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It pays to speak plain English
June, 15th 2006

News


15th June, 2006

It pays to speak plain English

Generally, accountants dress neat. So are their products, the financial statements neatly dressed with numbers aligned, lines drawn, columns named, references given, and totals tallied to the last decimal.

Language is understandably sparse in the P&L and balance-sheet, constrained by the column width. What you find in these statements are but labels and tabs for incomes and expenses, assets and liabilities, more in the form of phrases rather than complete sentences. But in the notes and explanations, there are invariably whole paragraphs, where the slip usually shows; slips, not of grammar or usage, but of comprehension.

Yet, it is customary in most meetings to take accounts as read. Rarely does anybody stand up and say he or she doesn't understand what the accounts are all about... Till somebody calls the bluff, as a child did in the story of emperor's new clothes.

Feng Li of Stephen M. Ross School of Business at the University of Michigan is one such. In a recent research paper, available on http://ssrn.com, he studies annual report readability. And he goes one step further to relate readability to earnings and stock returns.

Li begins by mentioning the efforts of the US Securities and Exchange Commission (SEC) on the plain English front, such as disclosure rules adopted in 1998. There is a reference to the 1969 `Wheat Report'. Not about the grain, but about language. "Among other findings, the Wheat Report noted that the average investor could not readily understand the complicated prospectuses and therefore recommended that companies avoid unnecessarily complex, lengthy or verbose writing."

Li explains the underlying argument for the plain English disclosure regulation as follows: One, firms could use vague language and format in disclosure to hide adverse information; and two, the average investors may not understand complex documents and this could result in capital market inefficiency.

You can download on www.sec.gov the 83-page document A Plain English Handbook: How to create clear SEC disclosure documents. Warren Buffett writes in the preface, "For more than forty years, I've studied the documents that public companies file. Too often, I've been unable to decipher just what is being said or, worse yet, had to conclude that nothing was being said." Stilted jargon and complex constructions are usually the villains, he concedes.

Arthur Levitt's intro speaks of the many benefits of plain English.

Investors will be more likely to understand what they are buying and make informed judgments.

Brokers and investment advisers can make better recommendations to their clients.

Companies that communicate successfully with their investors form stronger relationships with them. These companies save the costs of explaining legalese and dealing with confused and sometimes angry investors.

Lawyers reviewing plain English documents catch and correct mistakes more easily.

To these, Li would add one more: that the positive earnings of firms with annual reports that are easier to read are more persistent in the next one to four years. Conversely, "annual reports of firms with lower earnings are harder to read." Li is quick to add, however, that he does not find "any correlation between annual report readability and future stock returns, suggesting that the market does impound the implications of disclosure readability into stock prices."

What was Li's methodology? "I empirically measure annual report readability using established statistics from computational linguistics based on syntactical textual features (such as syllables per word and words per sentence) in the 10-K filing," he explains. "The intuition is that, everything else equal, more syllables per word or more words per sentence make a document harder to read."

Readability measures used by Li are Fog and Kincaid. The former, developed by Robert Gunning, is a simple formula for measuring readability, says the paper. "The index indicates the number of years of formal education a reader of average intelligence would need to read the text once and understand that piece of writing with its word sentence workload. It is calculated in the following way: Fog = (words per_sentence + per cent_of_complex_words) x 0.4." Complex words are defined as words with three syllables or more. "FOG {gt}=18 means the text is unreadable; 14-18 (difficult); 12-14 (ideal); 10-12 (acceptable); and 8-10 (childish)."

The formula for Kincaid is (11.8 x syllables_per_word) + (0.39 x words_per_sentence) {minus} 15.59. "A score of 8.0 means that the document can be understood by an eighth grader. A score of 7.0 to 8.0 is considered to be optimal."

To arrive at a benchmark, Li downloaded all the editorials from the June 2005 issues of the Wall Street Journal, and calculated their readability. The editorials scored 15.2 on the Fog index and 12.2 on the Kincaid, "suggesting they are much easier to read than a typical annual report."

The mean and median Fog Index for annual reports were 19.4 and 19.2 respectively, implying these were `unreadable'. Kincaid stood at 15.2, which too was the high end.

Wish we computed the indexes for our annual reports too. On the denseness in Indian accounting, see accompanying article `Dense fog in the accounting jungle'.

D. Murali

 
 
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