Len Boselovic’s Heard off the Street: Earnings reports often muddle language to obscure bad news
February 22, 2015 12:00 AM
By Len Boselovic / Pittsburgh Post-Gazette
Anyone who reads corporate earnings releases long enough will sooner or later develop a healthy skepticism regarding the ways practitioners of the fine art of making bad news appear to be good news have elevated their game. Companies routinely trumpet good news that is not as relevant and bury bad news that is more significant, hoping that investors will overlook it.
New research by three academicians indicates the strategy can work. They discovered the powerful influence using hard-to-fathom language in earnings releases can have on investor judgments about a company.
The study was done by Elaine Ying Wang of the University of Massachusetts Amherst, Hun-Tong Tan of Nanyang Technological University, and Shanghai University’s Bo Zhou. It was published in the American Accounting Association’s Accounting Review.
“Readers tend to focus on what’s easy to understand and to give short shrift to what isn’t, and therein lies an opportunity for investor manipulation,” Ms. Wang said.
The three professors focused on two ways companies frequently benchmark their performance: by comparing quarterly results to year-ago results and by comparing their results to what management forecast results would be. The professors said investors should care more about whether a company did better than a year ago than they do about whether it met its earnings forecast.
They said research by others indicates that about 37 percent of the time those two measures send conflicting signals. Either the company beats analyst forecasts but generates poorer results than a year ago or the numbers fall short of analyst expectations but are better than what the company generated a year ago.
When that happens, investors can be confused by the conflicting signals. The researchers found the language that corporate wordsmiths use to describe how the company performed by both measures can influence how investors shape an opinion about the company’s performance.
To measure that influence, the professors lined up a group of reasonably well informed investors: 131 M.B.A. students with substantial experience investing in stocks and reading earnings reports, as well as some finance and accounting courses under their belts.
They gave the students background information and financial data about a hypothetical company as well as a four-paragraph earnings release. The first two paragraphs described in plain English how the company did in comparison with company guidance. The fourth paragraph was the obligatory expression of confidence in the company and its future, something most companies feel compelled to provide no matter how dark and stormy the road ahead is.
The third paragraph, the key to the experiment, described the company’s performance against year-ago results, which the researchers consider the more relevant measure. Relying on passages from actual press releases, the professors concocted four versions of the paragraph, providing positive and negative comparisons to year-ago results as well as making the explanation easy to read and difficult, if not impossible, to read.
In the case of a company that performed better than a year ago but whose results fell short of analyst expectations, if the favorable year-ago comparison was written in hard to read prose but the failure to meet guidance was clearly stated, the students rated the company less favorably than a company that hid the fact that it did worse than a year ago in inscrutable language but very clearly stated that it beat analyst expectations.
“The greatest danger to investors may not be low readability per se, but that managers can use it opportunistically to obfuscate unfavorable [results] while embracing clarity for favorable ones that are less important,” Ms. Wang said.
Her advice to investors: “Don’t assume that, just because it’s hard to read, it isn’t important. That may very well be what some devious manager is counting on you to think.” If the news is as clear as mud, take the time to decipher what the company is saying, they said.
The professors suggest that in addition to keeping an eye out for companies playing with the numbers, the Securities and Exchange Commission should check out whether companies are playing with the words.
“Regulators should also be concerned when managers make the overall disclosure readable, but strategically use difficult to read language in selected parts of the disclosure,” they write.
Len Boselovic: firstname.lastname@example.org or 412-263-1941.
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