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Financial Opacity and Firm Performance: The Readability of REIT Annual Reports

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Abstract

We examine the capital market pricing implications of firm disclosure opacity as measured by the linguistic readability of REIT annual reports. The SEC has expressed concern that firms selectively manage the transparency of disclosures in order to hide adverse information. After controlling for other non-experimental factors that influence the readability of REIT financial statements, we find (1) financial opacity is negatively related to reported firm performance, and (2) the residual opacity that remains after controlling for other determinants of annual report readability has incremental explanatory power for returns beyond the Fama and French (1992, 1993) risk factors. The opacity risk-return premium persists after controlling for a (heretofore undocumented) stark monotonic decrease in annual report readability following the Sarbanes-Oxley Act of 2002.

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Notes

  1. See Healy and Palepu (2001) for an extensive review of this literature.

  2. For example, with regard to the small stock premium, it is well known that less publicly available information is generated for smaller firms, and that both smaller firms and firms neglected by the analyst community regardless of size earn positive abnormal CAPM returns (see Arbel and Strebel 1982).

  3. Still, Kalay and Loewenstein (1985) find significant stock price declines preceding late announcements as the market anticipates bad news.

  4. Soffer et al. (2000), Tan et al. (2002), and Miller (2005) further examine preannouncements and show that the decision of when to release news is a function of whether that news is good or bad. For example, bad news tends to get preannounced all at once, while firms with good news release only approximately half of it leaving the rest for a positive earnings surprise. Similarly, preannouncements are expected to understate positive and overstate negative news.

  5. The Fog Index is the average number of words per sentence plus the percentage of complex words (i.e., those with three or more syllables) with that sum total multiplied by 0.4. Documents with a resulting index of greater than 18 are considered unreadable, while those with a score less than 10 are considered childish.

  6. The Flesch-Kincaid Grade Level index was created in 1975 as part of a study for the U.S. Navy to develop a readability measure that equates to a school grade level (For a complete technical description of the Flesch-Kincaid Grade Level index see Kincaid et al. 1975). As with Li (2008), we also computed the Flesch (1948) Reading Ease Score. This is an inverse measure of opacity (higher scores correspond to higher reading ease) and is computed as 206.835 - 1.015 * (number of words per sentence) - 84.6 * (number of syllables per word). Our sample had a mean Reading Ease score of 24.36, similar to the average of 26.0 that Jones and Shoemaker (1994) found in their meta-analysis.

  7. Use of alternative accounting income numbers such as EBIT and EBITDA resulted in qualitatively similar findings to those we report.

  8. While many traditional organizations choose to incorporate in Delaware, Maryland is the state of choice for many investment companies—including the majority of publicly traded REITs. See, for example, Subramanian (2002), Daines (2001), and Romano (2005).

  9. Li (2008) included all industries and considerably more control variables in his analysis. The fact that REITs are a homogenous industry group means that there is naturally less ability for firm-specific differences to offer as much cross-sectional explanatory power in our regressions.

  10. Forward, backward, and stepwise regression each resulted in the same reduced model. The SAS default selection criterion was employed whereby the incremental -statistic for variable entry/exit is specified at the 0.15 level.

  11. http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html. We also conducted tests using the Carhart (1997) momentum factor. Interestingly, the sign on momentum was significantly negative rather than positive, suggesting mean-reversion rather than risk compensation for our sample. This finding, which is seemingly at odds with the preponderance of the evidence from the mainstream finance literature, is entirely consistent with the findings of Lin and Yung’s (2004) investigation into the performance persistence of real estate mutual funds. Inasmuch as we are solely concerned with risk determinants in the explanation of excess returns, and our focal readability results are robust to the inclusion or exclusion of this model parameter, we choose to exclude it from our reported model specifications. The results are available from the authors upon request.

  12. This approach mirrors that employed by both Sloan (1996) and Chai and Tung (2003).

  13. Detailed results available upon request.

  14. Again, when using a four factor baseline model, the Carhart Momentum factor was found to be significantly negative, while the RESIDFLKGRADE remained significantly positive at the .01 level.

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Authors and Affiliations

  1. University of Vermont, Burlington, VT, 05405, USA

    Stephen J. Dempsey

  2. Texas Tech University, Lubbock, TX, 79409, USA

    David M. Harrison

  3. Old Dominion University, Norfolk, VA, 23529, USA

    Kimberly F. Luchtenberg & Michael J. Seiler

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  1. Stephen J. Dempsey
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Correspondence to David M. Harrison.

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Dempsey, S.J., Harrison, D.M., Luchtenberg, K.F. et al. Financial Opacity and Firm Performance: The Readability of REIT Annual Reports. J Real Estate Finan Econ 45, 450–470 (2012). https://doi.org/10.1007/s11146-010-9263-2

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