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Do firms hide bad news in financial reports?

Low readability of narratives in a firm's financial reports may be a red flag for stock price crashes.

Stock price crashes have a devastating effect on investor welfare, but investors' exposure to crash risk (i.e., the risk of extreme losses rather than the risk of return volatility) can be reduced only by screening and not by diversification. Corporate financial reports have two types of information, numbers and narratives. Narratives provide free-form explanations for how the accounting numbers were presented as well as detailed descriptions of some business transactions or risk factors that are hard to explain solely with accounting numbers. Nowadays, high-power computing and text mining techniques provide an opportunity to identify more factors for screening potential crash risk. Based on research from the Alberta School of Business, poorly performing firms tend to write less readable or more complex annual reports to mask bad news and subsequently are more likely to experience stock price crashes.

"The concept of crash risk speaks to tail events, or the third moment of the stock return distribution," says Ke Wang, assistant professor of Accounting at the Alberta School of Business. "Over years, business and financial practitioners have been well trained to analyze risk and return, but training to identify and manage tail events or crash risk is still in its infancy. Using textual analysis techniques to identify potential factors for screening crash risk could be of practical relevance for risk management applications."

Bad news hiding

Stock price crash risk is significantly higher for firms with less readable annual reports. This relation is particularly stronger among firms that exhibit poor performance or transitorily good performance, which is normally seen as bad news. In this sense, it is likely that the low readability of financial report narratives is due to managers' hiding bad news, and thus potentially serves as a precedent of future crashes, which largely result from an abrupt release of accumulated bad news.

Managers' incentive

Because corporate managers and CEOs own shares of companies as part of their compensation, they have personal incentives to maximize investors' perceptions of firm value as reflected by stock prices. The research finds that the relation between annual report readability and future stock price crash risk is more significant when the firm's CEO holds more stock options of the firm, which props up stock prices.

The Sarbanes-Oxley Act

Financial data is under more stringent regulatory monitoring and public scrutiny thanks to the Sarbanes-Oxley Act (SOX) passed by the U.S. Congress in 2002. As a result, it is harder to hide bad news simply by manipulating the bottom line in financial statements. In the post-SOX era, however, earnings manipulation is still related to future crash risk among firms with low readability of annual report narratives. Managers can and do hide bad news in a "wiser" way by using more complex financial report narratives to mask their earnings manipulation behavior.

Investors and regulators are by no means at rest after the enactment of SOX. They should be concerned about subtler ways of hiding bad news, which are harder to detect. The U.S. Securities and Exchange Commission has started working on text mining techniques to identify clues of potential misrepresentation of economic performance by public firms.

The article, "Readability of 10-K reports and stock price crash risk," is co-authored by Ke Wang and is forthcoming in Contemporary Accounting Research.

Ke Wang Ke Wang focuses his research on the role of accounting information in the context of capital markets. His current research examines capital market implications from corporate disclosure narratives. He also explores how a firm's stakeholder relations shape its financial reporting choices and capital market outcomes. Before joining the University of Alberta, Ke attended the Hong Kong Polytechnic University (BBA) and City University of Hong Kong (PhD). He is currently an Assistant Professor of Accounting at the Alberta School of Business.