The following post comes to us from Tim Loughran and Bill McDonald, both of the Department of Finance at the University of Notre Dame.
The Fog Index has become a popular measure of financial disclosure readability in recent accounting and finance research. The SEC has even contemplated the use of the Fog Index to help identify poorly written financial documents. However, the measure has migrated to financial applications without its efficacy in the context of business disclosures having been determined.
In our forthcoming Journal of Finance paper, Measuring Readability in Financial Disclosures, we argue that traditional readability measures like the Fog Index are poorly specified in the realm of business writing. The Fog Index is based on two components: sentence length and word complexity. Although sentence length is a reasonable readability measure, it is difficult to accurately measure in financial documents. More importantly, we show that the count of multisyllabic words in 10-K filings is dominated by common business words that should be easily understood. Frequently used “complex” words like company, operations, and management are not going to confuse consumers of SEC filings. Additionally, the correlation of complex words with alternative measures of readability contradicts its traditional interpretation.