RESEARCH CORNER

Foggy reporting...

Walking my dog on a recent afternoon as heavy fog rolled into downtown Vancouver, I was reminded of an interesting research paper presented at the Journal of Accounting and Economics conference* held this September in Chicago.

In a paper entitled, "Annual report readability, current earnings, and earnings persistence," University of Michigan professor Feng Li examines whether companies typically prepare more readable annual reports when they've had good earnings performance.

Professor Li used a "Fog Index" to measure readability. Derived from the field of computational linguistics, this index is a function of the number of words in a sentence and the number of words with three or more syllables.

Using a computer program to analyse more than 50,000 annual reports, Li found that firms with poorer earnings did, indeed, produce "foggier" reports. Moreover, the effect was approximately three times stronger when he focused only on the management discussion and analysis sections of these annual reports.

Li's paper also analyses whether fogginess is a forward-looking indicator of earnings' future sustainability. Interestingly, his research suggests that firms with good earnings performance and more readable annual reports do experience more persistent (and positive) earnings in the future.

These results suggest that smart investors should pay careful attention not only to what management says, but also to how management delivers its message. Obfuscation is likely a sign of bad times-not only in the previous year but also in the years ahead. Simply put: Just as drivers should refrain from driving in heavy fog, investors should stay clear of firms with foggy annual reports.

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