Audit Quality and Readability of the Annual Reports

1. Introduction

Investors, analysts, and other stakeholders extensively rely on information provided in the annual reports. The clarity, transparency, and understandability of annual reports and 10-Ks have increasingly become a topic of interest for regulators, auditors, and investors (Li, 2010). SEC had taken an initiative to encourage the use of plain English and issued the earliest guidelines in 1998.¹ This initiative has continued to evolve (Loughran and McDonald, 2014b). Concurrently, the disclosure requirements have significantly increased due to changes in the reporting regulations, emergence of complex financial transactions and instruments, and advancements in technology, resulting in less readable annual reports. Additionally, managerial incentives play an important role in structuring the annual reports (Bloomfield, 2008), which adds another dimension to the debate on the readability of the annual reports.

Measuring readability is inherently difficult due to the nature of the subject matter, intended audience, and the preparer’s intentions. The interdisciplinary research in the readability of the corporate annual reports started in the 1950s and continues until today. The earliest studies have used measures such as Flesch scale (Pashalian and Crissy, 1950; Soper and Dolphin, 1964), Dale-Chall readability formula (Smith and Smith, 1971), and Fog index (Parker, 1982; Cassell, 2019). The recent accounting studies have mainly used Fog index as a measure of readability (for example, Li, 2008; Biddle, Giles, & Rodrigo, 2009; Miller, 2010; Lehavy, Li, & Merkley, 2011; Lawrence, 2013; Inger et al., 2018). Bonsall et al. (2017) use Bog index as a measure of readability in narrative disclosures on bond ratings. Loughran and McDonald (2014a) demonstrate that the Fog index is not an appropriate measure of readability for the financial documents. Instead, they present a 10-K document file size as a proxy for readability measure that outperforms Fog index. Compared to the Fog index, file size is easier to measure and can be readily verified.

The previous accounting studies in the readability of the annual reports have not examined the relationship between audit quality and readability. The authors address this gap by examining the association between audit quality and readability of the annual reports. Specifically, the purpose of this paper is to examine the effects of audit quality, as proxied by Big 4 auditors and industry specialization, on the readability of the annual reports. Assuming that higher audit quality is associated with the better readability, the authors empirically test whether (1) the readability enhances if audited by the Big 4 auditor and (2) the readability enhances if audited by the industry specialized auditor.

Based on Loughran and McDonald (2014a) study, the authors use file size of 10-K documents as a proxy for readability in this paper. Audit quality has been defined and operationalized in numerous ways in the audit literature (Watkins, Hillison, & Morecroft, 2004; Francis, 2011; DeFond and Zang, 2014). The authors use Titman and Trueman (1986) definition of high-quality audit as an audit that improves the reliability of financial statement information and allows investors to make a more precise estimate of the firm’s value.² This definition encompasses numbers as well as text included in the financial statements; readability of the financial statements can certainly aid investors in valuing the company.³