Annual Report Readability and the Cost of Equity Capital

Abstract

Using a large panel of U.S. public firms, we examine the relation between annual report readability and cost of equity capital. We hypothesize that complex textual reporting deters investors’ ability to process and interpret annual reports, leading to higher information risk, and thus higher cost of equity financing. Consistent with our prediction, we find that greater textual complexity is associated with higher cost of equity capital. Our results are robust to a battery of sensitivity checks, including use of multiple estimation methods, alternative proxies of annual report readability and cost of equity capital measures, and potential endogeneity concerns. In addition, we hypothesize and test whether the nature of the relation between readability and cost of capital depends on the tone of 10-K filings. Our results show that the effect of annual report complexity on cost of equity is greater when disclosure tone is more negative or more ambiguous. We also find that the effect of annual report readability on cost of equity capital depends on the degree of stock market competition, level of institutional investors’ ownership, and analyst coverage.

Keywords: Annual Report Readability, Bog Index, Disclosure Tone, Information Risk, Cost of Equity Capital

JEL Classification: G12, G14, G32, M41