Financial Reporting Readability: Managerial Choices versus Firm Fundamentals

Abstract

An implicit premise of regulators and much empirical research is that financial reporting readability (readability) substantially reflects management choices. To investigate this issue, we decompose readability into its discretionary and innate components. To validate this decomposition, we examine whether these two components have different uncertainty effects. Our empirical findings show that readability is primarily the result of firm fundamentals rather than managerial choices. Furthermore, consistent with expectation, discretionary readability has a weaker uncertainty effect than innate readability. The findings are robust to a variety of additional tests. This study contributes to regulators to better assess readability and to empirical literature to construct more accurate tests.

Keywords: Quality of financial disclosures, Readability, Managerial discretion, Discretionary readability, Firm fundamentals, Uncertainty

JEL Classification: D80, G14, G32, M16, M40, M48