When the Use of Positive Language Backfires: The Joint Effect of Tone,Readability, and Investor Sophistication on Earnings Judgments

Recent studies document that market participants react positively to the positive language sentiment or tone embedded in financial disclosures, and that investors’ reactions to negative news are more muted with poor disclosure readability. However, while language sentiment and readability co‐occur in practice, their joint effects remain largely unexplored. In an experiment with MBA students as participants, we investigate how the effect of language sentiment varies with readability and investor sophistication level. We find that language sentiment influences investors’ judgments when readability is low, but not when readability is high. Specifically, when readability is low, disclosures couched in positive language lead to higher earnings judgments for less sophisticated investors, but lower earnings judgments for more sophisticated investors. These findings show that the main effects of readability and language sentiment documented in prior studies have boundary effects, and may reverse when both variables are jointly considered along with investor sophistication.     

How Does Using a Mobile Device Change Investors’ Reactions to Firm Disclosures?

I examine how characteristics of investors’ information access tools change investors’ reactions to firm disclosures. I examine my research question in the context of information choice (i.e., allowing investors to choose the order of information and sections to read within a disclosure) and spatial layout (i.e., how information is displayed when viewing the disclosure). Results of an experiment are consistent with information choice improving investors’ judgments if the disclosure is viewed on a computer screen. Conversely, and consistent with cognitive overload, information choice harms investors’ judgments if the disclosure is viewed on a smaller screen, such as that of a mobile device. Follow-up experiments show that changing the disclosure presentation to reduce the need to scroll is one way to improve investors’ judgments on a smaller (or mobile) screen. My findings caution firms and regulators about expanding information choice within disclosures without considering the screen size used to access the disclosure.     

Credit Ratings and Managerial Voluntary Disclosures

This study investigates whether managers influence credit ratings via voluntary disclosures. I find that firms near a rating change have a higher incidence of a disclosure regarding product and business expansion (PBE) plans. This finding is more evident for firms that are subject to lower proprietary costs of disclosures, which implies that managers do trade off both the benefits and costs of the disclosures. I find no evidence that firms close to a rating change selectively release good news or suppress bad news on PBE. Overall, my results suggest that firms generally exhibit a credible commitment to maintaining disclosure transparency for a desired credit rating.     

Voluntary Disclosures,Corporate Control,and Investment

We examine the valuation and capital allocation roles of voluntary disclosure when managers have private information regarding the firm’s investment opportunities, but an efficient market for corporate control influences their investment decisions. For managers with long‐term stakes in the firm, the equilibrium disclosure region is two‐tailed: only extreme good news and extreme bad news is disclosed in equilibrium. Moreover, the market’s stock price and investment responses to bad news disclosures are stronger than the responses to good news disclosures, which is consistent with the empirical evidence. We also find that myopic managers are more likely to withhold bad news in good economic times when markets can independently assess expected investment returns.     

Intangible Assets and Firms' Disclosures: An Empirical Investigation

This study examines how research and development (R&38;D) and advertising expenditures affect firms' disclosures. Generally accepted accounting principles (GAAP) mandate that these expenditures be immediately expensed in financial reports, despite the fact that they often benefit the firm for longer periods. Prior studies find, however, that investors consider intangible assets in their valuation of firms. These studies argue that current GAAP, by not recognizing the value generated by these assets, severely impairs the usefulness of accounting reports. I investigate if firms with higher levels of R&38;D and advertising expenditures place greater reliance on voluntary, and therefore more flexible, disclosures such as voluntary publications and investor relations. Using analysts' ratings of firms' disclosures, I find that firms with higher levels of intangible assets are more likely to receive significantly higher ratings for their investor relations programs or voluntary publications than for their annual reports. These findings suggest that firms with higher levels of intangible assets emphasize supplemental disclosures because mandated accounting disclosures inadequately present their financial performance. These results have important policy implications for regulators and investors since they indicate that voluntary disclosures, which are unregulated and unaudited, are an important means of disclosure for these firms.     

Managerial incentives for discretionary disclosure: evidence from management leveraged buyouts

Managers in management leveraged buyout (MBO) firms prefer to purchase their firms at a low offer price. This motive gives them a clear incentive to make pessimistic discretionary disclosures. Using a sample of press releases, I find that managers involved in their firms’ MBO selectively release negative disclosures to denigrate their firm just before the MBO transaction when compared with prior period: they issue more bad news disclosures and more pessimistic quotes. Additionally, they issue less optimistic quotes, fewer good news disclosures, less positive earnings forecasts, and they manage earnings downwards. I control for factors that may not be caused by managers’ purchase motives by comparing the MBO sample with a third-party leveraged buyout sample where management is not involved in the buyout and with a performance-matched control sample. I find that the disclosure of MBO firms becomes significantly more pessimistic than the leveraged buyout firms where management is not involved in the transaction and significantly more pessimistic than the performance-matched control sample.     

Insider Trading and Voluntary Disclosures

We hypothesize that insiders strategically choose disclosure policies and the timing of their equity trades to maximize trading profits, subject to the litigation costs associated with disclosure and insider trading. Accounting for endogeneity between disclosures and trading, we find that when managers plan to purchase shares, they increase the number of bad news forecasts to reduce the purchase price. In addition, this relation is stronger for trades initiated by chief executive officers than for those initiated by other executives. Confirming this strategic behavior, we find that managers successfully time their trades around bad news forecasts, buying fewer shares beforehand and more afterwards. We do not find that managers adjust their forecasting activity when they are selling shares, consistent with higher litigation concerns associated with insider sales. Overall, our evidence suggests that insiders do exploit voluntary disclosure opportunities for personal gain, but only selectively, when litigation risk is sufficiently low.     

Cryptocurrency,confirmatory bias and news readability – evidence from the largest Chinese cryptocurrency exchange

We investigate whether Chinese cryptocurrency investors show confirmatory bias when processing authority‐related news. Authority‐related news is defined as news that is related to government authority (including central bank) policies or talk. By using data from the largest cryptocurrency exchange in China, we find that investors’ response to authority‐related news is negative and significant in general. Moreover, we find that the abnormal trading volume and standard deviation of abnormal trading volume are significantly higher for authority‐related news with higher readability, suggesting investors respond to the more readable authority‐related news with more trading behaviour.     

The Interpretation of Information and Corporate Disclosure Strategies

This paper analyzes a setting in which a firm's manager can credibly disclose facts, but not their valuation implications. Consequently, he is uncertain as to how those disclosed facts will be interpreted by investors. Introducing such uncertainty affects the manager's disclosure strategy in two important ways. First, it becomes a function of the market's prior valuation of the firm since that valuation provides a clue as to how future disclosures are likely to be interpreted by investors. Second, the disclosure strategy is no longer characterized, in general, by a single good news/bad news partition of the manager's private information.     

The value relevance of timely information: The case of comparable store sales growth

Investors and analysts have called for more timely disclosure of corporate information. Responding to these demands, some retail firms issue comparable store sales (CSS) on a monthly or a quarterly basis in addition to an annual basis. This study examines whether a timely disclosure of CSS provides value-relevant information to market participants by examining investors' and financial analysts' responses at the time of CSS disclosures (short-horizon) and over the month or the quarter (long-horizon). We find that both monthly and quarterly CSS are associated with contemporaneous market returns and analyst forecast revisions. More importantly, we find that quarterly CSS news becomes less important to investors when firms provide more timely CSS information, indicating that monthly CSS reports may preempt the information content of quarterly CSS. Additional tests show that investors and analysts rely less on CSS if CSS news and earnings (sales) news are inconsistent.     

Corporate Innovation and Disclosure Strategy

This study investigates the impact of firm innovation on MD&A disclosure. Firms need to reduce information asymmetry to assist investors on the one hand and to prevent rivals from benefitting from disclosures on the other. Innovative firms can use an optimistic tone to convey good news but increase content similarity to reduce proprietary costs. Management chooses a certain content similarity and tone strategy for an innovation and as the number of innovations increases, the ratio of similar innovation disclosure and positive tone increases in the overall MD&A, resulting in greater content similarity and more news conveyed with a positive tone. We find that the firm's level of innovation is positively related to content similarity and tone optimism. We also find that this positive relation is more pronounced when product market competition is stronger and when regional intellectual property rights protection is weaker. Our further analyses on market responses provide evidence suggesting that management's disclosure strategy functions as intended.     

Does voluntary balance sheet disclosure mitigate post-earnings-announcement drift?

Theory suggests that balance sheet information such as total assets, total equity, or total liabilities complements earnings information in helping investors assess a firm’s profitability and estimate earnings growth. The voluntary disclosure of balance sheet information at earnings announcement could help investors gather and process this information at a lower cost. We therefore predict that voluntary balance sheet disclosure at the time of an earnings announcement helps investors promptly understand the implication of current earnings news for future earnings and subsequently reduces post-earnings-announcement drift (PEAD). Consistent with these predictions, our results show that when firms provide voluntary balance sheet disclosures, the earnings response coefficient in the event window is significantly higher and the corresponding PEAD is significantly lower. We further find that the impact of voluntary balance sheet disclosure on PEAD is more pronounced when the magnitude of balance sheet value surprise is larger, when balance sheet value is more informative about future earnings, when earnings uncertainty is higher, or when information cost is higher, consistent with our conjectures that helping investors to better understand future earnings performance and lowering information costs are key mechanisms underlying the effect of voluntary balance sheet disclosure on PEAD.     

The consequences of deviating from financial reporting industry norms: Evidence from the disclosure of foreign cash

This study examines how investors respond to firms’ disclosure practices that deviate from the majority of industry peers (i.e., industry norms). The SEC has made repeated calls for the disclosure of foreign cash in order for investors to have more information in determining firms’ liquidity positions. We examine the association between firm value and the non-disclosure of foreign cash in industries where the majority of firms choose to disclose foreign cash. We define partial disclosure as disclosing permanently reinvested earnings (PRE), but withholding the disclosure of foreign cash, and find that when the majority of industry peers disclose foreign cash, investors discount the firm-specific partial disclosure of foreign operations. This finding suggests that investors have similar information demands as the SEC, and that withholding foreign cash results in a valuation discount. We also find that this discount is more pronounced for firms predicted to have higher levels of foreign cash and higher levels of PRE. The discount in firm value is also concentrated among firms with managers who have more career concerns, suggesting that managers shift the cost of partial disclosure to shareholders instead of bearing the personal reputational cost of full disclosure. Our results are robust to multiple matched samples and entropy balancing. While previous literature has considered the valuation implications of foreign cash disclosures, we reveal the consequences of opting to withhold the disclosure of foreign cash. Our findings should be of interest to both managers and policy-setters in forming their disclosure protocols.     

Pro forma disclosure and investor sophistication: External validation of experimental evidence using archival data

Insights on how ordinary, less-sophisticated investors interpret and process management-issued pro forma earnings numbers are useful to regulators because of concerns that pro forma disclosures are misleading to ordinary investors. Two recent experimental studies [Frederickson, J. R., & Miller, J. S. (2004). The effects of pro forma earnings disclosures on analysts’ and nonprofessional investors’ equity valuation judgments. The Accounting Review, 79(3), 667–686; Elliott, W. B. (2006). Are investors influenced by pro forma emphasis and reconciliations in earnings announcements? The Accounting Review, 81(1), 113–133] find that the existence of a pro forma number in the earnings press release as well as the relative placement of the pro forma and GAAP earnings figures within the press release affect the judgments of less-sophisticated investors but not those of more-sophisticated investors. Experimental and archival methodologies complement one another and results that persist in both settings are likely to be robust to both internal and external validity concerns. Therefore, we complement experimental evidence using trade-size-based proxies constructed from intraday transactions data to distinguish the trading activities of less-sophisticated investors from more-sophisticated investors. Our results suggest that less-sophisticated investors rely significantly more on quarterly earnings press releases that include a pro forma number than on those that do not, while more-sophisticated investors exhibit the opposite behavior. This result is consistent with Frederickson and Miller’s experimental evidence. Further, consistent with Elliott’s results, we find that less-sophisticated investors rely more on the pro forma figure when it is placed before the GAAP earnings number in the press release, while more-sophisticated investors’ trading behavior is unaffected by the relative placement of the two earnings metrics. We conclude that the existence of a pro forma number as well as its strategic placement in the press release generally affect the judgments of less-sophisticated (but not more-sophisticated) investors and these inferences are robust because they persist in both experimental and archival settings.     

Disclosure frequency and information asymmetry

The main purpose of this paper is to investigate whether more frequent disclosure by firms is associated with lower levels of information asymmetry among investors. Using a panel of 386 firms in the US retail sector, I find that the practice of regularly providing monthly revenue disclosures is not associated with reduced information asymmetry. In contrast, I find that more detailed (greater quantity) disclosure is associated with reduced information asymmetry. I provide preliminary evidence that the distinction between disclosure frequency and disclosure quantity is due to more frequent disclosure providing an incentive for increased private information acquisition by sophisticated investors. The results indicate that the relation between disclosure and information asymmetry is multi-dimensional and varies depending on the disclosure attribute being studied.     

Financial estimates against investors’ preferences: anchoring,denial and spillover effects

This experimental study investigates how the characteristics of an estimate in a sensitivity disclosure and the level of threat it presents to investors’ preferences interact to influence investors’ risk judgments. Firstly, I predict and find that variation in an estimate affects not only investors’ judgment on a related issue but also their future judgments on an unrelated issue. Secondly, I predict and find that investors are more sensitive to variations in an estimate when information contained in the estimate presents less threat to their preferred conclusions than when it presents greater threat. Finally, I predict and find that investors perceive more uncertainty regarding the association between the disclosed risk factor and the estimated financial reporting item in the estimate when the information presents greater threat.     

Electric Utility Stranded Costs: Valuation and Disclosure Issues

We analyze the stock market's valuation of electric utility "stranded costs" (i.e., costs that might become unrecoverable under deregulation), and investigate whether stranded costs that have arisen as a result of voluntary firm business decisions are valued differently from those that are more directly linked to regulatory mandates. Further, we study whether investor valuations differ across jurisdictions. Finally, we examine the relation between investor valuation of stranded costs and the decision by utilities to make stranded cost-related disclosures in their financial statements voluntarily.
We find that investors anticipate that, on average, approximately 10% of total stranded costs will be borne by utility shareholders. Stranded costs arising from voluntary operating or investing decisions made by utilities are valued more negatively than those associated with mandatory power purchase contracts, consistent with investors assigning a higher recovery probability to the latter. Investor valuations of stranded costs associated with utility generating investments do not differ systematically across jurisdictions. We find that stranded costs are valued less negatively for voluntary disclosers not just in the year of disclosure but also in the preceding two years, implying that it is not disclosure per se that favorably influences valuation. Voluntary disclosers operate in jurisdictions that have more clearly established stranded cost recovery mechanisms, suggesting that both stranded cost disclosure and valuation are prompted by reduction in uncertainty about recoverability.     

Disclosure Versus Recognition: Inferences from Subsequent Events

Standard setters explicitly state that disclosure should not substitute for recognition in financial reports. Consistent with this directive, prior research shows that investors find recognized values more pertinent than disclosed values. However, it remains unclear whether reporting items are recognized because they are more relevant for investing decisions, or whether requiring recognition itself prompts differing behavior on the part of firms and investors. Using the setting of subsequent events, I identify the differential effect of requiring disclosure versus recognition in a setting where the accounting treatment of an item is exogenously determined. For comparable events, I find a stronger initial market response for firms required to recognize relative to firms that must disclose, although the large magnitude of the identified effect calls into question whether this difference can be attributed to accounting treatments alone. In examining various reasons for the stronger market response to recognized values, I fail to find support for the hypothesis that this difference is due to differential reliability of disclosed and recognized values. I do find some evidence that investors underreact to disclosed events, consistent with investors incurring higher processing costs when using disclosed information.     

Shareholder activism and voluntary disclosure

We examine the relation between shareholder activism and voluntary disclosure. An important consequence of voluntary disclosure is less adverse selection in the capital markets. One class of traders that finds less adverse selection unprofitable is activist investors who target mispriced firms whose valuations they can improve. Consistent with this idea, we find that managers issue earnings and sales forecasts more frequently when their firm is more at risk of attack by activist investors, and that these additional disclosures reduce the likelihood of becoming an activist’s target. These additional disclosures also prompt a positive price reaction, contain more precise guidance, and exceed prevailing market expectations. These findings imply that managers use voluntary disclosure to preempt activism at their firm, and that activists prefer to target relatively opaque firms.     

The effects of firm size,corporate governance quality,and bad news on disclosure compliance

Motivated by calls for increased compliance, size-based regulation, and continued exemption of small firms from internal control reporting requirements, we assess the incremental effects of firm size, corporate governance quality, and bad news on disclosure compliance. We examine compliance with the disclosure requirements of an SEC-mandated filing that requires no computations or complex judgments but is nonroutine and may reveal value-decreasing information (bad news) that otherwise would not become public. The disclosures studied are those that firms provide in Form 8-K Item 4 when changing external auditors. We find that noncompliant firms have lower quality corporate governance and less need for external financing but are not smaller than compliant control firms. Additional analyses indicate that compliance is negatively associated with bad news.