Puzzling on purpose: Why the message is obscured in some annual reports

Fudging the words can be a strategic barrier against potential litigation

Annual reports produced for the benefit of multiple stakeholders – by corporations, charities and not-for-profits, governments and other organisations – by their nature are never light reading.

These documents of financial status and future prospects are arduous to compile and when it comes to their clarity – or readability – whether they're for investors, mum-and-dad shareholders, regulators and analysts, or employees and other interested parties, some reports are definitely better than others.

Often the writing is dense and complicated, and plain English rules for clear communication are ignored in preference for 'obfuscation', that is, obscure or unintelligible language.

Vague, ambiguous and difficult to interpret 'weasel words' can be used as a protective mechanism in reports by organisations, according to a recent paper, Why do companies make reports less readable?, co-authored by Mark Humphery-Jenner, an associate professor in the school of banking and finance at UNSW Business School.

Former studies have shown less readable reports can have harmful effects, such as increasing the cost of capital and lowering stock market performance, but CEOs or managing directors may still sign off on a report that uses opaque language and more complex words in an attempt to avoid litigation, say the paper's authors.

Two likely motivations are the rise of securities class actions, when shareholders band together to sue a company due to "false statements", inaccurate projections or forecasts in a report, or if the company is in an industry that's frequently targeted for litigation, the research team finds.

Managers use readability strategically and, essentially, fudge the words to potentially avoid future legal action, explains Humphery-Jenner.

Foggy and boggy

To some extent, financial statements in annual reports are exercises in marketing because managers have to give a forward projection of how they believe their organisation will go in the future, and they obviously want to appear positive, says Humphery-Jenner.

"Conversely, the information they provide has to be accurate – if it's not, it leaves them open to litigation."

Readability can mitigate the problem in two ways, he says. "First, if the report is less readable, it's more opaque and open to interpretation which makes it more difficult to claim the report is incorrect.

"Second, even if it is found to be incorrect, when a report is opaque and a variety of meanings can be put on the words, it becomes more difficult to pin down the exact loss to shareholders in a class action, so it can be argued that the compensation to shareholders would be lower if the report is less readable."

Using a series of recognised measures, including the aptly named Fog and Bog indices, Humphery-Jenner and his co-authors tested the readability of 10-K reports – annual filings required by the US Securities and Exchange Commission to provide a comprehensive summary of financial performance – lodged by some 96,000 firms between 2003 and 2013.

They found the text in the 10-K reports of firms which faced higher litigation risk were 8.8% foggier than industry peers with lower risks, and those who had been sued in the four years prior also produced reports with reduced readability.

Ironically, the research also shows the incidence of reduced readability grew after the Sarbanes-Oxley Act was introduced in 2002. The legislation was designed to improve corporate governance and other avenues of disclosure, but a side effect of greater openness is potentially exposing US firms to greater risk of legal action.

While message-muffling is a strategy, the research team discovered firms found improving readability useful sometimes as well, says Humphery-Jenner, such as when the number of analysts covering a company drops.

"Then firms are likely to increase the readability of their reports because they actually need to get a base level of information out to shareholders."

The study zooms in on US companies and 10-K reports because they are standardised and the data is more readily available, but there's no reason to expect Australian reports would be any different, says Humphery-Jenner.

At the same time, he notes securities class actions have been less common until recently in Australia, but they are becoming more prevalent.

'If the report is less readable, it’s more opaque and open to interpretation which makes it more difficult to claim the report is incorrect’

- MARK HUMPHERY-JENNER

Legalese and jargon

The readability of company reports is not a new topic. More than a decade ago, after rewriting the US rules for executive pay in 2006, the SEC targeted large companies for poor communication standards in compensation reports, for example, and identified 40 prominent US companies as having unreadable compensation disclosures.

Then SEC chairman Chris Cox expressed disappointment in 2007 with the narrative disclosure "that isn't anywhere close to plain English".

The regulator aimed to eliminate legalese and jargon. In fact, according to objective third-party testing, "most of it's as tough to read as a PhD dissertation", Cox claimed, adding verbosity was a major problem with many compensation reports running in excess of 5000 words, more than 1000 words longer than the US Constitution. The average Fog Index rating for compensation disclosure and analysis was 16.45.

The Australian arm of global executive pay and board governance firm, Guerdon Associates, compared the remuneration reports of companies of the ASX50 in 2007 with their US counterparts and found Australian companies scored even higher – an average of 17.75, with 59% of the surveyed companies above 17.

There has been continuous improvement on readability in the intervening years, according to Michael Robinson, Guerdon Associates co-founder and director.

He observes Australian remuneration reports are more complex, because they have more information in them, which is required under the Corporations Act, and a lot of voluntary additional information is demanded by institutional investors and proxy advisers in their guidelines.

Remuneration reports are aimed at institutional investors and proxy advisers because they vote, whereas retail investors typically don't, Robinson notes. While the level of understanding of institutional investors might be assumed to be higher, "clarity is still important", he emphasises.

‘[Annual reports are] little more than marketing tools for unsophisticated retail investors produced at ridiculous expense’

- MARCUS PADLEY

Design and presentation

Today, companies are using more graphics in their reports, which aren't picked up by the readability index technologies.

"Descriptions have fewer technical terms, sentences are shorter, and the words are less complex with fewer syllables. You can see the reports have had professional treatment," Robinson says, though the length of remuneration reports has grown as they are addressing so many different stakeholders.

The remuneration framework has become more complicated, and the investor community requires more detailed responses, "and is upping the ante all the time".

Robinson says this applies across the whole annual report: "There's a lot more on gender diversity and sustainability, for instance, that wasn't there 10 years ago."

Shifts in the reporting landscape, such the Global Reporting Initiative and the increasing momentum of integrated reporting, which both bring the future sustainability of organisations into view, have improved transparency and reporting quality broadly, some experts claim.

Technology is also playing a part, with the move to online reports having both positive and negative impacts on readability depending on their design and presentation.

However, when it comes to splashily produced annual reports, outspoken stockbroker and media commentator, Marcus Padley, questions the need to explore readability issues at all.

"Due to continuous disclosure requirements, these days that style of annual report is redundant," Padley says.

"They exist because they are a summary of the full-year's results, but the numbers in the colourful brochures we call annual reports are actually out of date and irrelevant. The valuable information has already been published elsewhere."

Annual reports today are "little more than marketing tools for unsophisticated retail investors produced at ridiculous expense", Padley insists.

"Perhaps it's a point of focus for CEOs to write down what they think, or they provide a framework for the annual general meeting, in which case just write an agenda," he suggests.

"Companies that want to tell us how great they are can just send us a marketing email."