Firms Far from the U.S. Write More Clearly

The further a company is from the United States, the clearer its press releases and financial disclosure statements are, according to a recent paper by Russell Lundholm, Rafael Rogo, and Jenny Li Zhang, all of the Sauder School of Business at the University of British Columbia. 

Startled by this finding, I called up Professor Lundholm and asked him to explain. Here’s an edited version of our conversation.

Why are far-flung firms seemingly more motivated to make their communications clear?

It’s related to the “home bias” problem. For a variety of reasons, investors have a bias against firms outside their home country, which makes them less willing to hold their stock. The bias increases with the distance between the investor and the firm. For instance, US investors are pretty happy to hold Canadian stock, but less inclined to hold UK stock, and even less inclined to hold Australian stock. Now flip it around and look at it from the point of view of the firm. If you’re in Australia and want to attract U.S. investors, you have to go the extra mile.

We found that the further the firm is from the investor, the more effort the firm puts in. That’s true whether it’s a regulatory statement, and MD&A disclosure, or a press release.

Is the home bias effect just limited to US investors?

No; you could do the same study in any country. For instance, a previous study found that Finnish investors have a bias against Swedish firms, and even had a bias against Finnish firms that wrote their financial reports in Swedish.

Back up a bit; how did you measure the clarity of these statements? 

We measured clarity with something called the FOG index, which has been around forever and is the go-to measure of readability. Basically it looks at the number of words per sentence, and the number of complex words (which is defined as a word containing three or more syllables). You add those up and multiply by .4 to get a score; if the score is 14, you need 14 years of education to read that. The readability of the US firms’ statements was about 18 — and yeah, you pretty much need a college education to read those documents.

We also looked at the number of numbers in the statements – after all, we are accountants! We wanted something tangible to add to the somewhat foggy FOG index.

It’s not perfect, but the FOG has been used for decades and is widely used. And of course there are facts that aren’t numerical, and there are some numbers that are redundant, but we looked at thousands of documents from companies in 45 countries and the effect was consistent.

From the headline, I’d assumed your finding was just tied to geographic distance, but when I read the paper, I was surprised to see you’d focused on five other types of distance, as well as physical distance. Why do that?

[A bias based on] geographic distance makes no logical sense [for an investor]. If we were shipping goods that weighed something, then yes, you’d predict a bias. But financial assets have no weight! There’s no reason geography should matter at all. But it’s by far the most powerful predictor of bias. So we thought, it’s clearly proxying for a collection of other things – let’s look for some of those other, maybe more logical, things.

So we started looking at differences in accounting practices and in investor protection — those were two that we studied quite a bit. We created these measures called accounting distance and investor protection distance, which basically measure how similar or different the laws (or the enforcement of them) are. And we found that these variables predicted the same behavior; if you’re from a country with different accounting rules then your communication is better, again to overcome the distance an investor might feel. Think of this kind of distance as “unfamiliarity.”

So which kind of distance mattered post?

Even though it’s the least logical, geographic distance. Even when we controlled for factors like accounting practices, investor protection, even language, there was still a home bias problem.

So do these efforts at clarity pay off?

The short answer is yes. The home bias still exists, but firms that provide more readable disclosures have more institutional investors. We compared companies within the same country — two firms inside South Africa, for instance — and the one that provides the more readable disclosure got more institutional investors.

What about the possibility that the US firms might just have hired terrible writers?

Actually since the US is biggest capital market in the world, with the best investor protections and very good accounting rules, we were expecting the US would be the best! When we found that the US firms had less clear communications and used fewer numbers, we sort of scratched our heads and went back to the drawing board. Then when we figured out it was the home bias effect, it made more sense.

Of course, another explanation could be that US firms are dominated by lawyers writing in legalese, which would ramp up their FOG index score.

But basically, if you don’t need investors from other countries, then you’re not as motivated to be clear or detailed in your public statements. Foreign investment may not be as important to US firms. If you’re a small country, then getting US dollars is a big inflow of capital.

But why doesn’t every company try to make their communications as clear as possible?

That’s a good question. Probably because there’s a thousand other forces at work. Clarity of these statements has to exist in an equilibrium with all the other things a company has to get done.

And the world inside these firms is complex. If you’re a big pharmaceutical company, you can’t just write, “We invented a drug; it was good.” We did try to control for complexity in our regression, to avoid punishing firms that are just more complicated in their structure.

You can also only put so many numbers into a report before you hit overload. We have some evidence from work we’re doing right now that there is such a thing as too many numbers.

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