The Readability of Financial Statements, Information Asymmetries and Managerial Compensation

Abstract

Research Question/Issue: This paper examines whether CEOs whose writing is more difficult to read is a signal or proxy for difficulty in monitoring their activities, resulting in increased monitoring costs. If so, does this increased monitoring cost result in higher performance-pay sensitivity (PPS) as a component of their compensation contract?

Research Findings/Insights: Results indicate that CEOs who write in a less readable way have higher PPS compared to those who write clearly (i.e., in plain English), and that boards provide these CEOs with higher amounts of stock-based performance pay. This paper makes use of the Management Discussion & Analysis (MD&A) sections (which are written by top management) of firm 10-Ks from a scraped sample covering the period 2006 to 2017. This unique sample is used to construct readability statistics as a proxy for information asymmetries and implicit monitoring costs.

Theoretical/Academic Implications: Prendergast (2002, 2000) argues that boards set CEO compensation based on the monitoring costs they will incur. These results suggest that boards use increased incentive alignment as a substitute for monitoring. As a result, we provide support for the monitoring substitution hypothesis and resulting implications for efficient corporate governance.

Keywords: Compensation, CEOs, Flesch-Kincaid, Readability, Information Asymmetries, Managerial Compensation, Performance-Pay Sensitivity, Governance Substitution, Monitoring, Agency Problem

JEL Classification: J33, G30, G41