Of Fogs and Bogs: Does Litigation Risk Make Financial Reports Less Readable?

Abstract

We hypothesize that firms’ attempts to reduce litigation risk can worsen financial report readability: as firms strive for disclosure accuracy and thoroughness, reports increase in size and complexity. Readability deteriorates with management exposure to securities class actions at the current firm or at another firm connected through, for instance, a board interlock or prior employment. Using an SEC rule change as an exogenous shock, we show adjustments to readability can moderate firm litigation risk. Furthermore, firms respond to exogenous shifts in the information environment, e.g., the impact of brokerage mergers on analyst following, by adjusting readability as circumstances warrant.

Keywords: Readability, Transparency, Securities Class Actions, Litigation Risk, Plain English Rule

JEL Classification: G30, G38, K22