The Contribution of Banks' Annual Report Writing Quality to Investor Decision-Making

EVOLUTION OF THE ANNUAL REPORT The annual report ostensibly serves a simple purpose in American business--to evaluate the financial performance of the corporation during the previous year. This stylized business report originated with the Securities Acts of 1933 and 1934, known as the "truth in securities" laws. These acts established the Securities and Exchange Commission (SEC) and required companies with more than $10 million in publicly traded assets to issue independently audited annual reports providing investors with information, including: A statement of earnings A balance sheet A statement of cash flow A statement of stockholders' equity Relevant quantitative and qualitative information needed to understand the data (Plung & Montgomery 2004). After thirty years, a new idea emerged. In addition to answering the financial obligations, annual reports could also serve as the corporation's principal public relations document. As a public relations tool, annual reports became advertisements for the company. Management used them as a platform for promoting their philosophies, strategies, and corporate successes. Annual reports took on a magazine look. They included glossy paper, color photographs, fancy graphics, and layouts. By 1986, the SEC was receiving criticisms that annual reports sacrificed information for design. Investors wanted shorter reports that gave clearer perspectives on a company's earning potential. After three years of study, the SEC agreed to a radical change in reporting style--companies could put detailed financial information into a separate document (the 10-K or Proxy Statement) and create a Summary Annual Report (SAR). This SAR was more compact, concise, and readable. It moved footnote material into the narrative, used more graphs, and wrote financial information in laymen's terms (Kulkosky 1987). The SAR effectively recast the report into the province of the communicator, who would now be assisted by, rather than dictated to by, the analysts and design houses. The first company to produce an SAR was McKesson Corporation in 1987. The company claimed they saved $60,000 in production costs, or 20 percent of their annual total expense for financial reports. The corporate Vice President also praised the SAR for "greatly improving the readability of the report and its use as a communication device" (Simone 1988). After the scandals of 2001 involving Enron, Arthur Andersen, WorldCom, Xerox, and other companies, public confidence in the securities and accounting industries plummeted. Public scrutiny of corporate financial disclosures increased. As a result, last year, President George W. Bush signed into law the Sarbanes-Oxley Act of 2002, changing forever the financial reporting landscape. The most dramatic change to federal securities laws since the 1930s, the Act redesigns federal regulation of public company corporate governance and reporting obligations. It also significantly tightens accountability standards for corporate directors and officers, auditors, analysts, and legal counsel. Numerous changes are mandated, among which is "increasing transparency" of financial reports, the mandate most relevant to this paper. Furthermore, new powers are granted to the Securities and Exchange Commission (SEC), requiring it to review reporting procedures and strengthening its authority to hand down criminal penalties for "white collar" (economic, non-violent) crimes. First and foremost, a corporate annual report must be credible. A survey by Hill and Knowlton Inc. and reported by Jacobson (1988) revealed that lack of credibility is the main complaint against annual reports. Critics complain that annual reports are long on fluff and short on substance. One study even suggests that readers can predict how a company's stock will perform based on the language used in the CEO's Letter to Shareholders. CEOs of top performers use optimistic phrases implying confidence and growth, while poor performers tend to discuss neither gains nor losses (Jacobson 1988). …