The Structure of Voluntary Disclosure Narratives: Evidence from Conference Calls. Kristian D. Allee * University of Wisconsin Madison

Transcription

1 The Structure of Voluntary Disclosure Narratives: Evidence from Conference Calls Kristian D. Allee * University of Wisconsin Madison Matthew D. DeAngelis ** Michigan State University May 2014 * Corresponding author. Department of Accounting and Information Systems, University of Wisconsin- Madison, 975 University Ave. Madison, WI Phone: (608) kallee@bus.wisc.edu ** Department of Accounting and Information Systems, Michigan State University, 632 Bogue St. East Lansing, MI Phone (517) deangelis@broad.msu.edu We are grateful for constructive comments by Ted Christensen, Fabio Gaertner, Ken Merkley, Holly Skaife, Tyler Thomas, Jim Wahlen, Terry Warfield and workshop participants at Michigan State University, the University of Arkansas, and the University of Wisconsin - Madison. We would like to thank the Wisconsin School of Business and the Eli Broad College of Business for financial support.

2 The Structure of Voluntary Disclosure Narratives: Evidence from Conference Calls Abstract We examine tone dispersion (i.e., the degree to which tone words are spread evenly throughout a narrative) to evaluate whether narrative structure provides insight into managers voluntary disclosures and the response to these disclosures. We find that tone dispersion is both informative and subject to managers incentives to influence perceptions about performance. Consistent with tone dispersion being informative, we find that positive (negative) tone dispersion is (inversely) associated with improvements in disaggregated performance. We also find that negative tone dispersion is associated with poor future performance. Furthermore, we find that analysts and investors respond to negative tone dispersion. Consistent with managers using tone dispersion to influence perceptions, we find evidence that managers increase negative tone dispersion in order to emphasize bad news when firm performance is exceptionally high and reduce negative tone dispersion when they have a large amount of negative news to share. In addition, we find evidence that managers disperse positive tone in order to emphasize good aggregate performance, which may suggest strategic motivations on the part of managers. Keywords: voluntary disclosure, conference calls, tone, analysts JEL classification: M41, M49, G30

3 1. Introduction Disclosure narratives provide context for financial data and convey incremental information about firm performance (Kravet and Muslu [2013]; Merkley [2014]; Davis, Piger, and Sedor [2012]; Loughran and McDonald [2011]; Henry [2008]; Li [2006]; Price, Doran, Peterson and Bliss [2012]). However, extant research provides little evidence on how the structure of these words within disclosure narratives affects information content. In addition, with the exception of Li [2008] and related studies on readability, we know little about how managers choices regarding word order and narrative construction affect users response to the information presented. We examine whether tone dispersion, or the degree to which tone words are spread evenly throughout a narrative, provides additional insight into what information managers communicate and how users interpret that information. The structure of a narrative reflects the organization of inter-related ideas and helps users interpret and comprehend the preparers message (Strunk and White [1979]; Kintsch and Yarbrough [1982]; Spivey [1990]). When crafting disclosures, managers do not present loose bits of information (Spivey [1990]), but rather provide a carefully worded and thoroughly organized discussion of relevant information (Matsumoto, Pronk, and Roelofsen [2011]). Managers use narrative information in their financial reports to tell a story (Sedor [2002]), usually outlining the contribution of multiple components of performance to aggregate performance. As such, we predict that increased tone dispersion indicates the presence of positive or negative news in a greater number of these performance components. That is, when a firm experiences good (bad) performance related to components of aggregate earnings (e.g., financial statement line items, business or geographical segments), we expect positive (negative) tone dispersion to be higher because discussions of positive (negative) news are spread more evenly throughout the report. However, since prior research suggests that managers alter narrative structure strategically in order to obfuscate information (Li [2008]) or direct attention away from past performance (Rennekamp [2012]), we also expect managers to alter 1

4 tone dispersion in order to influence perceptions. For instance, managers may condense their discussion of bad news into one section in order to avoid drawing attention to it. We examine the role of tone dispersion in earnings conference calls because they are an increasingly important and value relevant channel of corporate communication (Frankel, Johnson, and Skinner [1999]; Bushee, Matsumoto, and Miller [2003]; Skinner [2003]). 1 Prior research examining information in conference calls has found that investors and other stakeholders react not only to (1) what managers say, but (2) how they say it, documenting significant responses to word choice (Price, Doran, Peterson and Bliss [2012]), vocal cues (Mayew and Venkatachalam [2012]) and conference call time (Chen, Demers, and Lev [2012]). In addition, since conference calls are interactive, with a question-and-answer period following management s prepared remarks, using conference calls also allows us to examine the effect of the prepared narrative on the language used by analysts when questioning managers on firm performance. We test our predictions using a measure of linguistic dispersion from the computational linguistics literature, averaged reduced frequency (ARF), to measure the degree to which tone words are evenly distributed throughout the prepared remarks section of a conference call. 2 We hypothesize that tone dispersion is associated with news in current performance components and future performance. Consistent with our hypothesis, negative tone is less dispersed when the firm experiences improvements in income statement line items (sales, cost of goods sold, etc.) and when future earnings are higher, suggesting that negative tone dispersion reflects the presence of 1 Research has found that the prepared remarks (Frankel, Johnson, and Skinner [1999]; Bowen, Davis, and Matsumoto [2002]; Kimbrough [2005]) and interactive analyst sections of conference calls (Matsumoto, Pronk, and Roelofsen [2011]) elicit significant incremental information relative to those firms only issuing a press release associated with their quarter end. 2 We use Loughran and McDonald's [2011] word list to measure positive and negative tone because it is tailored specifically for financial reporting settings, unlike general tone word lists such as the Harvard IV-4 dictionary, and has been shown to perform better in these settings (Davis and Tama-Sweet [2012]; Price et al. [2012]). While Henry [2008] also develops a dictionary suited for financial reporting, it includes words like increase and decrease, the tone of which is dependent on what is increasing or decreasing (e.g., sales or costs). We acknowledge, however, that our results may be sensitive to the words used in measuring tone dispersion. In addition, our study depends on the bag-of-words approach accurately measuring tone. 2

5 disaggregated information about future value. In addition, we find that our measure of negative tone dispersion is not predictably associated with measures of aggregate firm performance (i.e., losses), suggesting that the dispersion of negative tone is associated primarily with bad news in earnings components as opposed to a poor aggregate earnings number. Finally, negative tone dispersion is actually inversely associated with the level of negative tone, inconsistent with a mechanical relation between the level of tone and our measure of tone dispersion. In contrast, positive tone is more dispersed when aggregate performance is above analyst expectations but is only weakly related to the number of line item improvements. This evidence suggests that managers use dispersed positive tone predominantly to discuss aggregate earnings realizations and not to emphasize good performance in individual income components or line items. Managers also discuss pro forma earnings to a lesser degree when positive tone is more dispersed, suggesting that positive tone dispersion reflects managers focus on aggregate GAAP earnings. While inconsistent with our hypothesis that positive tone dispersion is associated with news in components of performance, this result is consistent with Graham, Harvey, and Rajgopal's [2005] survey evidence. They document that CFOs devote the conference call to the positive aspects of a firm s future prospects if they meet the earnings target. On the other hand, if the company fails to meet earnings guidance, the tone of the conference call becomes negative and the focus of the discussion shifts to talking about why the company was unable to meet the consensus estimate. We also hypothesize that tone dispersion is associated with managers incentives and financial reporting strategies to influence investors perceptions. Consistent with this notion, our results indicate that firms with extremely high performance disperse negative tone to a greater extent, thereby emphasizing and detailing bad news when they have an incentive to avoid future negative earnings surprises (Soffer, Thiagarajan, and Walther [2000]; Graham, Harvey, and Rajgopal [2005]). We also find that firms that hold conference calls after hours or on nontrading days, which prior research suggests may be associated with managers attempts to limit the market s response to bad 3

6 news (Patell and Wolfson [1982]; Dellavigna and Pollet [2009]), disperse negative tone less. This evidence is consistent with managers providing less detail on bad news when they want to minimize negative returns. Additionally, we find that positive tone dispersion is associated with higher classification shifting (McVay [2006]; Fan, Barua, Cready and Thomas [2010]; Barua, Lin, and Sbaraglia [2010]), consistent with managers emphasizing aggregate earnings more when they have intervened to improve that number. Finally, our evidence that negative tone dispersion is inversely associated with the level of negative tone might suggest that managers condense their discussions of bad news as firm performance deteriorates. Given the observed relation with firm performance and financial reporting decisions, we next examine whether tone dispersion provides incremental information to analysts and investors. Consistent with information content in negative tone dispersion, analysts ask more negatively toned questions and investors respond more negatively to the call when negative tone in the prepared remarks section is more dispersed. 3 Consistent with positive tone dispersion providing no information beyond aggregate earnings and the level of positive tone, analysts and investors do not respond incrementally to positive tone dispersion. However, when we control for situations in which tone dispersion is inversely related to the level of tone (i.e., potential strategic tone dispersion), we find that some portion of positive tone dispersion is informative. Furthermore, we find that analysts respond more negatively when positive tone dispersion is accompanied by a lower level of positive tone, suggesting that analysts are more skeptical when managers emphasize a relatively small amount of positive news. Additionally, consistent with Matsumoto, Pronk, and Roelofsen [2011] and Price, Doran, Peterson and Bliss [2012], we find that investors responses to the conference call are more positive when analysts ask more optimistically toned questions, suggesting that investors respond 3 Cohen, Lou, and Malloy [2013] find that firms manipulate their conference calls by calling on analysts with the most optimistic views on the firm and that these firms appear to be hiding bad news. Therefore, an alternative interpretation of our findings could be that managers that condense negative tone may call disproportionately on favorable analysts. 4

7 both directly to negative tone dispersion in the disclosure narrative and indirectly to more optimistic analyst responses to that narrative. This study makes several contributions to the literature. First, we provide evidence on how the structure and tone of the narrative in conference call disclosures (1) is affected by the information presented and (2) influences analysts and investors reactions to that information. As such, our study unifies two strands of accounting and finance literature examining word choice and sentence structure. Whereas prior research uses word counts to measure information content and word and sentence structure to measure the costs of analyzing that information (e.g., Li [2008]; Lehavy, Li, and Merkley [2011]; Lee [2012]), ours is the first study in accounting to find evidence that narrative structure is important to understanding meaning. In doing so, we address a common concern that the so-called bag-of-words approach to textual analysis research ignores the context in which those words are used and to suggest a new line of research using statistical approaches to measure narrative structure. 4 Second, we contribute a useful measure of dispersion from computational linguistics into the financial reporting literature. Average reduced frequency, a measure originally designed to quantify the commonness of words within document collections (Savicky and Hlavacova [2002]), combines word placement with word choice to determine the distribution of words within a text. Although a relatively simplistic view of narrative structure, linguistic dispersion provides a useful first look at the effect of structure on meaning. By examining the dispersion of tone (structure), we also contribute to prior evidence that tone is informative for firm value. Finally, we contribute new evidence on managers financial reporting decisions. Prior research suggests that managers modify the components of firm performance that analysts and investors include in their estimates by suggesting that some components, usually those that result in 4 While prior studies have examined narrative structure in firm disclosures (e.g., Sydserff and Weetman [1999]), ours is the first, to our knowledge, to propose a measure of structure that does not rely on hand-coding by researchers. 5

8 poorer aggregate performance, are nonrecurring or misleading (Christensen, Merkley, Tucker and Venkataraman [2011]; Schrand and Walther [2000]; Curtis, McVay, and Whipple [2013]; Whipple [2014]). Our results suggest that managers are also more likely to disperse bad news than good news in their disclosure narratives when discussing recurring earnings components and that this dispersion is useful in predicting future performance. While managers motivations for these choices remain unexplored, the decision to voluntarily provide increased detail on bad news is consistent with prior research suggesting that bad news is more difficult to explain than good news (Bloomfield [2008]). However, our results also suggest that managers may present good news strategically by dispersing uninformative positive tone throughout their narratives. In addition, we provide novel evidence that managers may structure tone to lower expectations on future earnings. Together, these results shed light on managers use of disclosure narratives to shape users understanding of financial results. 2. Background and Hypotheses 2.1 BACKGROUND Accounting research has long acknowledged that structure is important for understanding financial reports. Research on firm communications has found that investors are more responsive to earnings metrics that managers emphasize (Bowen, Davis, and Matsumoto [2005]) and that managers can influence pro forma earnings exclusions by discussing those exclusions in their earnings guidance (Christensen, Merkley, Tucker and Venkataraman [2011]). In addition, audit research has found that auditors are influenced by the order in which information is presented (Boritz [1985]; Butt and Campbell [1989]) and the presentation of decision-irrelevant information with relevant information (Hackenbrack [1992]; Hoffman and Patton [1997]; Shelton [1999]). 5 5 Related to the importance of structure in understanding financial reports, prior research has documented that analysts and investors are influenced by the choice to present comprehensive income on the income statement instead of the statement of equity, paying greater attention to the same items when they are presented on the former than the latter (Hirst and Hopkins [1998]; Maines and McDaniel [2000]; Lee, Petroni, and Shen [2006]). 6

9 Structure is also important for understanding the role of words within disclosure narratives. Prior research has found that managers discuss multiple dimensions of firm performance in their disclosures (Li [2010]; Davis, Piger, and Sedor [2012]; Campbell, Chen, Dhaliwal, Lu and Steele [2010]; Li [2006]; Merkley [2014]; Kimbrough and Wang [2014]; Engelberg [2008]). Sedor [2002] notes that, while managers theoretically could present information about these various topics in the form of an unordered list, managers choose instead to structure their narratives to include concrete details and causal orderings that link current states, planned actions, and anticipated future outcomes (Sedor [2002, 738]). Within this ordering, the rhetoric and communication literature suggests that words are less likely to be topically related to one another as the distance between them within the narrative increases. 6 To the extent that managers use effective communication strategies in their disclosure narratives, we expect that observing two words in close proximity has very different narrative implications than observing the same two words at opposite ends of the text. We predict that managers will, in structuring their narratives, discuss components of performance sequentially as they build a story about aggregate performance. We choose to focus our investigation on the role of linguistic tone dispersion in understanding discussions of those components. Prior studies have established the pricing relevance of linguistic tone in a variety of settings (Davis, Piger, and Sedor [2012]; Price, Doran, Peterson and Bliss [2012]; Demers and Vega [2012]; Baginski, Demers, Wang and Yu [2012]; Loughran and McDonald [2011]; Durnev and Mangen [2011]; Balakrishnan and Bartov [2010]; Li [2010]). However, we know very little about how managers use tone to construct narratives about firm performance. We build on substantial evidence that managers use narratives to convey information and shape perceptions (Bowen, Davis, 6 Strunk and White [1979] suggest that each topic be assigned its own paragraph with smooth transitions between topics. In a well-structured narrative, then, words that share the same sentence, or sentences that share the same paragraph, are more likely to relate to one another than those that do not, and the same holds for adjacent paragraphs. Likewise, Strunk and White suggest that related words be kept together even within sentences, making adjacent words more likely to be related. 7

10 and Matsumoto [2005]; Li [2008]; Christensen, Merkley, Tucker and Venkataraman [2011]; Huang, Teoh, and Zhang [2013]) to examine the role of tone structure in these narratives. 2.2 HYPOTHESES We examine the structure of disclosure narratives in earnings conference calls. Conference call dialogues between managers and analysts have been increasingly scrutinized since the passage of Regulation Fair Disclosure (Skinner [2003]). Prior research has found that managers use these calls to provide supplementary information about earnings (Frankel, Johnson, and Skinner [1999]; Kimbrough [2005]; Matsumoto, Pronk, and Roelofsen [2011]) and that analysts and investors make decisions regarding their earnings estimates based on what managers choose to discuss (Black, Christensen, Kiosse and Steffen [2013]). As such, the disclosure narrative of the prepared remarks section of these calls is primarily about the future value implications of current period aggregate performance and line-item and segment components of that performance. Given our expectations regarding narrative structure, we predict that tone dispersion within the conference call narrative reflects managers choices about which performance components to discuss and how to frame the implications of those components. Managers may discuss performance components either to provide value-relevant information or to manage users perceptions about firm value. In general, news in performance components is informative for predicting future earnings (Ou and Penman [1989]; Fairfield, Sweeney, and Yohn [1996]). In addition, managers may call attention to value-relevant components that users might otherwise exclude from their value estimates (Elliott, Hobson, and Jackson [2011]) or one-time items that users might prefer to exclude (Elliot and Hanna [1996]; Bradshaw and Sloan [2002]; Bhattacharya, Black, Christensen and Larson [2003]). However, managers may also strategically use their disclosure narratives to manage perceptions of and expectations for the firm. Prior studies suggest that, given a certain level of good or bad news released with earnings, managers prefer that analysts and investors respond more 8

11 positively to good news and less negatively to bad news. 7 Managers may therefore prepare their disclosure narratives motivated partly by a desire to put a positive spin on performance (Bloomfield [2002]; Li [2008]; Davis and Tama-Sweet [2012]) or strategically alter benchmarks and reporting complexity in an effort to make it more difficult for investors to analyze firm performance (Schrand and Walther [2000]; Riedl and Srinivasan [2010]; Li [2008]). Managers may also structure their narratives to suggest that certain components of earnings are less persistent than others, leading to a measure of street earnings that is often higher than GAAP earnings (Bradshaw and Sloan [2002]) but excludes components of firm performance that are useful for predicting future cash flows (Doyle, Lundholm, and Soliman [2003]). Prior research finds evidence that this type of manipulation is effective. That is, market prices increasingly respond to street earnings to a greater degree than GAAP earnings and analysts are more likely to exclude recurring components of earnings when managers exclude those components (Christensen, Merkley, Tucker and Venkataraman [2011]; Bradshaw, Christensen, Gee and Whipple [2014]). Moreover, investors are less likely to exclude transitory components of earnings (Schrand and Walther [2000]; Curtis, McVay, and Whipple [2013]; Whipple [2014]) when managers do not exclude those components. If managers structure their narratives to discuss performance components sequentially, we expect that positive (negative) tone dispersion will increase (decrease) with disaggregated improvements in performance. In addition, we posit that informative tone dispersion will have implications for future performance. On the other hand, if managers structure their narratives strategically, we predict that tone dispersion will not be associated with firm fundamentals. Instead, 7 Soffer, Thiagarajan, and Walther [2000] find that, because the market responds more negatively to bad news when it is released with earnings, managers tend to release bad news prior to the earnings announcement in order to achieve a positive stock price reaction on the earnings announcement date. Richardson, Teoh, and Wysocki [2004] find that managers gradually walk-down expectations in order to beat earnings targets, noting that this may be because the firm is likely to issue new equity, and managers are likely to exercise stock options and trade in the firm s stock, in the period immediately following the earnings announcement. 9

12 we hypothesize that managers will choose to emphasize good news by spreading positive tone throughout the report and minimize their discussion of bad news by condensing negative tone into certain sections. In addition to minimizing the amount of time that managers spend discussing bad news, condensing bad news may also reflect management s desire to present separate pieces of bad news as one or a few (perhaps non-recurring) items (McVay [2006]). We predict that tone dispersion is a function of the information presented and managers incentives to manage impressions, leading to our first set of hypotheses stated in alternative form: H1: Tone dispersion is associated with news in components of performance and future performance. H2: Tone dispersion is associated with managers incentives and financial reporting strategies to manage perceptions of firm value. Earnings conference calls also provide an opportunity to test whether the structure of the call narrative affects analyst responses to the call. Prior research has found that analysts participate actively in the call, clarifying the information presented (Matsumoto, Pronk, and Roelofsen [2011]), challenging management s assertions (Black, Christensen, Kiosse and Steffen [2013]) and providing more timely and accurate forecasts (Mayew, Sharp, and Venkatachalam [2013]). If narrative structure is informative regarding the implications of tone for firm value, or if managers are successful in using tone dispersion to influence analysts, we anticipate that more positive (negative) tone dispersion is associated with more positive (negative) tone on the part of analysts when they ask their questions. This logic leads to our third hypothesis, stated in alternative form: H3: Positive (negative) tone dispersion is associated with higher (lower) optimism in analysts questions. Likewise, we anticipate that more positive (negative) tone dispersion is associated with a more positive (negative) market reaction. H4: Positive (negative) tone dispersion is associated with a higher (lower) market response to the conference call. 10

13 3. Sample, Descriptive Statistics, Research Design and Results on Tone Dispersion 3.1 SAMPLE We use textual analysis of earnings conference calls to examine our research questions and test our predictions. We select this setting because we expect managers to utilize a higher amount of discretion when disclosures are voluntary and the information being communicated is qualitative in nature. Frankel, Johnson, and Skinner [1999, 36] suggest this may be true by stating conference calls, being less formal than written press releases, are subject to a lower standard of legal liability than statements made during press releases. Thus, managers may be more willing to provide certain information during the presentation portion of the conference call than they would be willing to provide in a press release (Matsumoto, Pronk, and Roelofsen [2011]). In addition, positive and negative language in company disclosures is often specifically articulated with respect to aggregate performance (i.e. earnings were better than expected ) or in terms of specific performance components (i.e., we observed improvements in gross margins ). As a result, positive and negative tone in conference calls is likely to highlight components of performance more so than simply reporting changes in financial statement line items. To measure tone, we use word counts from the business-specific dictionaries of positive and negative tone words developed by Loughran and McDonald [2011]. 8 To examine our research questions, we use a measure from the corpus linguistics literature, average reduced frequency (Savicky and Hlavacova [2002]), to quantify tone dispersion. We calculate average reduced frequency (ARF) for positive (negative) words by dividing the prepared remarks section of the conference call transcript into equally-sized sections equal to the number of positive (negative) words. We count the number of sections containing at least one positive (negative) word and then divide by the total number of sections. As an example of how we 8 We eliminated the word question from our list of negative words because managers tend to refer to analyst questions in both the prepared remarks section and the Q&A. We also adjusted for negation and did not count the word good if it was followed by morning, afternoon, evening or day ; the word effective if it was followed by income, tax or rate, the word efficiency if it was followed by ratio ; or the word closing if it was followed by remark or remarks. 11

14 would calculate this measure (based on positive tone), we count all positive words in each transcript. We then divide the transcript into sections based on the number of positive words: if there are 50 positive words, then the corpus is divided into 50 sections of equal length. ARF is the proportion of these sections containing at least one positive word. In this example, if all of the positive words are clustered together into one section, then average reduced frequency is 1/50. Alternatively, if every section contains one positive word, then ARF is 50/50. Thus, a higher ARF (closer to 1) indicates that words are more evenly distributed throughout the transcript, while smaller values of ARF indicate a chunkier distribution. Figure 1 plots the relative placement of words in a few selected conference calls to demonstrate the idea of ARF. The first row of selected conference calls (Tickers: WLT, CHKP, and SPG) demonstrates conference call narratives that disperse positive tone more than negative tone. Walter Energy, Inc. (WLT) has an ARF of 0.63 with positive words but only has an ARF of 0.21 with negative words. Check Point Software Technologies (CHKP) and Simon Property Group (SPG) are two other examples of this type of disclosure narrative with positive ARF values (pos_arf) of 0.60 and 0.67 and negative ARF values (neg_arf) of 0.23 and 0.26, respectively. Note that, for these firms, negative words are far more likely to be placed together (as demonstrated by the spikes in percentage of tone words), relative to the placement of positive words. However, this phenomenon seems to vary by firm such that, according to our measure, the firms on the second row of Figure 1 (ACMR, ACTG, and AFG) all have identical placement of both positive and negative words and the third row of firms (RHI, TOL, FMCN) disperse negative tone more than positive tone. 9 Thus, Figure 1 and the descriptive statistics reported in Table 1 reveal that there is significant variability in the average reduced frequency measure between firms. 9 The following are the ARF values for the remaining firms in Figure 1: Row 2 ACMR (pos_arf: 0.50, neg_arf: 0.50); ACTG (pos_arf: 0.50, neg_arf: 0.50); AFG (pos_arf: 0.60, neg_arf: 0.60); Row 3 RHI (pos_arf: 0.29, neg_arf: 0.55); TOL (pos_arf: 0.33, neg_arf: 0.68); FMCN (pos_arf: 0.33, neg_arf: 0.70) 12

15 For our analysis, we collect 36,047 conference call transcripts from SeekingAlpha.com between 2004 (the earliest year available) and We use Perl to separate the conference call into three sections: the list of participants, the prepared remarks section and the question-and-answer section (Q&A). We only include a transcript in our sample if our Perl script is able to detect all three sections because some of the available transcripts either do not contain some of these sections or they use inconsistent formatting which reduces the sample to 34,115. To make sure our measures of tone contain only manager or analyst speech, we calculate ARF after cleaning the prepared remarks and Q&A sections of all HTML, special characters and comments by the operator. We then use Perl and the list of participants to separate the speech of managers and analysts in the Q&A section. In order to do this, we require at least one person from the list of participating managers to be identified in the Q&A, leaving 33,484 transcripts. Because the date that the transcript is posted to SeekingAlpha.com can differ from the date of the call itself, we require our Perl script to identify the date of the call in the transcript header. This eliminates 2,128 transcripts, leaving a sample of 31,893. We then match that sample to the Compustat database as of the closest date prior to, but within 3 days of, the call, leaving 20,339 transcripts with timely Compustat data available. We lose additional firm-quarter observations when matching with CRSP and IBES resulting in 18,306 observations with the requisite data for our analyses. 3.2 DESCRIPTIVE STATISTICS Table 1 contains descriptive statistics on the length (in words), tone, earnings news, variables of interest and conference call characteristics for the conference call sample used later in the multivariate regressions, as well as characteristics of the length of the Q&A session for the conference call, for both the analysts portion of the Q&A and managers portion of the Q&A. We find that the average (median) length of the prepared remarks in our sample is 3,025 (2,885) words, which is slightly longer than the 2,928 (2,798) words reported in Matsumoto, Pronk, and Roelofsen [2011]. This is on average about 7 single spaced pages when the disclosure narrative is written out. 13

16 There are substantially more positive words than negative words in the prepared remarks section, with a mean of 55.6 positive words and 29.9 negative words. Table 1 also indicates that 24 (35) percent of our firm quarter observations are loss (I/B/E/S miss) quarters and that the median firm beats analysts expectations by about 3.5 percent. Consistent with Chen, Demers and Lev [2012] we find that approximately 26 percent of our firms make conference calls at (or after) 5 PM EST or on a Saturday or Sunday. The descriptive statistics on the average reduced frequency measures indicate that there is a statistically significant difference between the extent to which firms disperse positive and negative tone, although the difference is very small. The mean (median) ratio of the difference in tone dispersion is (1.016), which is statistically greater than one. Tests of the mean and median differences between positive and negative tone dispersion are consistent with good news being more dispersed than bad news (i.e., positive tone dispersion less negative tone dispersion is statistically greater than 0 at less than the 1% level). Additionally, consistent with Figure 1, there appears to be significant variation in firms tone dispersion. This evidence suggests that there are conference calls that seem to be prepared consistent with a strategy of dispersing good news and condensing bad news (Q3 ratio = 1.13) and others that are prepared contrary to these potential strategic motivations (Q1 ratio = 0.91). Table 1 also reports that analysts ask on average 24 questions with an average total word count of 1,078 words, indicating that analysts questions are approximately one-third the length of the prepared remarks section of the call. Managers responses to analysts questions are similar in length to the prepared remarks section, such that the word count of 2,817 (2,754) words is only a few hundred words less on average (on the median) than the prepared narrative. Managers are significantly more optimistic in their responses to analysts than are the analysts questions themselves. However, we do not find a large difference in managers net optimism between their prepared narrative and the responses to analysts questions during the Q&A. 14

17 3.3.1 MODELING THE DECISION TO VARY TONE DISPERSION In order to address our hypotheses, we model the decision to disperse tone as a joint function of whether managers vary the tone structure in the prepared narrative based on current and future earnings performance (H1) and managers incentives and strategies to manage perceptions of firm value (H2). We test these hypotheses by examining the association of our average reduced frequency measures, pos_arf, neg_arf, and tone_dispersion, with firm performance and financial reporting behavior. The variable pos_arf is the average reduced frequency of positive words as described above. The variable neg_arf is simply the average reduced frequency of negative tone words. For both pos_arf and neg_arf values closer to one (zero) suggest a more dispersed (condensed) distribution of tone words throughout the text of the conference call. Finally, tone_dispersion is the degree to which managers disperse positive tone more than they disperse negative tone: pos_arf divided by neg_arf. We define all variables included in our tests in Appendix A. To test H1, we first examine whether managers performance discussions in conference calls are related to disaggregated current performance. We calculate our measure of disaggregated current performance, disagg_perf, as the natural log of the number of items on the income statement that represent increases in income increasing items (e.g., sales) or decreases in income decreasing items (e.g., expenses), using all items reported in the COMPUSTAT quarterly database, common sized by sales. Thus, if firm performance relative to the same quarter the prior year improves along multiple dimensions, then the disagg_perf measure will increase. Consistent with H1, we predict that as managers have more positive items to discuss, our measures of positive (negative) tone dispersion will increase (decrease). We also calculate a measure based on the same quarter one year ahead (disagg_perform_f1) to examine whether tone dispersion might also be related to future improvements in firm margins. We note that tone dispersion may not be related to disagg_perform_f1 because we have rarely seen managers 15

18 talking about how current performance may be related to disaggregated future performance in their conference calls. We also include earnings performance news: an indicator variable coded one if the firm has negative earnings (loss); an indicator variable equal to one if the firm misses analyst expectations (ibes_miss), and the percentage difference between the firm s actual earnings and consensus analyst expectations (%Δibeseps). 10 As linguistic measures have been found to convey incremental information about firm performance (Price, Doran, Peterson and Bliss [2012]), we include the log of the number of positive words (poscount), and the log of the number of negative words (negcount) in the prepared remarks section of the conference call to investigate whether tone is more dispersed as sentiment increases. Finally, as alternative profitability metrics, we include current return on assets (roa) and future return on assets (roa_f1). To examine H2, our tests include other attributes related to managers financial reporting decisions; %specialitems, accruals, pfcount, and fog, as well as measures of strategic reporting by managers; ratchet_down and nontrading. We include the magnitude of negative special items (%specialitems), calculated as negative special items as a percentage of sales, where positive special items are set equal to zero and negative special items are multiplied by -1 following McVay [2006]. Prior research has found that managers have incentives to report core expenses (defined as cost of goods sold and selling, general, and administrative expenses) as income decreasing special items in an attempt to inflate core profitability. Our negative word list contains many words related to these special items, such as abandon, restructuring, and writedown. Thus, discussions of special items in conference calls may be related to tone dispersion. We include accruals because Das, Kim, and Patro [2011] find that managers use earnings management and expectation management complementarily when managers ability to use earnings 10 Our results are robust to including alternative measures of earnings news such as standardized unexpected earnings (SUE) and unscaled unexpected earnings variables. 16

19 management is less restricted and as substitutes as the constraints on earnings management increase. Since many of our expectation management variables may depend on the use of earnings management, we include total accruals measured as the change in non-cash current assets (the change in current liabilities excluding the current portion of long-term debt depreciation and amortization) divided by lagged total assets (Das, Kim, and Patro [2011]). 11 A positive coefficient on total accruals would suggest that tone dispersion is related to lower earnings quality. Managers often disaggregate performance in order to propose pro forma earnings adjustments, so managers discussions of pro forma earnings is also likely to affect our tone dispersion measures. We include pfcount, calculated as the natural log of the total number of pro forma words from Christensen, Merkley, Tucker and Venkataraman [2011], in the analysis to proxy for the amount of pro forma discussion. Finally, prior research has found that managers may want to strategically hide adverse information through less transparent disclosures (Li [2008]). Managers may therefore prepare their disclosure narratives motivated partly by a desire to make them more difficult for investors to uncover information (Bloomfield [2002]; Li [2008]) which may be related to our measure of tone dispersion. Thus, we include fog which is the Fog Index measure of the readability of the prepared remarks section of the conference call. We include ratchet_down, an indicator variable coded one if the value of actual EPS less than I/B/E/S consensus expectations is in the highest decile of all observations in the sample and zero otherwise. Prior research indicates that managers prefer to ratchet down expectations of future earnings when they report large earnings surprises (DeFond and Park [1997]; Graham, Harvey, and Rajgopal [2005]). As such, firms may want to provide additional detail regarding bad news when 11 We also tried using other measures of accruals: the Jones model (Jones [1991]); the modified Jones model (Dechow, Sloan, and Sweeney [1995]); the modified Jones model with book-to-market ratio and cash flows as additional independent variables (Larcker and Richardson [2004]); and the modified Jones model with either current-year return on assets (ROA) included as an additional independent variables (Das, Kim, and Patro [2011]). However, none of these accruals measures were related to our measures of tone dispersion in the multivariate models and we lost sample firms due to the inability to run the requisite models to calculate the accruals variables. Thus, we include total accruals with the caveat that when more sophisticated measures are used we do not see a relation with pos_arf or neg_arf. 17

20 doing so helps them to avoid future negative earnings surprises (Soffer, Thiagarajan, and Walther 2000). Prior research has found that managers disclose bad news after trading hours to mute the market response to the news (Patell and Wolfson [1982]; Francis, Pagach, and Stephan [1992]). These managers may strategically use tone dispersion as well. For this reason we include an indicator variable if the conference call was made during non-trading hours or weekends (nontrading). We include a number of additional variables to examine the relationship between tone dispersion and firm- and call-specific characteristics. The significant correlations among the control variables and the length and tone of the prepared remarks section of the conference calls documented in Panel B of Table 3 suggests the importance of controlling for these factors in the multivariate analyses. We include the log of the number of total words (totalcount) to control for instances where tone is more dispersed as disclosure length increases. We include a variable indicating whether the call is made late (late) in the day since Chen, Demers, and Lev [2012] find that tone is related to the timing of the conference call. We include firm size (sizemktvl) to control for whether the managers of large firms, who are likely more sophisticated, use tone dispersion to a greater degree than other managers. We include the firm s book-to-market ratio (btom) to control for the possibility that managers of growth firms, which are under higher pressure to meet expectations (Skinner and Sloan [2002]), are more likely to use tone dispersion. Similar to Chen, Demers and Lev [2012] we include leverage (lev), defined as total liabilities divided by total assets, to proxy for the degree to which firm managers use debt versus equity to finance investments. Firms with more equity in their capital structure may be more sensitive to investors reaction to their earnings news. To control for the possibility that managers are more likely to use tone dispersion when uncertainty about the firm is high, we include the standard deviation of analyst forecasts prior to the call (stdfcasteps). Additionally, we include the degree of analyst coverage for the firm (an_following), calculated as the natural log of the number of analysts forecasting EPS estimates one month prior to the conference call, to control for interest in firm earnings by sophisticated market participants. We include 18

21 participantcount, which is the number of managers in the prepared remarks section of the conference call, to control for potential effects from multiple participants on the call affecting our measures of tone dispersion. Finally, prior research has found that managers may use voluntary disclosures to walk down analysts to a beatable consensus forecast (Soffer, Thiagarajan, and Walther [2000]; Richardson, Teoh, and Wysocki [2004]). Therefore, we include quarterly fixed effects in the model RESULTS ON MANAGERS USE OF TONE DISPERSION Table 2 Panel A presents the pairwise correlations between positive and negative ARF and predicted determinants. Consistent with H1, pos_arf is positively associated with disagg_perf and disagg_perf_f1, suggesting that positive tone is more dispersed as disaggregated firm performance improves and positively associated with future earnings, roa_f1. However, neg_arf is not significantly correlated with disaggregated performance in the univariate case, inconsistent with predictions. Both positive and negative tone dispersion are positively related to higher earnings (significantly positively correlated with roa and negatively correlated with loss and ibes_miss). Pairwise correlations between disaggregation of pos_arf and neg_arf and the number of positive and negative words (poscount and negcount) reveal that when managers have more positive things to say they tend to spread out good news (pos_arf and poscount correlation 0.12; p < 0.01), and managers tend to combine their discussions of bad news when they have more bad news to share (neg_arf and negcount correlation -0.09; p < 0.01). Regarding H2, pos_arf is significantly negatively associated with pfcount, suggesting that managers focus more heavily on GAAP earnings when positive tone dispersion is high. However, pos_arf is also positively correlated with accruals and fog, suggesting that tone dispersion reflects increased manager intervention in earnings and reduced disclosure transparency. Although we 12 We winsorize three of our variables (%Δibeseps, accruals, and stdfcasteps) at the 1 percent and 99 percent levels due to the influence of outliers; however, our results on variables of interest are identical when we include these outliers. The statistical significance of the %Δibeseps, accruals, and stdfcasteps variables differs significantly in some cases when the unwinsorized variables are used. 19

22 predicted that %specialitems would be a significant determinant of neg_arf, the variables are not significantly associated. However, we note that negcount is highly positively correlated with %specialitems, suggesting the need for caution in interpreting associations between our ARF measures and determinants without controlling for other aspects of the disclosure narrative, and particularly levels of tone. We further examine H1 and H2 in the multivariate setting. Table 3 reports the results of regressing the average reduced frequency of positive and negative toned words in the prepared remarks section of conference calls on our variables of interest. Column one reports the results for pos_arf, column two for neg_arf, and column three for tone_dispersion. 13 Consistent with H1, Table 3 indicates that pos_arf and neg_arf are significantly related to current and future firm performance. Specifically, managers tend to condense positive tone when they miss IBES expectations (ibes_miss) (t-stat = -4.95) and have more negative news to share (t-stat = -5.14). However, we find that pos_arf is only weakly associated with our measure of disaggregated performance. This evidence suggests that managers use positive tone more to reiterate improved aggregate performance than to disaggregate good news into earnings components. For negative tone dispersion, we find that the coefficient on neg_arf is smaller when firms have a larger number of improvements in components of earnings to report (t-stat = -2.85), but only marginally larger when the firm misses analysts expectations, consistent with our predictions in H1 that tone dispersion reflects managers insights about individual line items and segments. We also find that negative tone dispersion is significantly positively correlated with poor future earnings (tstat = -2.88), suggesting that negative tone dispersion is incrementally informative about future value. To investigate our evidence that managers appear to use positive tone dispersion to reiterate good aggregate earnings and negative tone dispersion to discuss bad news in earnings components, 13 We test for statistical significance of the parameter estimates by using heteroskedasticity robust standard errors in our regressions with errors clustered by firm. 20