If you had ever thumbed through a corporate financial report—those quarterly and annual tomes which clog your mailbox or computer memory—you must have wondered about the numerous pictures of smiling people in these reports: Isn’t anybody there taking business seriously? But pictures aside, there are lots of numbers and particularly words in these reports. What about the information they convey?
Well, in my recent book, The End of Accounting… (Wiley, 2016), I have empirically demonstrated that the numbers in financial reports (earnings, assets) lost much of their relevance to investors over the past 3-4 decades. For new-era companies, these numbers are largely irrelevant (think Amazon’s and Tesla’s earnings, for example). But what about the extended narrative in financial reports? The lengthy discussions of the company’s business, its exposure to various risk factors, compliance with regulations, or the effectiveness of internal controls (the latter was raised to prominence by the Sarbanes-Oxley Act of 2002). And what about the detailed explanations of the impact of the ever-changing-and more-complex accounting rules on how earnings and assets were computed? All this must be a trove of information for investors, making it worthwhile to slog through the numbing dreariness of the reports and pick up nuggets obscured from other investors. So, should you really read financial reports or just toss them to the wastebasket (real or virtual)?
To address this question, a cottage industry in finance and accounting research—the fog and bog in the title of this post—is currently examining the readability and understandability of financial reports: If you can’t understand the narrative, what’s the use of spending time on these documents? Understandability is a desired qualitative characteristic of financial reports, as stipulated by the Financial Accounting Standards Board (the other characteristics: relevance, reliability, and materiality).
Fog? Bog? Well, these are computational linguistic indicators of the readability, and understandability of documents. The simplest is the Fog index, which measures the number of words per sentence, and the number of syllables per word. More syllables per word and longer sentences make the narrative harder to understand. Long, convoluted words and sentences are hard to fathom. Not exactly what the SEC had in mind in 1998 when it issued “plain English” guidelines for drafting IPO prospectuses and financial reports.
Applying the Fog index to the 10-K (annual) reports of U.S. public companies, Feng Li (Annual report readability, current earnings, and earnings persistence, Journal of Accounting and Economics, 2008) reports that the mean Fog index of the reports was 19.4, indicating that they are “unreadable” according to the standard interpretation of the index. (Wall Street Journal editorials have an average Fog index of 15.2). So, by Fog, reading financial reports is a waste of time.
The Bog index is designed to capture attributes of plain English, recommended by linguistic experts. Bog reflects sentence length, word difficulty (abbreviations, specialist terms, clichés, wordy phrases, etc.), and good writing (like names and interesting words). The figure below (from Bonsall et al., 2017, A plain English measure of financial reporting readability, Journal of Accounting and Economics) shows that both the Bog and the Fog average measures of financial reports increased steeply during 1994-2011, indicating that financial reports are less and less readable and understandable.
Note that the steepest increase is of the report length (tree killers). Amazingly, the median length of corporate 10-Ks more than doubled between 1996 and 2013. 200-300 page reports are now common, further damaging the ability to comprehend the message, if any, in these statements.
What accounts for the dramatic increases in the obfuscation and size of financial reports? You guessed it: mainly compliance with new accounting rules, internal controls, and other legal and risk issues. In short, rather than providing informative explanations of the business and its operating results, financial reports degenerated into highly convoluted legal documents, like your standard insurance contract. That’s what you get when you let lawyers and accountants be in charge of financial reports.
I am holding in my hands the 1902 first annual report of U.S. Steel corporation. It has everything that current reports have: a balance sheet, income statement, cash flow statement, footnotes, and much more. But it’s only 40 pages long! You don’t need more than that.
The takeaway for investors: Don’t waste your time reading corporate financial reports, unless you suffer from chronic insomnia. Better listen to, or read, the transcripts of quarterly earnings conference calls with analysts and the presentation “decks.” Much clearer, more focused, and relevant discussion of the business and its challenges. I became an avid reader of earnings calls.
Takeaway for the SEC and FASB: the evidence indicates that your efforts at enhancing “plain English” and report understandability failed. Plain and simple. This is a serious problem worthy of your attention.