THE READABILITY OF FINANCIAL STATEMENT NOTE DISCLOSURES.

AuthorTschopp, Daniel
PositionReport

INTRODUCTION

The American Accounting Association's Statement of Basic Accounting Theory describes the importance of communication in the reporting process and how vital it is that information being reported can be understood as part of the decision-making process (American Accounting Association, 1966). The Financial Accounting Standards Board's (FASB) Statement of financial accounting concepts no. 1 states "Financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. The information should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence" (FASB, 1978).

These two basic guidelines are used as a starting point for this research to answer the question; is the information being reported by companies useful to its intended users? To be useful, the users must be able to read and understand what is being reported. To determine if this is happening, this study focuses specifically on financial statement note disclosures.

Financial statement note disclosures complement the financial statements providing additional information to users aiding them in the decision-making process. Each note is sequenced by a number. Financial statement notes are intended to provide clarity to the financial statements. Some give more specific detail on accounting policies, standards, and methods of accounting used. Some notes are required by the Securities and Exchange Commission (SEC). Some notes expand on a specific line item in the financial statements giving the user more information. The notes serve as a tool for users to examine additional information about a company instead of relying solely on the financial statements themselves.

This study examines the financial statement notes of the 30 companies that comprise the Dow Jones Industrial Average. Readability tests are performed on the financial statement notes for the years 2000, 2010 and 2015 to determine if the information being reported can be used by the average user and if the level of complexity has changed over time. The readability tests used for analysis are the number of passive sentences, Flesch Reading Ease readability test, and Flesch-Kincaid readability test. If the readability levels are at the level of people "who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence" then there is no problem. If the readability levels have not changed significantly over time then there is no problem. However, if this is not the case then recommendations should be made to assist the intended user.

LITERATURE REVIEW

The globalization of economies, the development of financial instruments to aid in risk management, and the increase in accounting scandals have resulted in an increase in financial statement note disclosures (Kieso, Weygandt, & Warfield, 2017). The increase in the amount of disclosures in terms of number of disclosures, length of disclosures, and complexity of disclosures, has brought their usefulness into question (Bloomfield, 2012; Lawrence, 2013; Morunga & Bradbury, 2012). There are also differing opinions on whether the increase in financial statement note disclosures is a result of the development and implementation of new accounting standards or a result of how preparers apply the standards (Barker et al., 2013). Regardless of the reason for the increase in note disclosures there remains a concern that the increase has made it difficult for the average user to interpret and make informed decisions from reading the notes. To assess this ability of financial statement users, this article looks at the readability of the notes.

As Braswell (2000) states "Congruity between comprehensibility of written financial information and user ability is essential if the primary goal of communication in financial accounting is to be met". Prior research suggests that readability plays an important role in how accounting information is perceived. Not understanding the information or perceiving the information is irrelevant or too complex would mean the information would not be useful for decision-making (Lawrence, 2013),

Prior research has focused on a variety of communication issues related to financial reporting, including the readability of reporting standards (Dzinkowski, 2006; Wells, Barney, Tschopp, 2008), annual reports and note disclosures (Henderson, 2016).

Soper and Dolphin (1964) used the Flesch Reading Ease Formula to test the readability of 25 public company annual reports noting no significant change in readability from 1948 to 1961 Braswell (2000) used prior readability research (1948-1990) and found no significant change in readability during this time period (Smith & Smith 1971; Healy 1977; Courtis, 1986). Although those findings incorporated the research of others on annual report readability, they did not limit it to disclosure notes (Braswell, 2000). This research builds upon prior research and is needed because of more recent developments in the reporting process. The Sarbanes Oxley Act was partly responsible for the content and detail of increased disclosures. Accounting standards have continued to grow and evolve with the adoption of codification. The development of changing standards brings concern that more emphasis is placed on content rather than readability. Therefore, this research serves as a continuation of the results found by Braswell.

There has been some more recent research relating to readability. Lehavy, Li, and Merkley (2011) used readability tests to analyze annual reports from 1995 to 2006. The authors concluded that more complex annual reports have more "sell-side" financial analysts following those companies. Those more complex annual reports are also associated with greater forecast dispersion and less accurate forecasts. The authors conclude "that investor demand for analyst information is increasing in the complexity of the annual report disclosure" (Lehavy, Li, & Merkley, 2011).

In 1995 Courtis tested the readability of disclosure notes from 32 public companies in Hong King. He used the Flesch Reading Ease Formula, the Gunning Fog Index, and the Lix measure to test random passages from the notes. The research found no statistically significant change in the readability levels 1986 to 1991, nor did it conclude the levels were at too high a level for their intended user (Courtis, 1995).

Collins (2012) studied the impact that the readability of disclosure notes had on the decision-making process of users concluding that "the complexity of an...

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