The Effect of Firm Performance on Annual Report Readability

Syafira Ratna Sari

and Arif Darmawan

Managerial Accounting Study Program, Politeknik Negeri Batam, Indonesia

Keywords: Gunning Fog Index, Readability, Firm size, Firm age, Firm Performance.

Abstract: This study aims to examine whether there is an effect of firm performance on the readability of the annual

report and how the influence between these variables. This study uses a sample of companies with various

industrial sectors listed on the IDX for 2017-2019 period. The number of samples used as many as 114

companies. The independent variable in this study is expressed by the company's performance using Tobin’s

Q value and the dependent variable is expressed by the readability of the company's annual report using

gunning fog index. This study also uses control variables that are proxied by the size and age of the company.

The data processing in this study uses SPSS version 20. The results of the hypothesis indicate that the

company's performance influences on the readability of the company's annual report. Companies with high

performance get a high readability value of the annual report as well. This is due to the increasing size of the

company's operations so that the company offers a more detailed explanation. The high age of the company

does not affect the readability of the annual report. The conclusion of this study states that other factors have

more influence on the readability of the annual report.

1 INTRODUCTION

PT. The Indonesia Stock Exchange, as one of the

regulators and trade organizers in the Indonesian

capital market, provides data services for trading

stocks, bonds, and derivatives. The Law of the

Republic of Indonesia Number 8 of 1995 in

CHAPTER III states that the Indonesia Stock

Exchange provides supporting facilities and reviews

the activities of members of the Indonesia Stock

Exchange and has the objective of conducting

orderly, fair, and efficient securities trading. The

Indonesia Stock Exchange makes it easy for parties

such as investors, creditors, and others to easily

access financial reports and annual reports.

Financial statement information is one of the

important things for investors as an object of

decision-making analysis seen from stock

movements, company profitability, quality of

financial performance, and prospects of the company

(Fatmasari, Sulistiyo, & Mustikowati, 2014). The

results of the analysis of the financial statements will

provide a signal to investors whether the investment

made in the future will benefit or vice versa. Apart

from financial reports, investors can also carry out

decision-making analysis through descriptive

expressions in the company's annual report.

The company's annual report is currently

changing by including more information in the form

of narrative text with a scale of 80% disclosure and

the rest is representative quantitative data (Lo,

Ramos, & Rogo, 2017). This is due to the

development of variations in annual reports for each

period so that understanding the readability of the

annual report can be said to be crucial. OJK

Regulation Number 29 / PJOK.04 / 2016 states that

annual report information is presented in the form of

narrative text which is elaborated through written

submissions of the board of directors, the board of

commissioners, the profile of the issuer, management

discussion, and analysis, corporate governance, social

responsibility, and statements of members of the

board of directors as well as explanations related to

quantitative data are presented through a summary of

important financial data, stock information and also

audited financial reports.

According to the Big Indonesian Dictionary

(KBBI), legibility is about being able to read text

quickly, easily understand and remember.

Readability can also be said as an aspect used in

regulating and assessing a company. In PSAK

Number 1 regarding the presentation of financial

reports and the Regulation of the Financial Services

Authority Number X.K26 part II, it states that the

132

Ratna Sari, S. and Darmawan, A.

The Effect of Firm Performance on Annual Report Readability.

DOI: 10.5220/0010862400003255

In Proceedings of the 3rd International Conference on Applied Economics and Social Science (ICAESS 2021), pages 132-139

ISBN: 978-989-758-605-7

annual report must be made in such a way that it is

not difficult to read and easy to understand.

Companies that publish easy-to-read annual

reports will be very useful for users to understand

how the company is performing in a certain period,

which is conveyed through the company's annual

report. Financial report users who do not understand

accounting can analyze the company's performance

through the narrative text of the company's annual

report. This is also reinforced by a statement (Lehavy,

Li, & Merkley, 2011) which states that financial

reporting narratives are needed for investors who

have limited knowledge of accounting or finance.

Investors who have minimal knowledge have

difficulty understanding the meaning of numbers in

financial reports and decide to collect more

information from the narrative text provided

(Rohmawati, 2020).

As a representative candidate for the company,

management must provide information regarding the

company properly and correctly as a form of matter

that can be trusted by investors. Each period the

management will project a profit target to be

achieved, but due to uncertain economic conditions,

the company does not always succeed in getting large

profits and even may suffer losses from several

causes that cannot be controlled by the company.

Companies with poor performance translate their

performance using language and meaning that is

difficult to understand (Subramanian, Insley, &

Blackwell, 1993). This statement is linear with

research (Li, 2008) which states that annual reports

that are difficult to understand occur in companies

with low profits.

Several researchers have conducted research

related to readability with different results caused by

differences in measurement variables and proxies.

Research development is carried out in this study.

Research related to readability in Indonesia has also

been carried out by (EDT, Febrianto, & Rahman,

2018) regarding the relationship between company

performance and the readability of the company's

annual report. The company's performance becomes

the independent variable and the readability of the

annual report is expressed as the dependent variable.

The study used a sample of 1,222 annual reports of

companies listed on the IDX from 2013-2017.

Company performance measurement using ROA,

ROS, and ROE and readability is measured by

Gunning Fog Index. The results show that the

company's performance has no effect on the

readability of the annual report but ROS has an effect

on the readability of the company's annual report. The

study stated that the company's performance in the

form of high return on sales (ROS) resulted in the

readability of the annual report which focused on the

report of the board of directors to be easily read.

Previous research was conducted by (Gu &

Dodoo, 2020) on the effect of firm performance on

the readability of the annual reports of companies

listed on the Ghana Stock Exchange (GSE) for the

period 2008-2017. The results found that corporate

governance harms the readability of the company's

annual report and for firm performance has a positive

effect on the readability of the company's annual

report. The study states that other determinants have

a relationship with legibility, so this study adds the

implication of firm age as one of the factors that may

influence the readability of the company's annual

report. Rationally, a company that has been

established for a long time will have a more complete

annual report because it has more experience than a

company that has only been running for a few years.

Another difference from previous research

occurred in selecting a sample of companies by

focusing on the miscellaneous industry in Indonesia

and taking the latest period issued by the IDX from

2017-2019. This is because based on IDX Yearly

Statistic 2017-2019 data, this sector has experienced

an increase in the value of PER (price to earnings

ratio), which is the company's annual profit rate

against its share price. It can be considered that this

sector has a good ability in firm performance and will

rationally have good readability of annual reports. On

the other hand, with these good points, a company can

also succeed in hiding its bad performance so that the

readability of the company's annual report is needed.

The research contribution of this research

literature is practically focused on companies paying

more attention to legibility so that users of annual

reports can easily interpret the information presented.

Users of company annual reports can pay more

attention to the legibility of the annual reports issued.

Theoretically, this research is expected to be able to

increase understanding of the determinants of

readability and can be used as a reference for other

studies.

2 THEORETICAL STUDY

2.1 Agency Theory

Agency theory begins with the separation between

company owners and management (Priguno &

Hadiprajitno, 2013). Statement (Jensen & Meckling,

1976) states that there are two forms of agency

The Effect of Firm Performance on Annual Report Readability

133

relationships, namely the relationship between

managers and shareholders and the relationship

between managers and lenders (bondholders).

Agency theory can be viewed as a contractual model

between two or more parties, namely the principal

and agent. The principal delegates responsibility for

the company's decision-making to the agent so that

the agent is given the mandate to carry out tasks based

on a properly executed contract agreement between

the two parties.

Eisenhardt (1989) stated that agency theory involves

three assumptions of human behavior, first is that

humans are usually selfish, secondly, humans have

limited thinking capacities and third humans always

avoid risks. One of the reasons for management to

avoid risk is that they do not want their weaknesses to

be seen by other parties. Agency problems arise when

the principal (investor) finds it difficult to guarantee

that the agent (management) acts to maximize their

welfare (Yushita, 2010). Ownership of information

held by managers can trigger activities by following

per under the wishes and personal interests of

management so that capital owners find it difficult to

effectively supervise activities carried out by

management because of the limited information they

have. Certain policies carried out by company

management are sometimes also carried out without

the knowledge of the owner of the capital so that

differences in ownership of information held between

the two parties lead to misalignment of information

or information asymmetry (Cahyaningtyas & et al,

2017). Conflicts related to information asymmetry

can be minimized by disclosing good and correct

company reports to the principal as a form of

transparency of management performance.

2.2 Readability Theory

The readability of narrative text disclosures in annual

reports is one of the important matters for annual

report users in assessing a company (Prasadhita,

2018). The relationship between accounting narrative

information in legibility is defined as the percentage

of success and difficulty in communicating

accounting information (Hidayatullah &

Setyaningrum, 2018). Narrative information has a

function to convince users of financial statements

about the condition of the company.

Readability theory was put forward by Robert

Gunning in 1952. The theory became known as

gunning fog index which was used to see the level of

legibility of the text. According to (Christanti, Naga,

& Benedicta, 2017) Gunning Fog Index has a

function as a guarantee that the readability of the text

can be understood by readers so that it is considered

important to test the readability of the annual report.

2.3 Signal Theory

Signal theory was first put forward in a study entitled

Job Market Signaling by Michael Spence in 1973.

The involvement of management who has a role as

the party giving the signal and outside management

as the party receiving the signal is the purpose of this

theory. Rationally, an investor will make predictions

before deciding on investment by observing the

signals given by the company. This theory is based on

the asymmetric information held between the internal

parties of the company who have more information

related to the company than the external parties,

including investors.

Ross developed this theory in 1977 by stating that

better company information encourages executives to

convey this information to investors as well as

potential investors. Good presentation and disclosure

of information can be assessed from the completeness

and accuracy of the data which is then used by

interested parties for decision making. According to

external parties, companies with good corporate

values will provide good signals.

2.4 Hypothesis Development

2.4.1 Effect of Firm Performance on

Readability of Annual Reports

The readability of the presentation of the annual

report is the responsibility of management to

stakeholders which will then be used as material for

decision making. As the owner is entrusted with

running the company, the manager will make efforts

to improve the company's performance by following

per the owner's wishes. Reports with a good

performance level only need to interpret the

information according to the reality of the existing

conditions without extending the reasons for

achieving good or bad performance (EDT, Febrianto

& Rahman, 2018). When companies have low

performance, they will take several actions to

manipulate accounting numbers or attribute bad

news(Lo, Ramos, & Rogo, 2017). The hypothesis in

this study is as follows:

H1: Firm Performance Affects the Readability of

the Annual Report

Based on the description of the theoretical study,

literature review, and hypothesis development that

have been described previously, the research model

can be seen in Figure 1:

ICAESS 2021 - The International Conference on Applied Economics and Social Science

134

Figure 1: Research Model

3 RESEARCH METHOD

This research is a quantitative study to provide

evidence of the effect of firm performance on the

readability of the company's annual report. Secondary

data on company annual reports published on the

Indonesia Stock Exchange (IDX) for 2017-2019

period through the website www.idx.co.id and the

company's official website was used as the source of

data in this study. The population used as the sample

of this study consists of companies with the

miscellaneous industry sector for the period 2017-

2019. This study uses three variables, namely the

dependent variable, the independent variable, and the

control variable. The type of data in this study used

cross-section data because the independent variables

were not influenced by the previous year's report data

or afterward.

3.1 Operational Definition

3.1.1 Dependent Variable

The dependent variable is stated by the readability of

the annual report. To measure the readability value of

the company's annual report in this study using

gunning fog index measurement which has been

widely used by several previous researchers such as

(Lo, Ramos, & Rogo, 2017), (Gu & Dodoo, 2020),

and (EDT, Febrianto, & Rahman, 2018) taking into

account the relevance of legibility complexity.

Gunning Fog Index is a linguistic computing system

that was first created by Gunning in 1952 to help staff

in environmental companies improve their

communication relationships through writing. (Gu &

Dodoo, 2020). Fog Index is an easy system with

calculating the average sentence length (comparison

of the number of words to several words) and the

average difficult words (comparison of several some

many words with several some many complex

words). This research uses the web www.gunning-

fog-index.com which is used for the time efficiency

of manual calculations. The form of the formula for

calculating legibility using gunning fog index comes

from:

Gunning Fog Index formula

Source: (Gu & Dodoo, 2020)

If the value,

Fog ≥ 18 : complex text

Fog 18-14 : unreadable text

Fog 14-12 : ideal text

Fog 12-10 : acceptable text

Fog 10-8 : easy to read text afterward.

3.1.2 Independent Variable

The independent variable is stated by the company's

performance as measured using Tobin's q by

comparing the accumulated stock market value and

debt market value divided by the total value of capital

placed on assets. Tobin's q value illustrates the

performance of management in utilizing company

assets. This measurement measures whether the

company is experiencing growth, steady or even

declining (Rengga & Sukamulja, 2015). A high q

ratio value means that the company has a competitive

advantage or tends to have attractive investment

opportunities (Rengga & Sukamulja). Here is the

formula for Tobin's q:

Tobin's q formula

Source: (Rengga & Sukamulja)

Information:

MVS: closing price x number of shares outstanding

MVD: book value of total debt)

RVA: Change the value of the overall production

capacity

* Tobin's q <1 denotes an undervalued stock

* Tobin's q = 1 represents the stock average

* Tobin's q> 1 indicates the stock is overvalued

Fog = 0.4 x (word per sentence) + 100 (complex

word per word)

q = (MVS + MVD) / RVA

The Effect of Firm Performance on Annual Report Readability

135

3.1.3 Control Variable

Firm Size

The first control variable in this study is stated by the

size of the company. Measurements are made by

calculating the company's total assets. The size of the

company shows the progress of a company so that

investors are likely to respond well and the company

value will increase (Sujoko & Subiantoro, 2007).

Firm Age

The second control variable in this study is stated by

the age of the company. The measurement of the age

of the company can be calculated from the time the

company is founded. According to (Roiston &

Harymawan, 2020) older companies have sufficient

skills and experience in managing company annual

reports.

3.2 Data Processing Techniques

Four stages need to be done in the data processing.

First, identify the variables that will be used. Second,

tabulating the data into Microsoft Excel. Third,

providing coding to shorten element names. Fourth,

re-checking the data that has been inputted. Fifth, data

processing using SPSS software version 20. The

method of analysis in this study uses descriptive

statistics, classical assumption tests, multiple linear

regression analysis, and hypothesis testing. The

regression models in this study are:

Y=α+β1X1+β2X2+ β3X3+e

Model 1:

Annual Report Readability (MD&A) = 0.360 +

0.032 Tobin's Q + 0.428 Firm Size + 0.015 Firm

Age + e

This research was conducted in Indonesia through

data collection on the Indonesia Stock Exchange

through the existing official website. The choice of

location is because the Indonesia Stock Exchange has

a draft of going public companies in Indonesia. The

object of this research is the company's annual report

which includes financial information as well as

management discussion and analysis which is used as

research measurement material.

4 RESULT

The data population in this study are companies with

the miscellaneous industry sector in Indonesia which

are listed on the Indonesia Stock Exchange with 2017-

2019 period with a total of 156 companies. The sample

taken is the whole of the population which among

some of the data is not sampled due to certain reasons.

In addition, outlier data in the study were also not

sampled because these data had values that were far

different from other data (extreme values) which

could bias the data analysis process. The total sample

as a whole that can be processed during 2017-2019

period is 114 companies. The number of samples for

this research can be seen in Table 1 as follows:

Table 1. Final Sample Firm

Criteria 2017 2018 2019 Total

List of

companies on

the IDX 2017-

2019

52 52 52 156

Companies

that do not

provide

complete data

during 2017-

2019

(5) (11) (13) (29)

Companies

that present

unprocessed

MD&A

Report

(0) (1) (3) (4)

Data of

companies

experiencing

outliers

(4) (3) (2) (9)

Final Sample

Firm

43 37 34 114

4.1 Descriptive Statistical Analysis

Below is a descriptive statistical analysis table:

Table 2: Descriptive statistical table

Variable Mean Max Min Std. Dev

3.54790 70.870 .2500 10.83816

28.1578 30.710 25.22 1.261920

37.3800 103.00 9.000 17.73800

13.0682 17.300 8.620 1.905360

Residual

.00000

5.03066 -3.72119 1.77510

Valid (N) 114

ICAESS 2021 - The International Conference on Applied Economics and Social Science

136

Tobins’ Q

Tobin's Q with the formula of market capitalization

plus the total amount of debt divided by the total

number of assets is used as a measure of firm

performance which is an independent variable from

the study which has an average of 3.5479 and std. a

deviation of 10.83816 from 114 companies. With this

average number, it can be concluded that stocks in the

miscellaneous industry sector from 2017-2019 have

been overvalued because of the average value of

Tobin's Q> 1.The maximum value is at PT Ricky

Putra Globalindo Tbk (RICY) in 2017. This is

because The largest market capitalization among

companies in the miscellaneous industry sector in

2019 with a nominal value of 96,258,000,000,000,

total debt of 941,305,576,442 and total assets of

1,371,570,948,138. With the results of this

capitalization, it was stated that the shares of PT

Ricky Putra Globalindo in that year were overvalued

and the company's performance level was 70.87. The

minimum value is at PT Selamat Sempurna Tbk in

2017 with a market capitalization value of

7,227,137,677, total debt of 615,157,000, total assets

of 171,333,000,000. These results stated that the

shares of PT. Selamat Sempurna Tbk experienced

undervalued and the company's performance level

was 0.25.

Fog Index

Gunning Fog Index is a proxy for measuring the

readability of the company's annual report as the

dependent variable, which shows that the average

readability of the company's annual report is 13.0682

and the std value. a deviation of 1.90536 for 114

companies. It can be concluded that the average text

readability of MD&A in the annual report of

companies with the miscellaneous industry sector is

categorized as ideal. The highest readability value

occurred at PT Uni-Charm Indonesia Tbk in 2019

with a value of 17.30% or it can be said that it is

difficult to read and a low readability value occurred

at PT Steadfast Marine Tbk in 2019 with a value of

8.62% or it can be said that the text is acceptable.

4.2 Determination Coefficient Test

This test aims to determine whether the independent

variable can explain the dependent variable in the

study. The results show that the value of R Square is

0.363 and Adjust R Square is 0.132. It can be

concluded that the firm performance variable can

explain the readability of the company's annual report

but cannot explain it as a whole because the value is

still far from one or if it is only able to explain as

much as 1.32% which is considered there are other

aspects as much as 8.68% who will be able and can

explain more. readability of the report. The results of

the test of the coefficient of determination can be seen

in Table 3 as follows:

Table 3: Determination Coefficient Test

R Square Adjust R

Square

Decision

0.363 0.132 Be able to

explain the

dependent

variable

4.3 Partial Hypothesis Test

The result of partial hypothesis testing statistically

shows that the significant value of the firm

performance variable which is expressed in Tobin's Q

value has a sig value. Amounting to 0.044 which is

valued at ≤ 0.05 with a positive t value of 2.036. The

independent variable, namely firm performance as

measured using Tobin's Q, has a positive effect on the

readability of the company's annual reports in the

discussion and analysis management section of the

company. So that H1 in this study can be supported.

The results of hypothesis testing can be seen in Table

4 as follows:

Table 4: T-Test (Partial)

Variable T Sig. Decision

Content .095 .925 0,5207

Tobin’s Q 2.036 .044 Hypothesis

Supported

Based on the research that has been done, it was found

that the disclosure of company information with high

performance is different from the disclosure of

companies with low performance. Companies with

high performance get a high readability value of the

annual report as well. This is due to the increasing

complexity of the company's operations so that the

company offers more detailed explanations by

translating sentences into longer narrative

information and using more words. The complexity is

seen from the high market capitalization, total debt

and total asset ownership. This is in line with previous

research conducted by (Rohmawati, 2020) which

supports the hypothesis of this study. In the study, it

was stated that the higher the financial performance

of a company, the more complex the report on the

company's responsibilities. And the results of this

study are also in line with previous research

conducted by (Gu & Dodoo 2020), the results of this

study state that the company's performance variable

has a positive effect on the readability of the

company's annual report. The high and low

The Effect of Firm Performance on Annual Report Readability

137

readability of the annual report will have an impact

on the company's stakeholders. According to the

conclusion of research conducted by (Lee, 2012)

disclosure of more complex information will require

investors to use deeper thinking. The company as the

party that prepares the annual report needs to

understand that the readability of the information in

the report is an important thing that will be used by

investors. This complexity will reduce the ability and

understanding of stakeholders in evaluating the

company's prospects based on the delivery of such

information which will have an impact on decreasing

decision results. The results of the decline in

decisions made by investors can be wrong or even

distorted, which will then affect the company itself.

Therefore, the complexity of delivering information

does not need to be done because it will make it

difficult for investors to make decisions.

5 CONCLUSION

Based on the research results, it can be concluded that

the company's performance has a positive effect on

the readability of the company's annual report. This

explains that the higher the company's performance,

the higher the readability value of the annual report.

The use of control variables in this study to minimize

or eliminate other influences between the

independent variable and the dependent variable. The

results show that companies have been around for a

long time or have been established does not effect on

readability of annual report. The results of this study

are expected to add references to the literature on

research that discusses the effect of firm performance

on the readability of annual reports. The results of this

study are also expected to be reference material for

decision-making for stakeholders and investors who

wish to invest in stocks. The research has limitations,

namely:

a. This study only includes companies with the

miscellaneous industry sector that are listed

on the IDX.

b. Taking the period in this study starts from

2017-2019 so that the research cannot be

generalized to the previous year or the year

after.

c. The independent variable, namely the

company's performance in this study, is only

measured from the point of view of Tobin's

Q value, which has not been able to

optimally explain the legibility of the

company's annual report.

d. The dependent variable in this study uses

gunning fog index to measure the readability

of the company's annual report.

e. The involvement of control variables in this

study only uses the size and age of the

company.

From the limitations of this study, there are several

suggestions for further research including further

research is expected to expand the research sample

not only to one sector but to cover the entire sector,

add other variables and other proxy differences to see

what factors have an influence or effect. it even has a

strong influence on the readability of the company's

annual report and the timing for further research is

expected to use the most recent time issued.

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