The contribution of banks' annual report writing quality to investor decision-making.

Hynes, Geraldine E. ; Bexley, James B.

EVOLUTION OF THE ANNUAL REPORT

The annual report ostensibly serves a simple purpose in American business--to evaluate the financial performance of the corporation during the previous year. This stylized business report originated with the Securities Acts of 1933 and 1934, known as the "truth in securities" laws. These acts established the Securities and Exchange Commission (SEC) and required companies with more than $10 million in publicly traded assets to issue independently audited annual reports providing investors with information, including:

A statement of earnings

A balance sheet

A statement of cash flow

A statement of stockholders' equity

Relevant quantitative and qualitative information needed to understand the data (Plung & Montgomery 2004).

After thirty years, a new idea emerged. In addition to answering the financial obligations, annual reports could also serve as the corporation's principal public relations document. As a public relations tool, annual reports became advertisements for the company. Management used them as a platform for promoting their philosophies, strategies, and corporate successes. Annual reports took on a magazine look. They included glossy paper, color photographs, fancy graphics, and layouts.

By 1986, the SEC was receiving criticisms that annual reports sacrificed information for design. Investors wanted shorter reports that gave clearer perspectives on a company's earning potential. After three years of study, the SEC agreed to a radical change in reporting style--companies could put detailed financial information into a separate document (the 10-K or Proxy Statement) and create a Summary Annual Report (SAR). This SAR was more compact, concise, and readable. It moved footnote material into the narrative, used more graphs, and wrote financial information in laymen's terms (Kulkosky 1987). The SAR effectively recast the report into the province of the communicator, who would now be assisted by, rather than dictated to by, the analysts and design houses.

The first company to produce an SAR was McKesson Corporation in 1987. The company claimed they saved $60,000 in production costs, or 20 percent of their annual total expense for financial reports. The corporate Vice President also praised the SAR for "greatly improving the readability of the report and its use as a communication device" (Simone 1988).

After the scandals of 2001 involving Enron, Arthur Andersen, WorldCom, Xerox, and other companies, public confidence in the securities and accounting industries plummeted. Public scrutiny of corporate financial disclosures increased. As a result, last year, President George W. Bush signed into law the Sarbanes-Oxley Act of 2002, changing forever the financial reporting landscape. The most dramatic change to federal securities laws since the 1930s, the Act redesigns federal regulation of public company corporate governance and reporting obligations. It also significantly tightens accountability standards for corporate directors and officers, auditors, analysts, and legal counsel. Numerous changes are mandated, among which is "increasing transparency" of financial reports, the mandate most relevant to this paper. Furthermore, new powers are granted to the Securities and Exchange Commission (SEC), requiring it to review reporting procedures and strengthening its authority to hand down criminal penalties for "white collar" (economic, non-violent) crimes.

First and foremost, a corporate annual report must be credible. A survey by Hill and Knowlton Inc. and reported by Jacobson (1988) revealed that lack of credibility is the main complaint against annual reports. Critics complain that annual reports are long on fluff and short on substance. One study even suggests that readers can predict how a company's stock will perform based on the language used in the CEO's Letter to Shareholders. CEOs of top performers use optimistic phrases implying confidence and growth, while poor performers tend to discuss neither gains nor losses (Jacobson 1988). Kohut and Segars (1992) also compared the CEO's Letter in annual reports of high performing and low performing corporations and found striking differences in content, themes, and strategies.

These findings are consistent with that of Subramanian, Insley, and Blackwell (1993), who assessed the readability of stockholder letters written by company presidents and CEOs. They found that a tenth grade education was needed to comprehend the reports of companies that were performing well. For companies that were not performing well, a reader would need a fourteenth grade education to read their reports. Thomas (1997) also examined the CE's Letter and reported a disparity between the readability levels of reports that communicate good news and bad news to shareholders. She found that the letters from companies that were financially stable were easier to read.

The U.S. Securities and Exchange Commission is one of almost fifty agencies of the federal government that have joined the plain language movement (www.plainlanguage.gov). In 1998, SEC Chairman Arthur Levitt commissioned the Office of Investor Education and Assistance to publish A Plain English Handbook (www.sec.gov). Designed to help writers create clear SEC disclosure documents, the handbook is not under copyright restriction and may be downloaded and printed by all. In his Introduction, Chairman Levitt explained the benefits of plain English for investors, brokers, companies, and even lawyers. He urged writers "in long and short documents, in prospectuses and shareholder reports, to speak to investors in words they can understand. Tell them plainly what they need to know to make intelligent investment decisions" (U.S. SEC, 1998).

METHODOLOGY

Our study investigates the effectiveness of banks' annual reports. Potential investors were asked to read excerpts from two annual reports and evaluate their writing quality. Based on their responses to the discourse features of the excerpts, the readers were then asked how likely they were to invest in the companies. Additionally, readers were asked what other sources of information they use when making investment decisions, and the extent to which their investment decisions are influenced by their understanding of the information in annual reports.

For this study, the potential investors were 51 MBA students enrolled in two graduate courses during summer 2003. Ninety-two percent are employed at least part-time. The sample is demographically diverse in terms of race, age, and gender. Because of their occupational and educational experience, we can say that the sample reflects a larger population of potential investors in the stock market, and hence potential readers of corporate annual reports.

Excerpts were selected from the 2002 annual reports of two banks, one a regional bank (Company A) and the other a national bank (Company B). The excerpts were taken from the Management Discussion and Analysis section of each annual report, a narrative section rather than a section containing only financial data. All bank identifying information was withheld. Flesch-Kincaid Grade Level was the same for both excerpts (12.0 grade). Flesch Reading Ease score was 24.8 for Company A's excerpt; Flesch Reading Ease score was 12.3 for Company B's excerpt. The Reading Ease score rates text on a 100-point scale; the higher the score, the easier it is to understand the text. This formula factors in average sentence length and average number of syllables per word. Thus, according to this readability formula, Company A's excerpt was easier to read than Company B's excerpt. Both excerpts included graphic elements such as charts, tables, and headings. Other key discourse features are listed in Table 1 below.

Readers evaluated each excerpt's writing quality using the U.S. Securities and Exchange Commission's writing guidelines, as described in their Plain English Handbook (SEC, 1998). The Handbook offers writers of prospectuses and other corporate reports a set of guidelines and standards for presenting "information in a clear, concise, and understandable manner" (p. 66). A rating form listing the SEC's guidelines was provided for each excerpt. The readers rated the excerpts on a five-point scale, from "excellent" to "unacceptable." Categories and criteria were: Overall message--logically organized, understandable on first reading Language-concrete, concise, familiar, positive Sentences-short, active voice, personal, strong verbs, parallel, amount of repetition Design elements-graphs, tables, headings, bullets

Finally, the subjects were asked about how they make investment decisions and, in particular, how they use annual reports in that decision process. They responded to each item on Likert-type scales. Questions included:

To what extent are your investment decisions affected by the understandability of a company's annual reports?

To what extent are your investment decisions affected by non-financial, qualitative factors?

Based solely on your evaluation of each annual report excerpt, how likely are you to buy stock in each company?

RESULTS

Readers first rated the "overall message" of both annual report excerpts on a five-point scale, with 1=excellent and 5=unacceptable. Company A's excerpt received a slightly higher evaluation for being logically organized, with 63.82 percent of the readers rating it "excellent" or "good," vs. 60.87 per cent for Company B. This result is not surprising, considering that Company A's excerpt was shorter. On the other hand, Company B received a slightly higher rating for being "understandable on the first reading" compared to Company A's excerpt (Table 2). While this result contradicts the Flesch Reading Ease scores of the two excerpts, a closer look provides some explanation. Company B's excerpt had an average of 2.7 sentences per paragraph, while Company A's paragraph length averaged 4.1 sentences (Table 1). The shorter paragraphs in Company B's excerpt may account for the readers' higher ratings of understandability.

Readers were next asked to rate the two excerpts' language and sentences on a five point scale, with 1=excellent and 5=unacceptable. The readers' ratings of the two excerpts concur with their Flesch Reading Ease scores (Table 3). The excerpt from Company A's annual report was rated slightly higher than Company B's on the factors of conciseness, use of everyday words, positive tone, sentence length, active voice, personal pronouns, and strong verbs. There were no differences in ratings of the two excerpts in terms of concrete language, parallelism, or repetition.

Next, the readers were asked to rate the excerpts' design elements on the same 5-point scale. Both excerpts included design elements such as headings, callouts, tables, and graphs. Company A's bar graphs received higher ratings than Company B's tables, while Company B received higher ratings than Company A for its excerpt's descriptive headings.

The final section of the survey yielded interesting results regarding the readers' investment decision-making processes. Over 50 percent of respondents said that they "always" or "often" read a company's annual report when considering investing in it. Only 13.6 percent of the respondents said that they "never" read annual reports. Perhaps more important for our study is the finding that 43.2 percent said that their investment decisions are greatly affected by the understandability of a company's annual reports, while just 20.4 percent said they are not affected by an annual report's understandability.

When asked what sources of information they read (other than the company's annual reports) when they are considering buying a company's stock, the readers listed these sources most frequently: The Wall Street Journal, brokerage company research reports, and the company's quarterly financial disclosure reports (10-Q's). Only 7 percent of the respondents said they do not read other sources of information about a company. It is interesting to note that 43.2 percent said their investment decisions are greatly affected by non-financial factors, while just 22.7 percent said their decisions are not affected by qualitative or non-financial factors.

DISCUSSION

The value of this study is limited for several reasons. First, the sample size was small (n=51), homogeneous (MBA students), and did not necessarily represent the population of readers of annual reports. An assumption was simply made that MBA students were likely to be potential investors and annual report readers. Future research might tap perceptions of a group of actual investors. Second, the two annual report excerpts used in this study did not necessarily represent all publicly-held banks' annual reports (or those of any other industry, for that matter). Nor were they randomly selected. The researchers selected narrative segments from the 2002 annual reports of one national and one regional bank that were on similar topics and of similar length but that had widely disparate Flesch Reading Ease scores.

Previous research has shown that the narrative components of annual reports are less important to analysts and investors than financial data. The CEO's Letter (a narrative section) was ranked 10th of 11 annual report components in terms of usefulness in investment decisions (Most & Chang 1984). Yet, 77 percent of investors read the CEO's Letter, making it the most widely read section of the annual report (Kohut & Segars 1992). We may conclude that investors at least find the narrative sections interesting. These sections may have more influence on shareholders' impressions and beliefs about the company and its executives than on their investment decisions. Indeed, the subjects of the current study did not distinguish either excerpt as having more of an impact on their likelihood of buying stock in the bank (Mean score on "likelihood of investing in the company" was 2.8 out of a possible 5 points for each excerpt). On the other hand, the readers confirmed the importance of annual reports' understandability for investment decisions--less than 7 percent responded that report understandability does not affect their investment decision at all.

The chief value of today's annual report may be to promote the company image, to describe the company vision to investors, rather than to describe the company's financial condition. Today's investor can get up-to-the-minute financial data about any publicly traded company with the click of a button, making financial information found in annual reports obsolete. As an example, ninety-three percent of the subjects in our study said they read about a company in sources other than the corporate annual report when researching for investment purposes. However, in many cases, the annual report is the only window investors get into the thinking of the company, to determine what is important to its leaders. Thus, it must be skillfully written and designed to gain the reader's attention and leave a positive impression (Burrough 1986). It must say, "Here is why our company is a worthwhile investment" (Millman 1990).

Whether increased oversight, stiffer penalties, and more regulation will improve investor relations remains to be seen. While the annual report continues to be recognized as a communication tool, it has become more important than ever that its writers have the rhetorical skills to compose a document that is clear and understandable. Trust and confidence are complex attitudes that are not easily affected. Identifying all the factors that influence trust is an effort beyond the scope of our research purpose. Nevertheless, if financial statements are clear and informative rather than obfuscative or mindless marketing efforts, then the corporation's credibility can only be improved.

IMPLICATIONS FOR CONSULTANTS AND EDUCATORS

This study has implications for professional writers and for business communication educators. First, using the results of our research, a set of guidelines for composing annual reports will be developed. These guidelines for writing quality and process improvement will be offered to the banks and other companies that are interested in improving their annual reports and other financial documents and, hence, investor relations. To accompany the guidelines, professional communication consultants will design seminars for writers of financial disclosure statements. By offering such opportunities for employee training and development, radical change would be effected in some of the current communication processes and protocols of participating organizations.

Clearly the results of our research also have implications for higher education. Smith and Demichiell (1996) emphasized the importance of stakeholder surveys in designing curriculum. The results of this research may imply the continued criticality of business communication courses in both undergraduate and graduate business programs. As Tebeaux (1996) argues, research in nonacademic discourse is useful and applicable to students who are being prepared to work in the nonacademic world. Linking the results of this study back to the classroom suggests that students will be able to build their analytic writing skills while still in school so that their abilities to negotiate workplace discourse will be based on critical skills rather than on writing practices that corporate managers agree have not improved in the last decade (Tebeaux, 1996). Specific communication competencies, such as report writing and financial disclosure techniques, can be fostered in undergraduate and graduate courses so that graduates enter the workforce with necessary skills already in place.

CONCLUSION

This paper described the evolution of the annual report in the U.S. and demonstrated the role of this document in investor decision making. Previous research leads us to propose that improving the transparency of annual reports will improve investor relations. Following the enactment of the Sarbanes-Oxley Act, companies have a greater incentive for improving the quality of financial reporting. With the media, analysts, investors, and government leaders all challenging companies' integrity, financial reports of publicly held companies should be comprehensible and written in "plain English" (Deloitte & Touche 2002).

In Berkshire-Hathaway's 1998 annual report, Chairman Warren Buffett described his goals in reporting: "We want to give you the information that we would wish you to give us if our positions were reversed, and we want to make Berkshire's information accessible to all of you ..." These are worthy goals for all corporate financial reports. And professional communication practitioners, together with business communication faculty in academic institutions, must stand ready to help current and future corporate report writers learn how to reach these goals.

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Geraldine E. Hynes, Ph.D., Sam Houston State University

James B. Bexley, Chair, Sam Houston State University Table 1: Comparison of Excerpts Features Company A Company B Length (in words) 692 984 Number of sentences 29 41 Percent passive sentences 3 19 Average characters / word 5.2 5.8 Average words / sentence 23.7 24.0 Average sentences / paragraph 4.1 2.7 Flesch-Kincaid Grade Level 12.0 12.0 Flesch Reading Ease Score 24.8 12.3 Table 2: Ratings for Overall Message Criterion Company A Company B Logically organized 63.82% 60.87% Understandable 52.7% 42.5% Table 3: Ratings for Sentences and Language Company A rated higher on: No difference in ratings on: Conciseness Concrete language Use of everyday words Parallelism Positive tone Repetition Sentence length Active voice Personal pronouns Strong verbs