Does annual report readability explain the accrual anomaly?

Abstract

PurposeThe purpose of the study is to investigate the possible role of annual report readability in accrual anomaly, shedding light on why investors fail to incorporate accruals information in a timely and unbiased manner beyond the original naive investor fixation explanation.Design/methodology/approachUsing five proxies of annual report readability and available data over 1993–2017, we investigate whether accrual overpricing is more severe when annual reports are less readable.FindingsWe find little (substantive) evidence of accrual overpricing among high (low) readability firms. The readability effects are contingent on the level of business complexity and earnings management.Research limitations/implicationsThis study extends the original naive investor fixation explanation and documents annual report complexity as a market friction in explaining the accrual anomaly, contributing to the mispricing vs risk debate and supporting the efficient market hypothesis.Practical implicationsLow readability of annual reports is a red flag to investors.Social implicationsThis study provides support for regulatory initiatives aimed at enhancing readability of corporate disclosures to address market frictions and improve market efficiency.Originality/valueAccrual anomaly has posed a challenge to the efficient market hypothesis. This study draws on and adds to the line of research indicating that annual report complexity is a friction erecting a barrier to transparency, hindering market efficiency. This study contributes to our understanding of the enigmatic accrual anomaly.

A Review Analysis of Earnings Management Report Disclosure

“…The accrual anomaly has questioned the efficacy of the market hypothesis. Liu and Liu (2021) support legislative ideas aimed at making firm disclosures simpler to comprehend in order to reduce market friction and increase market efficiency. This implies the action to reduce annual report complexity that hinders transparency and undermines market efficiency.…”

“…One, Generally Accepted Accounting Principles (GAAP), and second, the International Financial Reporting Standard (IFRS). It has been used extensively to examine several matters such as taxation (Folorunso & Lokanan, 2022;Fernando et al, 2021), board characteristics (Khan & Kamal, 2022;Almarayeh et al,2022), stock return (Ellahie & Peng, 2021;Derun & Mysaka, 2021;Al Mamun et al, 2021;Bouaziz et al, 2020), readability (El-Din et al, 2021;Liu & Liu, 2021;Bradley et al,2021;Arora & Chauhan, 2021;Napier & Stadler, 2020), corporate social responsibility (Habbash & Haddad, 2019), and award (Deng et al, 2020) in last four years.…”

“…El-Din et al ( 2021) believe there is a connection between information overload and reporting complexity with the influence of a firm's profitability and earnings management techniques, especially in a large emerging economy such as India (Arora & Chauhan, 2021). This could provide insight into why investors fail to swiftly and objectively digest accruals information beyond the original naive investor fixation explanation (Liu & Liu, 2021). The usage of fair value instruments has been significantly increased by the Financial Accounting Standards Board (FASB), which accentuates the rise in uncertain assets and liabilities without actively traded market values.…”

“…El-Din et al (2021) used the LIX index and a predeveloped voluntary disclosure index to measure the level of voluntary disclosure in the annual reports. Contradicting Liu and Liu (2021), they believe that accrual overpricing is more severe when annual reports are less readable. Researchers believe that earnings management activities embedded in annual reports (Bouaziz et al, 2020;Khan & Kamal, 2022;Deng et al, 2020;El-Din et al, 2021;Liu & Liu, 2021;Fernando et al, 2021;Almarayeh et al, 2022;Pakawaru et al, 2021).…”

“…Contradicting Liu and Liu (2021), they believe that accrual overpricing is more severe when annual reports are less readable. Researchers believe that earnings management activities embedded in annual reports (Bouaziz et al, 2020;Khan & Kamal, 2022;Deng et al, 2020;El-Din et al, 2021;Liu & Liu, 2021;Fernando et al, 2021;Almarayeh et al, 2022;Pakawaru et al, 2021). To support the resource-based view, Mahmood et al (2020) employed the deductive technique of theory creation and used 60 industrial enterprises listed on the Pakistan Stock Exchange to collect data using many sources and methods with temporal interruptions.…”