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.