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Accounting Narrativeslocked

  • Tracey J. RileyTracey J. RileySuffolk University
  •  and Alex C. YenAlex C. YenStonehill College


Although accounting is typically seen as a numbers-oriented discipline, with an emphasis on quantifying economic events and activity, the nexus of language and accounting, specifically the role of language in communicating corporate accounting results, has received an increasing amount of attention in recent years. This is because quantified accounting results (e.g., earnings per share, sales revenue) are rarely communicated in isolation. Rather, they are usually accompanied by a non-quantitative narrative, such as an earnings press release, a corporate annual report, or the president’s letter, which, along with conference calls and content at corporate websites, we collectively refer to as “accounting narratives.” These narratives allow management to elaborate on and contextualize the financial performance of the company. However, because they are not as extensively regulated as the financial statements and are not standardized, these narratives can also be used by companies for impression-management purposes, to obfuscate (poor) performance and to “spin” the financial results to the companies’ favor.

Research into accounting narratives dates back to 1952 and has focused on a wide variety of features of narratives and on how those features affect financial statement readers’ (most notably, investors’) reactions. The earliest studies focused on accounting narratives’ readability by performing a syntactic analysis to assess the cognitive difficulty of written passages. This line of research has found that accounting narratives are syntactically complex and difficult to read and that management intentionally makes bad news less readable in order to strain the readers’ cognitive processes and lead to lower comprehension of the bad news. In addition to this evidence of obfuscation, researchers have found support for managers engaging in attributional framing, which is the tendency to attribute positive outcomes to actions within the company and negative outcomes to actions external to the company (e.g., the government or the weather) in an effort to influence readers’ perception of good versus bad news. More recently, researchers have found that managers use syntactic (sentence structure), semantic (word meaning), and metasemantic (abstract versus concrete construal) manipulation and make broad stylistic choices such as emphasis, length, and scenario form. In terms of how those features affect the readers of the narratives, readers (most notably, investors) have been shown to respond to length and readability; level of negativity; words pertaining to risk, uncertainty, credibility, commitment, and responsibility; justifications of excuses of poor performance; optimistic and pessimistic tone; vivid versus pallid language; internal versus external attributions; and use of self-references.

The smooth functioning of the market for capital investment (i.e., the “capital markets”) is facilitated by the regular flow of information from corporations to their current and potential investors. This flow of information takes the form of “glossy” corporate annual reports, regulatory filings, and corporation-issued press releases highlighting the corporation’s earnings news and other operational and regulatory developments.1

Not surprisingly, a central theme in financial accounting research (from its infancy and continuing to the present) has been to understand “whether,” “when,” and “how” the information produced by corporations affects investors’ assessments of that corporation’s financial performance and investment potential. The primary emphasis in this research has been on examining the influence of the quantitative information produced by corporations, in particular the information contained in the income statement (which serves as a quantitative representation of a company’s financial performance) and in the balance sheet (which serves as a quantitative representation of a company’s financial resources and obligations). The results from these studies consistently demonstrate that quantitative financial information has an influence on investors in the capital markets and on their investment decisions (e.g., Ball & Brown, 1968; Bhattacharya, Black, Christensen, & Mergenthaler, 2007; Francis, Schipper, & Vincent, 2002).2

This long-standing emphasis on quantitative information in financial accounting research belies the fact that quantitative accounting results are rarely communicated in isolation and that the information flowing from corporations to investors is actually a combination of quantitative information and qualitative narratives. For example, corporate annual reports, which contain quantified financial statements, also typically include a president’s letter summarizing the year’s highlights. Along the same lines, Form 10-K for publicly traded corporations in the United States is often over 100 pages long, but only a fraction of it is devoted to quantitative information. The rest of Form 10-K provides commentary on the financial statements, and this commentary notably includes “management discussion and analysis,” a management-authored discussion of the income statement and balance sheet on a line-by-line basis. Even earnings press releases go beyond simply announcing earnings per share and provide financial highlights in narrative form, as illustrated in the following example:

“Starbucks record Q4 financial results, highlighted by stunning comp store sales increases of 8% globally, 9% in the U.S. driven by a 4% increase in global traffic, demonstrate the strength and relevance of the Starbucks brand around the world,” said Howard Schultz, Starbucks chairman and CEO. “And our results underscore the success of the investments we continue to make in our people and business, in new beverage and food innovation and in groundbreaking technology innovation that is deepening our connection to customers everywhere,” Schultz added.

Consolidated net revenues were $4.9 billion in Q4 FY15, an increase of 18% over Q4 FY14. The increase was primarily driven by incremental revenues from the acquisition of Starbucks Japan, an 8% increase in global comparable store sales and the opening of 1,606 net new stores over the past 12 months. (Starbucks earnings press release, October 29, 2015)

We refer to these items (e.g., the president’s letter, management discussion and analysis, earnings press releases), along with conference calls and content at corporate websites, as “accounting narratives.”3 Corporations devote time and attention to crafting these narratives in order to elaborate on and contextualize the accompanying quantitative information with the goal of informing and ultimately persuading readers, such as investors. But are these accounting narratives effective in influencing investors? More specifically, in what particular linguistic features do accounting narratives vary across companies, and do these differences in these linguistic features influence investors’ judgments and decisions?4 And do the features of accounting narratives affect judgments directly or by moderating investors’ reactions to quantitative information? As we highlight later, research to date on accounting narratives has examined numerous features of accounting narratives and how they influence investors’ judgments and decisions, including features related to (1) disclosure content, such as attributional framing, length and readability, tone, and vivid language, and (2) disclosure style, such as use of passive sentences, concreteness, language categories, emphasis, pronoun usage, and delivery medium.

Although this research literature dates back to 1952, we observe that the literature has grown significantly in recent years, as research in accounting narratives appears to be in the midst of a “renaissance.” For example, a special Accounting and Business Research issue dedicated solely to accounting narratives was published in 2015. We believe that this renaissance is the result of (1) the wide variation (on multiple dimensions) in how companies construct their narratives, due to limited regulation and standardization of narratives, combined with (2) accounting narratives varying on both what is being communicated and how it is being communicated, making this area particularly ripe for the application of theories from social and cognitive psychology and linguistics. The wide variation in narratives is observed by Libby and Emett (2014, p. 429), who note that “managers often use the wide discretion they are afforded over narrative disclosures to present firm performance in a favorable light.” The link between accounting narratives and psychology and linguistics was in evidence in a 2017 conference on “New Corporate Disclosures and New Media” sponsored by the journal Accounting, Organizations, and Society, which observes that companies are producing “more information beyond the four basic financial statements” and that “much of the information disclosed is qualitative in nature, creating the potential for linguistic features [emphasis added] to impact users” (Hobson, Libby, & Tan, 2018, p. v).

The intersection of these two factors is generating renewed research interest in accounting narratives, as researchers are realizing the many variables that come into play when constructing/reading narratives and the resulting interesting research questions that can be asked in this area. It is our belief that the study of accounting narratives will continue to be fertile ground for researchers, and it is our hope that through our discussion of accounting narratives, we spur on other researchers to explore new dimensions of accounting narratives and to further expand our understanding of them.

Key Themes in Prior Research on Accounting Narratives—Disclosure Content

Research into accounting narratives dates back to 1952 and has focused on a wide variety of features of narratives and how those features influence investors. In the following sections and subsections we discuss the key themes of this research. However, before exploring “how” accounting narratives might vary, it is important to first understand “why” they might vary.

Information Perspective Versus Opportunistic Perspective

Prior literature has traditionally identified two competing schools of thought regarding companies’/managers’ disclosure motives and their resulting disclosure preferences—the information perspective and the opportunistic perspective (Riedl & Srinivasan, 2010).5 The information perspective posits that managers are motivated by transparency (and by the resulting liquidity benefits that are associated with transparency). Under this perspective, managers are expected to construct (neutral) accounting narratives that err on the side of providing more information rather than less information while also being subject to a counterbalancing constraint not to “overdisclose” (i.e., to reveal proprietary information associated with the firm’s competitive advantage).

On the other hand, the opportunistic perspective posits that managers use accounting narratives strategically, selectively choosing the narrative’s contents and how it is worded to “spin” the results to their favor, to portray firm performance in the most positive light, and to moderate investor reactions to the quantitative financial information. What is the benefit to managers from using accounting narratives for “impression-management” purposes, where the goal is to manipulate users’ perceptions of the company’s performance? Prior research suggests that managers are likely motivated to influence the readers of their narratives due to their incentives to maintain high stock prices, improve their compensation packages, protect their own reputation, obtain financing, and attract high-quality employees.

The success of managers’ impression-management techniques rests on the notion that financial statement users are cognitively limited when processing accounting information and that presentation choices made by managers, such as how accounting narratives are constructed, can exploit these limitations and affect users’ judgments and decisions. If impression-management techniques are successful and users are swayed by these techniques, this would result in managers successfully “gaming” the system to their benefit, leading to a misallocation of capital resources. A concern over this particular type of “inequity” motivated some of the early accounting narrative research on two possible impression-management strategies, obfuscation (of bad news) and attributional framing.

Obfuscation and Attributional Framing

The obfuscation hypothesis posits that making narrative disclosures of bad news less readable strains readers’ cognitive processes, resulting in users having a lower level of comprehension of the news and ultimately a muted reaction to the bad news (Courtis, 1998, 2004; Li, 2008). The research on obfuscation is associated with and has its roots in earlier research on the readability of accounting narratives, where researchers perform a syntactic analysis (such as the Flesch Readability Formula or the Fog Index) to assess the cognitive difficulty of written passages in the narratives. In general this research has found that annual reports are syntactically complex and are therefore considered difficult to read (Jones & Shoemaker, 1994).

Note that the use of syntactic complexity is in itself not evidence of obfuscation or impression management. Rather one needs to look for the interaction of the narrative’s level of syntactic complexity with the valence of the news being described in the narrative, such that bad news is described in a more complex manner. Subramanian, Insley, and Blackwell (1993) find that annual reports of companies with a net profit were easier to read and used significantly less jargon (i.e., vocabulary known only to professionals) or modifiers (i.e., adjectives or adverbs, which, when used excessively, can make writing difficult to understand) than annual reports of companies with a net loss. Overall, they determined that a reader would need a 10th grade education to understand the narratives of the profitable companies, yet four years of additional education were needed to understand the narratives of the unprofitable companies. While Subramanian, Insley, and Blackwell (1993) and others (e.g., Courtis, 1998; Li, 2006; Smith & Taffler, 1992) find support for the obfuscation hypothesis, others find either no support or moderate support (e.g., Clatworthy & Jones, 2001; Courtis, 2004).

The second impression-management technique is attributional framing, where managers develop verbal coping strategies such that their narratives attribute positive outcomes to the actions of company management and negative outcomes to external or chance factors such as governmental influences or extreme weather in an effort to influence readers’ perceptions of the company’s role (or lack thereof) in the observed good or bad news (Abrahamson & Park, 1994; Baginski, Hassell, & Kimbrough, 2004; Jones & Shoemaker, 1994).

For example, Bowman (1976) found that the best-performing and worst-performing companies in the food processing industry discussed different themes in their annual reports. More successful companies discussed company actions and their strategic directions, while less successful companies discussed external factors affecting performance, such as bad weather and price controls. Bettman and Weitz (1983) analyzed attributions in the letter to shareholders and found that these attributions were more frequent when a corporation did worse than expected, with unfavorable outcomes attributed more to external causes than favorable outcomes; Ingram and Frazier (1983) found that less successful firms focus on external events, while profitable firms refer to the performance of management; and Keusch, Bollen, and Hassink (2012) found that management has a greater tendency to engage in impression management by using self-serving biased language when they are experiencing a year of crisis.

While prior research shows that companies use both obfuscation and attributional framing for impression-management purposes, prior research also suggests that such strategies must be used in moderation to be successful. In order to influence readers, narratives must be credible and accurate (Merkl-Davies & Brennan, 2007). As such, managers must be able to avoid being so obvious in their impression-management techniques that audiences discount the self-promotion as sugar-coating or hype (Aerts, 2005). A strong stream of recent research focuses on impression management (Merkl-Davies & Brennan, 2007, 2011; Merkl-Davies, Brennan, & McLeay, 2011; Merkl-Davies & Koller, 2012).

Other Readability-Related Considerations

The study of the readability of accounting narratives has a long history, and although readability is central to the impression-management strategy of obfuscation (as discussed earlier), there are other readability-related considerations and observations outside of obfuscation. For example, in addition to annual reports being syntactically complex in general (Jones & Shoemaker, 1994), Clatworthy and Jones (2001) observe that readability can differ between different sections within the same annual report. And Courtis and Hassan (2002) compare the readabilities of annual reports in different languages (English and Chinese versions in Hong Kong; English and Malay in Malaysia) and find that indigenous language versions are easier to read than their English versions.

More recent research into readability examines whether corporate narrative disclosures have information content—that is, whether the level of narrative readability is associated with and is predictive of a firm’s future financial performance. Li (2008) measures the readability of public company annual reports using two variables—the Fog Index and the length of the document. In addition to finding that annual reports of firms with lower (current) earnings are more difficult to read, Li (2008) also finds that firms with annual reports that are easier to read also have more persistent positive earnings (in future periods).

The literature on readability has also evolved from an emphasis on readability features of narratives (i.e., characteristics) to how those features affect investor trading (i.e., consequences). Language is a tool for communication, and its main function is to direct the attention and focus of others to different aspects of reality (Semin, 2007). Given that language influences how information is perceived and understood, one would expect a market response to managers’ narrative disclosures (Davis, Piger, & Sedor, 2012). Empirical research has demonstrated that investment decisions are significantly affected by the management narratives in annual reports, including the president’s letter (Kaplan, Pourciau, & Reckers, 1990) and earnings press releases (Davis et al., 2012; Demers & Vega, 2014), and that this influence is more prominent for non-professional investors (Miller, 2010) either because processing fluency acts as a subconscious heuristic cue of readability (Rennekamp, 2012) or because readability leads to impairment of investors’ understanding of the message (Tan, Wang, & Zhou, 2015).

Recent research also suggests that reading a more syntactically complex corporate disclosure indirectly increases the extent to which participants search for outside (non–company-provided) information, such as analyst reports and news media. This finding potentially limits the extent to which managers can benefit from intentionally obfuscating poor performance (Asay, Elliott, & Rennekamp, 2016).

Other Disclosure Content Considerations

Content analysis, or thematic analysis, is a research method borrowed from the humanities and social sciences. It involves analyzing categories of narrative segments (i.e., words, sentences, paragraphs, etc.) for themes and drawing inferences or conclusions from the measures of these themes. Jones and Shoemaker (1994) provide a review of the early content analysis literature, discussing the methodologies used and evaluating the validity and reliability of the studies. Studies use analysis of narrative disclosure content to forecast information (e.g., Dev, 1974; Steele, 1982), help predict bankruptcy (D’Aveni & McMillan, 1990; Smith & Taffler, 2000; Tennyson, Ingram, & Dugan, 1990), predict litigation risk (Nelson & Pritchard, 2007; Rogers, Van Buskirk, & Zechman, 2011), predict fraudulent financial reporting (Larcker & Zakolyukina, 2012), and draw inferences about leadership personality characteristics (e.g., Amernic & Craig, 2007, 2013; Amernic, Craig, & Tourish, 2007, 2010; Brennan & Conroy, 2013; Craig & Amernic, 2004).

Studies focus on content attributes such as positive/negative keywords (e.g., Abrahamson & Park, 1994; Smith & Taffler, 2000), optimistic/pessimistic tone (e.g., Davis et al., 2012; Demers & Vega, 2014; Feldman, Govindaraj, Livnat, & Segal, 2010; Lang & Lundholm, 2000; Pagliarussi, Agujar, & Galdi, 2016), words expressing credibility, commitment, and responsibility (Segars & Kohut, 2001), and vividness (Hales, Kuang, & Venkataraman, 2011).

The study of attributional framing is under the umbrella of content analysis. As discussed earlier, recall that attributional framing research finds that corporate officers attribute positive outcomes to internal forces and negative outcomes to external forces. This attribution pattern holds whether companies are experiencing improving performance or declining performance (Clatworthy & Jones, 2003).

Abrahamson and Park (1994) sought to build on the attributional framing research and questioned whether and when corporate officers intentionally conceal negative outcomes in their communications to shareholders. Using a frequency count of negative words, they found that when financial performance is poor, corporate officers actually use more negativity in their disclosures. Further tests suggest this is due to the influence of outside directors, large institutional investors, and accountants, who limit concealment of negative outcomes by corporate officers.

Unlike the older research in the area, which relied on manual coding and judgment and limited sample sizes, more recent research takes advantage of computing power and the technology of textual analysis. (For a more thorough review of the textual analysis literature, see Loughran & McDonald, 2016; and Kearney & Liu, 2014.) Some of this research employs a text-analysis program called DICTION, which is able to count positive (optimistic tone) and negative (pessimistic tone) words in tens of thousands of narratives. Using DICTION, Demers and Vega (2014) find that an unexpected level of net optimism (the net amount of positive words minus negative words) in quarterly earnings announcements generates a higher market response, and Davis et al. (2012) find that managers’ press release language about earnings signals their expectations about future firm performance and that this signal generates a market response. While others have also found that the market reacts to variations in disclosure tone (Feldman et al., 2010; Lang & Lundholm, 2000), Tan, Wang, and Zhou (2014) find that tone only influences investors’ judgments when the disclosure is less readable, showing that the main effects of tone and readability found in previous research have boundary effects.

Haried (1972) was the first to study the semantic dimensions of accounting narratives. At the semantic level, strategic language use is achieved by using words with different meaning to attract or detract attention. Haried says that “semantic problems in communication are concerned with the proximity in meaning between that intended by the sender of the communication and that interpreted by the receiver” (1972, p. 376). He was the first to recognize the issue of semantics in external accounting communication due to the profession assigning technical meanings to words that convey different meanings in ordinary usage and the insufficient standardization of terms used in financial accounting.

Key Themes in Prior Research on Accounting Narratives—Disclosure Style

In the field of accounting narrative analysis, it is important to study both what is communicated and how it is communicated. Asay, Libby, and Rennekamp (2018) distinguish between studies of disclosure content (what information is shared), discussed earlier, and studies of disclosure style (how that information is shared), discussed in this section.

Disclosure style has little impact on the literal meaning of communications but can be very important if it affects the way in which information is processed and used. Studies have demonstrated the impact of disclosure styles such as language categories (Riley, Semin, & Yen, 2014), concreteness (Elliott, Rennekamp, & White, 2015), number of personal references (Clatworthy & Jones, 2006; Thomas, 1997), passive versus active voice (Clatworthy & Jones, 2006; Sydserff & Weetman, 2002; Thomas, 1997), and delivery medium (Elliott, Hodge, & Sedor, 2012).

Riley et al. (2014) shift the focus of accounting narrative research from semantic manipulations and word choice, which can alter a narrative’s overt meaning, to metasemantic manipulations. They examine the effects of language categories on investors’ judgment and decisions—the notion that narratives written with different predicates (verbs versus adjectives/nouns) will have a differential effect on investors. Their research is rooted in the social psychology research where researchers have found that predicates can be classified into four categories—descriptive action verbs, interpretive action verbs, state verbs, and adjectives/nouns—which vary systematically on the dimension of abstractness/concreteness, with descriptive action verbs being the most concrete and adjectives/nouns being the most abstract. Given the existence of verb and adjective/noun forms of the same root word, it is possible for that root word to be construed in a relatively more abstract or more concrete manner. For example, a manager may say “demonstrating our ability to broaden and diversify” by using verbs, or that manager may say “demonstrating our breadth and diversity” by using nouns. Riley et al. (2014) find results congruent with the social psychology research, where language in earnings press releases is more concrete when the associated financial information is positive and more abstract when the associate financial information is negative.

A manager can describe the very same behavior or event by using any of the categories. However, when the representation is at an abstract level, social psychology research finds that the behavior or event is perceived as less verifiable, less informative about the situation, more likely to be disputed, and less vivid. The opposite is true when the representation is at a concrete level. This level is perceived as being verifiable, more likely due to the intentional responsibility of the actor, and more vivid and imaginable (Semin & Fiedler, 1988). Riley et al. (2014) find that investors react more strongly to the information contained in an earning press release when it is written with concrete predicates than when it is written with abstract predicates.

Elliott et al. (2015) also find that investors are significantly more willing to invest in a firm when concrete language is highlighted in a prospectus than when abstract language is highlighted. They find that this is because concrete language facilitates visualization and is less open to interpretation, which increases investors’ feelings of comfort in their ability to evaluate an investment. Theirs is a semantics study with an example of a concrete disclosure being “one share of IBM stock” and an example of an abstract disclosure being “an asset.”

Others researchers find that personal pronoun usage and the use of the CEO’s photo in disclosures are related to firm performance. For example, Thomas (1997) finds that profitable companies use more personal references than non-profitable companies, and Li (2012) finds that managers use more personal pronouns when firm performance is better. Asay et al. (2018) find that investors react more strongly to disclosures with more personal pronouns and disclosures including a CEO photo.

Along the same lines, other research suggests that a related stylistic choice, that of the prominence of the CEO’s photograph in the company’s annual report, is associated with company performance. Incorporating the prominence of the photograph as part of their composite proxy measure for CEO narcissism, Chatterjee and Hambrick (2007) find that CEO narcissism is significantly positively related to company outcomes, including the number and size of acquisitions made, extreme performance, and fluctuating performance. Taking a similar approach, Olsen, Dworkis, and Young (2014) find that firms with narcissistic CEOs have higher earnings per share and share price than those with non-narcissistic CEOs.

Another stylistic choice is the use of active voice over passive voice. As a firm’s profitability declines, managers replace active voice with passive voice (Thomas, 1997), and profitable companies use marginally fewer passive sentences (Clatworthy & Jones, 2006), likely because active verbs show responsibility and are associated with success.

Social and Environmental Reporting Narratives

Although our emphasis in this article is on accounting narratives that play a complementary and contextualizing role to the concurrently disclosed quantitative financial results, we would be remiss if we did not acknowledge a significant group of accounting narratives that potentially overlap with the narratives that we discuss here. These narratives are in the area of social and environmental reporting (also known as corporate social responsibility [CSR], social and environmental accountability, and sustainability accounting). Broadly speaking, social and environmental reporting is a vehicle for firms to establish an image in the public sphere (Guthrie & Abeysekera, 2006) by reporting to shareholders and other stakeholders on their CSR efforts, which involve engaging in “actions that appear to further some social good, beyond the interests of the firm and that which is required by law” (McWilliams & Siegel, 2001, 2006).

The typical subjects covered in social and environmental reports include environmental actions, employee/human resources practices (including employee health and safety and gender equity in employment and promotion), fair business practices, and community activities/philanthropy (Ernst & Ernst, 1978; Unerman, 2000). This reporting is often done in the company’s annual report (thus the overlap with the “complementary” emphasis in our paper) but can also be done via ad hoc stand-alone reports, advertisements, and brochures (Unerman, 2000) and, most recently, the company’s social media platforms.

In his analysis of social and environmental reporting research during the period 1988 to 2003, Parker (2005) observes that this literature is split approximately 50/50 between commentary/theoretical/literature review and empirical studies (including content analysis, field studies, and surveys). Parker (2005) also observes that the research is tilted more toward environmental than social research. As noted by Parker (2005), content analysis is commonly used in social and environmental reporting research, with researchers often “quantifying” the narratives using content analysis to look at what is being disclosed (subject matter and extent of disclosure) and comparing across countries and longitudinally (Vourvachis & Woodward, 2015). Another stream of research relates firm characteristics with the propensity to disclose.

The remaining streams of research in the area of social and environmental reporting and CSR appear to follow two distinct and divergent paths. Researchers following a positivist approach (primarily North America–based) examine the relationship between CSR performance and firm value and market/investor reactions to CSR disclosure (for summaries of these research streams, see Huang & Watson, 2015; Liu, Radhakrishnan, & Tsang, 2017). Researchers following a normative approach (primarily based in Europe) have looked beyond this positivist approach (of describing the world) and have infused their research with an eye toward the role of social and environmental reporting as a vehicle to define the relationship between the market, the state, and communities (Gray & Laughlin, 2012; Parker, 2005), even suggesting an activist role that accountants (and accounting researchers) can play in promoting corporate accountability and transparency. (For more comprehensive and specific discussions of social and environmental reporting research, see Gray & Laughlin, 2012; Huang & Watson, 2015; Liu et al., 2017; Parker, 2005; Vourvachis & Woodward, 2015.)

Historiography: Research in Accounting Narratives Over the Years

The study of accounting narratives began over half a century ago with readability studies. Accounting narrative readability studies perform a syntactic analysis (e.g., word, syllable, and sentence counts) to assess the cognitive difficulty of accounting narratives. As described in Pashalian and Crissy (1952), Pashalian applied in her master’s thesis the Flesch Readability Formula to the 1948 annual reports of large, publicly held companies: Bell Telephone, Chrysler Corporation, General Electric, General Motors, Pennsylvania Railroad, Sears, Roebuck & Co., and U.S. Steel. Using the Flesch formula, she took 100-word samples from approximately every other page of the annual report and counted the number of syllables and average sentence length in the sample. Samples with fewer syllables and shorter sentences were consider easier to read. Pashalian published her results with Crissy (1952, p. 215), where they reported that these annual reports “use language incomprehensible to 75 per cent of U.S. adults.” Soper and Dolphin (1964) applied the same formula to the 1961 annual reports of the same companies and found no improvement in their reading ease over the intervening 13 years. The consensus in the literature continues to be that accounting narratives are syntactically complex and therefore considered difficult to very difficult to read (Brennan, Guillamon-Saorin, & Pierce, 2009; Jones, 1988; Jones & Shoemaker, 1994).

The initial readability research assumed that readability reflects understandability. The distinction between the two wasn’t addressed until the 1990s when it was discerned that readability is the textual difficulty of a passage, while understandability is the capability of a reader to discern meaning and gain knowledge from a passage because of that reader’s background and reading level (Jones & Shoemaker, 1994; Smith & Taffler, 1992). This distinction is important because unsophisticated investors rely more on accounting narratives than quantitative data in making investment decisions, yet even sophisticated investors have difficulty understanding the narratives.

A primary objective of financial reporting is to provide useful information for investment and credit decisions. If the readability of accounting narratives is such that it inhibits understandability, then the message becomes useless for decision-making. Researchers began to question whether corporate management was using accounting narratives to transparently communicate proprietary information or to opportunistically spin their results in an effort to manipulate readers as a form of impression management (Adelberg, 1979). This distinction is critical because if narratives are used for impression management, and users are influenced by that impression management, capital misallocations may result.

To bring evidence to bear on this concern, cognitive and social psychology theories around impression management, attribution, and framing began to pervade accounting research. Courtis (1998, 2004) explored whether corporate managers attempt impression management by obfuscating bad news—in other words, making news less readable in an attempt to strain the users’ cognitive processes and lead to lower comprehension of the news. Today, there is moderate support in the literature that managers intentionally obfuscate bad news by making the passages more difficult to read.

The social psychology theory of self-serving attributional bias suggests that individuals have a tendency to attribute positive outcomes to internal (personal) actions and negative outcomes to external (situational) factors. While Bowman (1976) found that less successful companies in the food processing industry complain about the weather and government price controls (actions external to the company) more than their successful counterparts, he did not regard this as attributional framing. Bettman and Weitz (1983) were the first to introduce attributional framing and causal reasoning into the literature on accounting narratives, and Aerts (1994, 2001, 2005) has been a leading researcher in the field.

In the 1990s, researchers began focusing on content analysis as a way to provide incremental predictive ability. This research focuses on tone, keywords, and vividness. Jones and Shoemaker (1994) provide a review of the early research in this area, which was limited by its reliance on hand-coding. Today’s researchers make use of digitized textual data and computerized linguistic techniques that allow large samples of data to be efficiently analyzed (Li, 2010; Schleicher & Walker, 2010).

In addition to disclosure content, researchers also began focusing on disclosure style, which has little impact on the literal meaning of the narratives. These studies focus on the use of language categories, personal references, passive voice, and delivery medium. More successful firms are found to have narratives that use more personal pronouns, more prominent CEO photographs, and fewer passive sentences. Additionally, the market reacts to these disclosure styles.

Today’s researchers are investigating alternative methods of measuring readability and understandability (Bonsall, Leone, Miller, & Rennekamp, 2017; Jones & Smith, 2014; Loughran & McDonald, 2014); the effects of CEO narcissism and self-serving attributions on profits and investor decisions (Kimbrough & Wang, 2014; Olsen et al., 2014); the use of concrete versus abstract language (Elliott et al., 2015; Riley et al., 2014); accounting narratives as storytelling (Beattie & Davison, 2015; Eshraghi & Taffler, 2015); and the use of metaphors (Merkl-Davies & Koller, 2012). Additionally, they are investigating alternative methods of delivery medium, such as conference calls, videos, CSR reports, social media, and websites (Elliott et al., 2012; Matsumoto, Pronk, & Roelofsen, 2011; Merkl-Davies & Brennan, 2017; Yang & Liu, 2017). Finally, today’s researchers are also investigating narratives written by third parties, such as analysts and the press, including microblogs and tweets (Hales et al., 2011; Sprenger, Tumasjan, Sandner, & Welpe, 2014; Tucker & Yukselturk, 2015; Twedt & Rees, 2012).

The quality of accounting narratives is the focus of worldwide regulatory attention given the role of these narratives in corporate reporting. In 1969, an internal study group commissioned by the U.S. Securities and Exchange Commission (SEC) released their “Wheat Report,” which recognized the reading difficulty of prospectuses and recommended that companies avoid unnecessarily long, complex, and/or verbose writing. In October 1998, the SEC issued the “plain English” rule in an attempt to ensure financial disclosures be accessible to the average investor by being free of obtuse language. This rule applied to certain sections of prospectuses. In 2008, the rule was expanded to include mutual fund summary prospectuses, and in 2010 the SEC voted to require it in an informational brochure that SEC-registered investment advisers are required to deliver to clients and prospective clients. Companies are, however, encouraged to use plain English in all of their narratives, including quarterly and annual reports. To test whether firms were adopting the plain English guidelines in their filings, Loughran and McDonald (2009) analyzed 12 years of annual reports through 2007. They found that the plain English rule has improved the readability of these disclosures over time.

In 2009, the Financial Reporting Council (FRC; the United Kingdom’s and Ireland’s independent regulator responsible for promoting confidence in corporate reporting) issued a publication entitled Louder Than Words. Principles and Actions for Making Corporate Reports Less Complex and More Relevant, which was called for by world leaders at the April 2009 G20 summit. The FRC suggests clear, understandable language be used in regulations and reports and states: “Writing in plain language means using everyday terms instead of jargon and relying on simple sentence structures. When technical terms are necessary, they should be clearly defined” (FRC, 2009, p. 35). In 2015, the FRC issued Clear and Concise Developments in Narrative Reporting, which provided a report card on the state of narrative reporting and reiterated the principles outlined in the 2009 publication.

Research Directions

Accounting narratives play an instrumental role in the financial reporting process, and therefore the study of accounting narratives remains a fertile opportunity for researchers. In 2015, the first special issue dedicated solely to accounting narratives was published in Accounting and Business Research. Papers in this issue offer innovative theoretical approaches based in literary theory, philosophy, and quantitative analysis. The editors call for research using new approaches, such as literary analysis and psychoanalysis, and innovation in the types of narratives examined, such as social media (Beattie & Davison, 2015).

One of the largest research areas in the accounting narrative literature is readability. A primary issue with the readability literature is the use of readability-measurement techniques (e.g., the Flesch formula) that were not designed to analyze business disclosures. Future research needs to continue exploration of alternative methods of measuring readability and understandability as well as developing ways to improve the current readability of accounting narratives. There is also evidence to suggest that disclosures can vary depending on culture contexts, accounting systems, legal systems, and economic conditions. Research studying the evolution in readability of non-English narratives, or the differences arising from different language versions of bilingual reports, is just beginning to expand (e.g., Fakhfakh, 2016; Kumar, 2014; Mahboub, Mostapha, & Hegazy, 2017; Moreno & Casasola, 2016; Rahman, 2014).

While the research has consistently demonstrated that accounting narratives have an influence on investors in the capital markets, a gap in the literature is whether investors understand and fully price this information and how the textual information affects investors’ understanding of other information (Li, 2010). Additionally, the majority of existing research stems from anglophone countries. Studies from other parts of the world are beginning to complement and extend our understanding of whether cultural differences and preferences extend to the language of accounting narratives and whether investors’ reactions to thematic and syntactic characteristics are conditional on their cultural background.

Despite the finding that presentation medium can result in differential reactions from investors (Asay et al., 2018), the main focus of accounting narrative research has been traditional financial disclosures, such as annual reports and press releases. With respect to other delivery mediums, such as conference calls, videos, corporate websites, and social media (Facebook, Twitter, microblogs, etc.), the research literature is relatively unexplored, with a few exceptions: for example, Matsumoto et al. (2011), who examine the information content of conference calls; Hobson, Mayew, and Venkatachalam (2012), who use vocal emotion analysis software to identify vocal markers of cognitive dissonance during earnings conference calls to identify potential financial misreporting; and Cade (2016) and Elliott, Grant, and Hodge (2016), who experimentally examine how Twitter can be used to influence investors.

Future research could also expand our understanding of narratives written by stakeholders other than management, including analysts, regulators, non-governmental organizations, and the media. For example, Brennan, Merkl-Davies, and Beelitz (2013) and Brennan and Merkl-Davies (2014) analyze CSR communication during a public controversy between Greenpeace and six firms in the sportswear and fashion industries, and Franco, Hope, Vyas, and Zhou (2015) show that analysts generate greater trading volume when they produce more readable reports. These studies notwithstanding, we have much to learn about how market participants and others react to these outside forms of communication about the firm. Finally, most of the theories used in accounting narrative research are based on the behavior of individuals, yet many accounting narratives are multiple-authored, calling into question whether the theories hold for groups of people.

Further Reading

  • Beattie, V. (2014). Accounting narratives and the narrative turn in accounting research: Issues, theory, methodology, methods and a research framework. British Accounting Review, 46(2), 111–134.
  • Brennan, N. M., Guillamon-Saorin, E., & Pierce, A. (2009). Methodological insights: Impression management: Developing and illustrating a scheme of analysis for narrative disclosures—a methodological note. Accounting, Auditing, & Accountability Journal, 22(5), 789–832.
  • Brennan, N. M., & Merkl-Davies, D. M. (2013). Accounting narratives and impression management. In L. Jack, J. Davison, & R. Craig (Eds.), The Routledge companion to communication in accounting (pp. 109–132). London: Routledge.
  • Healy, P. M., & Palepu, K. G. (2001). Information asymmetry, corporate disclosure, and the capital markets: A review of the empirical disclosure literature. Journal of Accounting and Economics, 31(1–3), 405–440.
  • Jones, M. J., & Shoemaker, P. A. (1994). Accounting narratives: A review of empirical studies of content and readability. Journal of Accounting Literature, 13, 142–184.
  • Kearney, C., & Liu, S. (2014). Textual sentiment in finance: A survey of methods and models. International Review of Financial Analysis, 33, 171–185.
  • Li, F. (2010). Textual analysis of corporate disclosures: A survey of the literature. Journal of Accounting Literature, 29(1), 143–165.
  • Libby, R., & Emett, S. A. (2014). Earnings presentation effects on manager reporting choices and investor decisions. Accounting and Business Research, 44(4), 410–438.
  • Loughran, T., & McDonald, B. (2016). Textual analysis in accounting and finance: A survey. Journal of Accounting Research, 54(4), 1187–1230.
  • Merkl-Davies, D. M., & Brennan, N. M. (2007). Discretionary disclosure strategies in corporate narratives: Incremental information or impression management. Journal of Accounting Literature, 26, 116–194.


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  • 1. For example, in the United States these regulatory filings include the Securities and Exchange Commission (SEC)–mandated Annual Report on Form 10-K as well as quarterly filings, which are less extensive than the annual filings.

  • 2. The importance of quantitative financial information to investors is further illustrated by the overwhelming tilt in the accounting rules (promulgated by the Financial Accounting Standards Board and the International Accounting Standards Board) toward recognition and measurement—that is, whether an item should be included in the income statement and balance sheet (recognition) and how to calculate the amounts that are associated with that item (measurement). Almost all of the promulgated rules focus on getting the amounts in the income statement and balance sheet right (or as close to economic reality as possible), while rules guiding companies’ disclosures are substantially fewer in number.

  • 3. We choose to introduce the topic of accounting narratives in the context of corporations reporting financial results to their investors. We recognize that financial statements are used for purposes other than reporting to investors, such as contracting, evaluation of stewardship, and reporting to non-investor stakeholders, and that narratives are used to support these other functions. However, given our contention that the primary purpose of narratives is for corporations to persuade investors and given the extent of research examining the flow of non-quantitative information in the corporation-to-investor channel, our discussion of accounting narratives in this article is framed primarily around a corporate reporting and investor setting. We recognize that the word “narrative” is associated with the European-style interpretive research tradition, where it is viewed as a means for organizations and their audiences to develop relationships through dialogue, while the word “disclosure” is associated with the North-American–style positivist research tradition (Beattie, 2014; Merkl-Davies & Brennan, 2017), where it represents a means for an organization’s private information to be revealed to stakeholders. Throughout this article we use the terms “narrative” and “disclosure” interchangeably, and our choice to use “narrative” or “disclosure” in any particular instance in this paper is not reflective of any intent to imply a deeper meaning to its use.

  • 4. Our discussion of accounting narratives covers both the various features of accounting narratives and the effects of these features on readers, such as investors. As such, our discussion alternates between taking a preparer perspective (when discussing the features of accounting narratives) and taking a user perspective (when discussing the effects of these features on investors).

  • 5. Recently, Brennan and Merkl-Davies (2018) argue there are actually three corporate communication strategies: (1) to provide information, (2) to influence or persuade, and (3) to engage in dialogue. In an information strategy, firms communicate information to their financial stakeholders, who are passive recipients. In a persuasion strategy, firms attempt to influence their financial stakeholders’ judgments, decisions, and behaviors in a way that is beneficial to the firm. Most accounting research is based on these two strategies and is discussed in this article. With the emergence of non-traditional means of corporate communication, such as online reporting, social media sites, and Twitter, a dialogue strategy should now be considered. Here, firms and their financial stakeholders are both active participants engaging in a two-way dialogue where information flows in both directions, with the aim of reaching a shared understanding and/or building a strong relationship. Research is just beginning to examine dialogic communication with stakeholders through interactive online digital media. With this shift in communication, where firms lose control over the information environment, readability indices will need to be replaced with new methods of measuring and evaluating quality and effectiveness.