The Impact of Narrative Disclosure Readability on Bond Ratings and the Cost of Debt Capital

Abstract

Prior research on the determinants of credit ratings has focused primarily on rating agencies’ use of quantitative accounting information, but the impact of financial disclosures, particularly textual attributes, on the bond rating process has gone relatively unexplored. This study examines the potential impact of the financial disclosure narrative on various bond market outcomes. We find that less readable financial disclosures are associated with less favorable ratings (higher default risk), greater bond rating agency disagreement, and a higher cost of debt capital. To address the potential confound that our results may be influenced by some underlying firm characteristic (e.g., firm complexity), we take advantage of a regulatory intervention provided by the 1998 Plain English Mandate requiring a subset of firms to exogenously improve the readability of their filings. Using a difference-in-differences design, we find that the firms required to improve the readability of their filings experience more favorable ratings (lower default risk), lower bond rating disagreement, and lower cost of debt capital. Collectively, our evidence suggests that textual financial disclosure attributes appear to not only influence bond market intermediaries’ opinions, but also firms’ cost of debt capital.

Keywords: Readability, Plain English, Reporting Complexity, Rating Agencies, Disagreement, Cost of Debt Capital

JEL Classification: G24, M40, M48