Rob Swystun, Pristine Advisers
Two professors from the University of Notre Dame are calling for a different way to measure the readability of financial disclosure documents.
Currently, the Fog Index is the tool of choice for measuring the readability of financial documents in recent accounting and financial research. The US Securities and Exchange Commission is even contemplating using it to identify poorly written financial documents.
However, professors Tim Loughran of the University of Notre Dame and Bill McDonald of the U of ND’s Mendoza College of Business in the Department of Finance, say the Fog Index isn’t a reliable way of assessing readability when it comes to financial documents because its efficacy in the realm of business disclosures hasn’t been determined. They espouse using the page count of financial documents alone for assessing readability.
Let’s break this down a little so we all know what we’re talking about.
Fog Index 101
Invented by American businessman Robert Gunning in 1952, the Fog Index is used to determine how easy it is to read a given piece of text by taking into account the average sentence length and the frequency of complex words, those being words with three or more syllables.
The index is meant to indicate the years of formal education a person would need to understand the text on a first reading. So, a Fog Index of 12 would indicate a person would need the equivalent education of an American high school senior while an index of 19 would indicate that a person would need the equivalent of a post-graduate university level of education to understand a passage. In order to be understood by pretty much anyone, the Fog Index number has to be below 8.
The Fog Index, while generally useful, does have its drawbacks. A short word can be a difficult word, like “abjure,” for example. And some multisyllabic words can be quite easy, like “pomegranate.”
The professors point to this last problem as the one that makes the Fog Index unreliable for assessing financial documents, according to a post in the Harvard Law School Forum on Corporate Governance and Financial Regulation by co-editor R. Christopher Small.
The count of multisyllabic words in 10-K filings may be high, the pair say, but most of those words tend to be common business words that should be easily understood by anyone with a business or finance background. For example, words like company, operations, and management are, technically, “complex,” but are obviously not going to confuse anyone who reads a 10-K filing.
Instead, the professors suggest looking at a much simpler measurement: the file size.
Simply using the file size means that you don’t have to actually do any parsing of the document, they argue. You simply have to look at how big the thing is. A measurement this simple can be easily replicated for numerous documents on the SEC’s EDGAR website. (They also point out that this is only a valid measurement for 10-K filings and not for other documents like news articles or press releases.)
And, showing that they’re fans of irony, the professors explain their reasoning in the most complicated way possible:
“In regression analysis, we report that, after controlling for other variables, larger 10-K file sizes have significantly higher post-filing date abnormal return volatility, higher absolute SUE, and higher analyst dispersion. This relation does not seem to be a simple artifact of firm complexity.”
Uh … thanks for clearing that up, guys.
The crux of their argument is in the next sentence, though:
“The less material investors and analysts must digest to get valuation-relevant information from company managers, the better they are at predicting subsequent value-relevant events.”
This makes a lot of sense. Nobody likes wading through a lot of excess information to find what they’re looking for. They want to be able to find it quickly and have it expressed as plainly as possible.
What Loughran and McDonald suggest is that the SEC focus less on the writing style in 10-K filings, which are all similar, and instead encourage succinctness.
“Clearly, an SEC rule simply dictating page limitations (presumably conditional on factors such as firm size and industry) is not a reasonable solution,” their report says. “The SEC, however, should emphasize to filers that the benefit of exhaustive disclosure in the interest of litigation avoidance must be balanced with the costs of information overload and effective communication.
“Concisely written documents are more likely to be read, and the information from the 10-K is more likely to be effectively incorporated into stock prices and analyst forecasts.”
Once again brevity comes out on top when it comes to business communication, just like it’s taught in school (at least at the one I attended, anyway). What do you think? Should the SEC champion concisely written 10-K filings or should analysts just suck it up and wade through the mess of words to get at the information they need?