Annual report readability and accounting irregularities: evidence from public listed companies in Indonesia

Abstract

PurposeThis study aims to examine the association between annual report readability and accounting irregularities in Indonesia. Using 967 firm-year observations over the 2014–2017 period, this paper unable to find evidence that annual report readability is associated with accounting irregularities. The results are robust after using alternate measurements of accounting irregularities proxies and readability indexes. This paper also finds that the corporate governance mechanism and foreign shareholder structure did not moderate the association between annual report readability and accounting irregularities.Design/methodology/approachThe study uses an archival method with cross-sectional regression of 967 firm-year observations over the 2014–2017 period to investigate an association between annual report readability and accounting irregularities in an emerging market setting. To check the robustness of the results, this paper conducts a battery of robustness tests.FindingsThis paper finds evidence that annual report readability is not associated with accounting irregularities in Indonesia. The results are robust after using alternate measurements of accounting irregularities proxies and readability indexes. This paper also finds that the corporate governance mechanism and foreign shareholder structure did not moderate the association between annual report readability and accounting irregularities. This implies that the readability of annual reports does not have the ability to predict the likelihood of accounting irregularities in Indonesia. It is possible that firms with accounting irregularities will be inclined to voice simpler stories which can counteract the tendency of lies to be linguistically more complex. Indeed, according to the Education First English Proficiency Index, Indonesia is categorized at a low proficiency level. Furthermore, this paper also discovers that the average readability of the management discussion and analysis (MD&A) of Indonesian public listed firms is at an ideal score by having a Fog Index of 13.32. The findings provide valuable insights for stakeholders in using annual reports for their decision-making, especially in an emerging market setting and non-English speaking countries.Research limitations/implicationsIt is important to interpret the findings in the context of the limitations of the readability index the authors used. It is argued that Fog Index, Flesch-Kincaid and Flesch Reading Ease have their own limitations as considered inadequate to be used in the context of business and accounting narratives that are adult-oriented and specialist in nature (Jones and Shoemaker, 1994; Loughran and McDonald, 2014). Another caveat relates to the use of proxies for accounting irregularities. The M-Score and F-Score have some limitations in which, among others, were determined without considering the normal level of accruals or period where manipulations were absent (Ball, 2013).Practical implicationsOne reason underlying the result is that Indonesian firms, in general, do not consider the complexity of the annual report, particularly MD&A disclosures, as a tool to mask financial reporting irregularities. It is also possible that firms with accounting irregularities will incline to voice simpler stories because it is difficult to be untruthful (Lo et al., 2017). Indeed, according to Education First English Proficiency Index, Indonesia was categorized in low proficiency level and ranked 61st out of 100 countries being surveyed (Education First, 2019). As policymakers, locally and globally, are calling for more simplified reports including a plain English approach, the study can be insightful to their deliberations. It suggests that policymakers need to consider a country’s English proficiency, writing skills, regulatory environment and corporate policy on shaping the complexity and narrative of a firm’s communications.Originality/valueThe study contributes to a scarcity of research that investigates English-written annual reports in non-English speaking countries (Jeanjean et al., 2015; Lundholm et al., 2014). As such, the study findings provide insights related to MD&A in an under-researched area and contribute to improving MD&A not only in Indonesia but also in neighbor countries that share similar social, political and economic characteristics. Also, this study is important for foreign institutions or individuals investing on Indonesian-listed firms. According to Candra (2016), approximately 60% of companies listed in the Indonesia stock exchange are owned by foreign individuals or institutions. They rely greatly on the English texts of annual reports to understand the companies’ financial performance. Moreover, La Porta et al. (2002) asserted that firms with a majority of foreign shareholders (dominantly owned by foreign investors) are more likely to face information asymmetry, primarily due to geographical factors and language barriers.