.37
35.37
35.37
35.37
DIVER
PROWN %
Exp_sales %
6.96
6.96
6.93
6.96
6.96
56.69
57.24685
57.746
58.14697
58.16236
11.47%
12.89%
10.43%
11.32%
11.81%
89
90
91
92
93
20
20
20
20
20
95.38
95.38
95.38
95.38
95.38
83.79%
86.19%
84.09%
83.80%
87.80%
1
1
1
1
1
1
1
1
1
1
22.56
23.41
25.03
24.9
25.03
0.00%
0.00%
0.00%
0.00%
0.00%
Given the cross-sectional data (firm-year observations), we use panel data regression to test our
hypotheses. The regression model is estimated as follows:
FLRE =
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5.0 Results
Table 4 presents the data on readability scores; and figure 1 depicts the trend of FLRE over the years.
Table 4: Descriptive Statistics for the Readability Scores
Year
2008
2009
2010
2011
2012
Average
28.9
28.4
27.9
26.6
27.1
FLRE
Maximum
45.6
47.0
45.2
42.9
53.4
Minimum
14.2
9.6
14.7
14.5
13.5
Figure 1: Flesch reading index for 5 years
FLRE
29.5
29
28.5
28
27.5
27
26.5
26
25.5
2008
2009
2010
2011
2012
Years
We find that the readability scores are relatively very low (less than 30) across years, indicating scientific
level of difficulty in reading. The maximum score is 53.4 in 2012 and the minimum score is 9.6 in 2009.
As we can see, the difficulty levels persist as the recession continues, and only improves in 2012.
Table 5 presents the correlation matrix among the variables. The results of the panel data OLS
regression are provided in table 6. We use “R” software for the analysis.
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Table 5: Correlation matrix
FLRE
ROE
exp.sales
Div
Logmcap
Age
PROWN
Year
FLRE
1.000
0.044
0.123**
-0.009
0.073
0.007
0.062
-0.115**
ROE
Exp_Sales
Log.Div
Logmcap
1.000
0.004
0.027
0.149
-0.124
-0.011
1.000
0.304
0.276
-0.091
-0.009
1.000
0.210
-0.245
0.127
1.000
0.049
-0.044
0.162
-0.116
-0.142
0.077
Age
1.000
-0.137
0.108
PROWN
1.000
0.044
Year
1.000
Table 6: Panel data regression results
lm (formula = FLRE ~ ROE + Exp_sales + Log.DIVER + LogMCAP + log.Age + PROWN + Year, data = dat)
Coefficients
(Intercept)
ROE
Exp_sales
Log.DIVER
LogMCAP
log.Age
PROWN
Year
Estimate
(t value)
1237.04
(0.004)**
0.81502
(.357)
5.1974
(.007)**
−0.8222
(0.481)
0.87106
(.024)*
0.21226
(0.862)
0.05088
(.0179)*
−0.6046
(0.004)**
Signif. codes: 0 ‘***’ 0.001 ‘**’ 0.01 ‘*’ 0.05
Multiple R-squared: 0.05017
Adjusted R-squared: 0.03467
F-statistic: 3.237 on 7 and 429 DF, p-value: 0.002339
Firm performance, as measured by return on equity does not show significant relationship with FLRE.
This is in contrast to the innumerous studies that have demonstrated that poor performing firms
obfuscate their texts more often than better performers (for instance, Courtis, 2004; Rutherford, 2003);
and firms obfuscate their texts when they perform poorly, compared to when they perform better (for
instance Bettman & Weitz, 1983; Salancik & Meindl, 1984). This may be due to the effect of external
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environment, rather than financial performance of the firm. We posit that the relationship between the
external environmental malevolence and textual obfuscation may be mediated through firm
performance, and therefore prior literature, which has only focused on the relationship between firm
performance and textual complexity, has found significant results.
Among the other variables that measure firm complexity, diversification and export intensity, only
export intensity is significant. This also lends support to our argument that the external environment, in
this case, global recession has more to do with textual complexity. Firms that have high export intensity
have to deal with a wider variety of stakeholders and possibly have to use such texts (such as the annual
reports) as a basis of image building for resource, technology, and other complementary capability
access in other markets, they would tend to keep their texts relatively simple. On the other hand, the
more the firm is dependent on a wide variety of stakeholders for resources and capabilities, the lesser
the textual complexity. The other variable that measured complexity, viz., diversification, did not show
any significant relationship. Possibly, in spite of the firm producing a diverse set of products, they are
communicating to the same set of stakeholders (resource providers) and thence there is no effect on
obfuscation of texts.
The concentration of ownership, measured by the extent of promoter ownership was also a significant
determinant of reading ease in our study. The positive sign indicates that higher the proportion of
promoter ownership, the easier are the texts to read. This is in line with the agency theory argument,
where significant shareholders, also take up executive/managerial positions in the firm, and therefore,
there is no explicit need to obfuscate the texts. This is especially true in the Indian context, where
similar members of the promoter family, most often also take up executive leadership roles. Since the
major consumers (promoters) of firm performance information (annual reports) have detailed access to
the same, the firms have no or very little incentive to obfuscate the texts to the relatively smaller
proportion of non-promoter owners. Corporate governance studies that have largely focused on the
content of disclosures, rather than form of communication, have found positive relationship between
concentration of ownership and opacity of communication (Mitchell, Chia & Loh, 1995; Atken, Hooper,
& Pickering, 1997). Combined together, we can conclude that since firms with concentrated ownership
communicate very little, there is not much need to obfuscate.
Our results also provide a relatively weak relationship between firm size and obfuscation. As the size of
the firm increases (measured using market capitalization), the firm is under increased analyst and public
focus. Therefore, the firms have a significant incentive to keep their texts simple to be able to address
the communication needs of a wider variety of stakeholders. The other variable we studied, firm
maturity, as measured by age, did not show any significant relationship.
6.0 Discussion
We provide significant evidence to the importance of external environment (environmental
malevolence) on the readability of annual report texts. We studied environmental malevolence through
a longitudinal study of annual reports texts, including years characterized by global economic recession.
This result is counter to the argument that managements of firms are concerned about maintaining
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stability and inertia of readability indices across years (Aerts, 2001). When a firm encounters an
exceptionally difficult external environment, irrespective of its performance, its annual report texts
become difficult to read. Earlier studies had almost exclusively focused on measuring the effect of firm
performance on the readability indices, and had found significant effects while using cross-section data
(Rutherford, 2003; Courtis, 2004). Even the few studies that use longitudinal data (Salancik and Meindl,
1984) have found the effect of firm performance on readability indices. This is possibly due to the
posited mediation of firm performance on the relationship between environmental malevolence and
textual complexity. We call for further studies to evaluate the mediating role of firm performance.
We also demonstrate the significance of diversity of stakeholders with whom the firm communicates to.
As the firm communicates to a wider set of stakeholders, it is possibly forced to keep their texts simple.
Our results on the significance of export intensity and size demonstrate the need to simplify texts as
firms communicate to larger audiences; whereas our result on concentration of ownership signals the
diversity of information needs between stakeholders (promoters with possibly executive roles in the
firm; and the small number of retail shareholders) and forces the firms to keep their texts simple.
Therefore, number and heterogeneity of stakeholders is a significant determinant of communication
efficiency of firms.
7.0 Conclusions
We study the relationship between textual complexity and firm performance in malevolent
environments. We find that the reading ease of annual report texts varies significantly across years; and
the annual reports do not get easier to read as the recession tapers off (persistence of obfuscation). The
only other variables that influence reading ease are concentration of ownership, firm size and the extent
of internationalization.
By introducing a panel data that combines cross-section and longitudinal data in our study, we establish
the primacy of external environment over firm performance in explaining changes in readability indices
of annual report texts. Rutherford (2003) concluded that not all poor performing companies obfuscate
their texts, and the presence of such complex language may be more a result of what is being
communicated than just firm performance. In our study, given the common external environment that is
being studied, we control the effect of information content on textual complexity.
One of limitations of our study is the use of a single readability index, the FLRE. Karlinsky and Koch
(1982) demonstrated the need for multiple readability indices using a reading experiment. Given the
exploratory nature of our study, where we wanted to demonstrate the effect of environmental
malevolence on the textual complexity, we were content with one and the most commonly used index.
Further studies could validate this assertion using multiple indices of readability.
We contribute to organizational communication literature by adding environmental malevolence as a
factor in determining textual complexity. We demonstrate that in years when the environment is
difficult (such as a global recession), firms obfuscate their texts, irrespective of their financial
performance. We demonstrate the relative importance of external variables (business recession,
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international exposure and stakeholder diversity) in influencing textual complexity than variables
internal to the firm. We call for further longitudinal studies on annual report narrative texts to explore
the effect of malevolent environments on the quality and efficiency of firm communication. We
contribute to the accounting narratives literature by calling for measures that narrative studies use to
study stakeholder diversity. We contribute to the corporate governance literature by emphasizing the
need for stricter regulations on the voluntary and mandated narrative disclosures in annual reports.
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