How important is the readability of corporate financial reports? What kind of impact does it have on a firm's stock price crash risk?

Professor of Accounting Liandong Zhang, explains how his findings are consistent with the argument that when managers can successfully hide adverse information by writing complex financial reports, this can lead to stock price crashes when the hidden bad news accumulates and reaches a tipping point.

https://accountancy.smu.edu.sg/faculty/profile/150531/Liandong-ZHANG

Research Interests

Financial Reporting; Corporate Disclosure; Corporate Governance; Tax Planning

Kim, Chansog (Francis) and Wang, Ke and Zhang, Liandong (2018). Readability of 10-K Reports and Stock Price Crash Risk. Contemporary Accounting Research, Forthcoming; University of Alberta School of Business Research Paper 2378586; Singapore Management University School of Accountancy Research Paper Series Vol. 6, No. 3 Paper No 2018-88.

Available at:

https://ssrn.com/abstract=2378586

http://dx.doi.org/10.2139/ssrn.2378586

Abstract

This study shows that less readable 10-K reports are associated with higher stock price crash risk. The results are consistent with the argument that managers can successfully hide adverse information by writing complex financial reports, which leads to stock price crashes when the hidden bad news accumulates and reaches a tipping point. Cross-sectional analyses show that the effect of financial reporting complexity on crash risk is more pronounced for firms with persistent negative earnings news or transitory positive earnings news, greater chief executive officer stock option incentives, or lower litigation risk. Finally, accrual manipulation appears to be positively related to crash risk, even since the Sarbanes-Oxley Act, if the manipulation is accompanied by complex 10-K reports.

KIM, Jeong-Bon, & ZHANG, Liandong. (2014). Financial Reporting Opacity and Expected Crash Risk: Evidence from Implied Volatility Smirks. Contemporary Accounting Research. 31. (3), 851-875.

Available at:

https://ink.library.smu.edu.sg/soa_research/1702

https://ssrn.com/abstract=1649182

http://doi.org/10.1111/1911-3846.12048

The recent financial crisis has stimulated a renewed interest in understanding the determinants of stock price crash risk (i.e., left tail risk). Recent research shows that opaque financial reports enable managers to hide and accumulate bad news for extended periods. When the accumulated bad news reaches certain tipping point, it will be suddenly released to the market at once, resulting in an abrupt decline in stock price (i.e., a crash). This study extends this line of research by examining the impact of financial reporting opacity on perceived or expected crash risk. Prominent economists, such as Olivier Blanchard, argue that removing the perception of tail risks (in addition to realized tail risks) is crucial in restoring investor confidence and stabilizing the stock market. Using the steepness of option implied volatility skew as a proxy for perceived crash risk, we find that accrual management, the presence of financial statement restatements, and auditor-attested internal control weakness are all positively and significantly associated with the level of perceived crash risk. Our results suggest that improving financial reporting transparency is an important mechanism for firms and policymakers to reduce the perception of tail risks and stabilize the stock market.

LI, Yinghua, & ZHANG, Liandong. (2015). Short Selling Pressure, Stock Price Behavior, and Management Forecast Precision: Evidence from a Natural Experiment.

Available at:

https://ink.library.smu.edu.sg/soa_research/1700

http://doi.org/10.1111/1475-679X.12068

Using a natural experiment (Regulation SHO), we show that short selling pressure and consequent stock price behavior have a causal effect on managers' voluntary disclosure choices. Specifically, we find that managers respond to a positive exogenous shock to short selling pressure and price sensitivity to bad news by reducing the precision of bad news forecasts. This finding on management forecasts appears to be generalizable to other corporate disclosures. In particular, we find that, in response to increased short selling pressure, managers also reduce the readability (or increase the fuzziness) of bad news annual reports. Overall, our results suggest that maintaining the current level of stock prices is an important consideration in managers' strategic disclosure decisions.

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Singapore Management University

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Keywords

Accounting, Corporate Finance, Readability, textual analysis, crash risk, SOX, 10‐K, D82, G12, G17, G18, M41, Financial Reporting Opacity, Expected Crash Risk, Implied Volatility Smirk, Internal Control Weakness, Restatements