ANNUAL RECKONING

You’re thinking of investing in companies X, Y, and Z. As part of your research, you’ve read these companies’ annual reports. You know that the financial information is legit; it has to pass muster with independent auditors. But how much stock can you put in the text—the letter to shareholders, the company report, and the management discussion and analysis? These give information—such as the firm’s values and business philosophy, its plans, and its management priorities—that might sway your investment decisions. So you need to know: Are most annual reports on the level?

Michael Michalisin, an assistant professor of management, says he wondered the same thing. "Are these companies blowing steam in their annual reports, or are they actually doing [what they claim to be doing]?"

Michalisin knew that many business research studies took annual report statements at face value. "Academics have been using annual report text for 30 years to measure various things without knowing if that was valid," he says. "Although academics have argued that annual report text is a good source of information, there have been articles in places like the Wall Street Journal saying that companies probably overstated things."

CEOs might feel great pressure to put a positive spin on things in these widely read reports—or they simply might not be objective in their assertions. Then too, many companies hire public relations firms to produce their annual reports. Perhaps these publications lean too much toward PR hype. If so, the findings of many research studies would be called into question.

Michalisin decided to put annual reports to the test. He analyzed the reports of 100 randomly selected Fortune 500 and Service 500 companies for statements about innovativeness and quality. Then he looked at objective indicators of innovativeness and quality to see how those statements checked out. (The quality analysis was done in partnership with Gregory White, an associate professor of management.)

To quantify each company’s emphasis on innovativeness, for example, Michalisin used a computer program to track the number of times certain words and phrases appeared in the annual report—terms like "creativity," "modernization," "automate," "new products," "advanced technologies," and so forth. For greater objectivity, he enlisted two other management scholars to help him identify the most-relevant terms from a computer-generated list of all words appearing in the reports.

Then Michalisin did "validity testing" by comparing that data with two independent indicators of innovation for each company. The first was Fortune magazine’s annual survey on corporate reputation, which includes a rating for innovativeness. The second was each company’s applications for trademarks over the preceding 10 years. Trademark history, says Michalisin, reveals a company’s "ability to develop and commercialize products and services to meet changing customer needs."

Michalisin’s statistical analysis also accounted for certain factors that could have skewed the findings. Those included the length of the annual report and the type of industry a company was in. Because some industries may be inherently more innovative than others, Michalisin computed the average number of company trademark applications for each industry represented in his sample and used that as a control. 

Did the firms stressing innovativeness in their annual reports have more trademark applications and a higher ranking for innovation than firms that didn’t stress innovativeness? In fact, they did, Michalisin found. Likewise, he and White discovered, firms stressing quality in their reports scored higher on independent benchmarks of quality. 

Conclusion: annual reports are pretty trustworthy after all. The two studies will be published this year in the Journal of Business Research and the Mid-Atlantic Journal of Business.

Michalisin’s data, some of which were gathered for his doctoral dissertation, came from 1988 annual reports. Although he notes that the findings "open up possibilities for continued research," including repeating the studies with newer data, he doesn’t think more-recent annual reports would be any less forthright.

"In 1988 we were in a recession," he says. "There probably would be more of an incentive to 'puff' the annual report during a recession than during economic prosperity. There may be added pressure to overstate organizational capabilities when you have to tell shareholders what you're going to do to regain profitability. But the CEOs were being honest about their innovative capabilities and the quality of their products and services even during bleak economic conditions."
 

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