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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 1 IIMB-WP N0. 486 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 2 IIMB-WP N0. 486 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 3 IIMB-WP N0. 486 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 4 IIMB-WP N0. 486 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 IIMB-WP N0. 486 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 6 IIMB-WP N0. 486 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 7 IIMB-WP N0. 486 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 8 IIMB-WP N0. 486 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 9 IIMB-WP N0. 486 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. 10 IIMB-WP N0. 486 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 = 11 IIMB-WP N0. 486 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. 12 IIMB-WP N0. 486 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 13 IIMB-WP N0. 486 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 14 IIMB-WP N0. 486 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. 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