Notes Readability and Discretionary Accruals
Legibilidad de las notas y devengo discrecional
Abstract
Narrative disclosures should help external users to better understand managerial discretionary accruals. However, both narrative disclosures and accruals earnings are subject to managerial discretion. This study investigates the relationship expected between earnings management, as gauged by discretionary accruals (DA), and readability, as measured by the Fog Index (Li, 2008). Prior studies investigate the relationship in terms of the readability of the management discussion and analysis (MD&A) which is not directly related to the disclosure of accruals estimation and is also not an audited section of the company’s annual report. This study makes a unique contribution to the extant literature by providing empirical evidence on the association between DA and the readability of the notes to the financial statements (hereafter, Notes). Based on 1,021 observations for UK data drawn from FTSE All Share non-financial firms over the period 2005 to 2011, an ordinary least squares (OLS) regression finds a positive relation between DA and the readability of the Notes. A positive association shows that managers of firms who manage DA tend to produce more readable Notes. This result is likely due to the absence of an incentive to manage DA along with managers’ awareness of the associated risk of producing less-readable Notes, which might result in deeper analysis by auditors and, consequently, a greater chance of them detecting DA. Thus, market participants should not always rely on the greater readability of the Notes as an indicator of higher-quality financial statement numbers, as the results suggest that greater readability is associated with higher DA.
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