Does annual report readability explain the accrual anomaly?

Abstract

Purpose

The 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/approach

Using 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.

Findings

We 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/implications

This 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 implications

Low readability of annual reports is a red flag to investors.

Social implications

This study provides support for regulatory initiatives aimed at enhancing readability of corporate disclosures to address market frictions and improve market efficiency.

Originality/value

Accrual 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.

Citation

Liu, M. and Liu, Z. (2021), "Does annual report readability explain the accrual anomaly?", Asian Review of Accounting, Vol. 29 No. 3, pp. 307-331. https://doi.org/10.1108/ARA-07-2020-0114