TERM PAPER (TERM IV)

TONE OF INTERIM AND ANNUAL FINANCIAL

REPORTS: EFFECT ON MARKET RETURNS

Submitted By:

Abhinav (MBA/0161/56)
Neha Kancharla (MBA/0272/56)

Project Guide:

Prof. Sudhakara Reddy

INTRODUCTION:

Information regarding a company’s performance, its financial situation, management and its
ownership structure, strategies employed and accomplishments, when delivered punctually
and accurately, is extremely essential for all stakeholders to assess the company’s progress
towards its long and short-term goals. It is also the base upon which analysts, clients and
investors build their future expectations and how the markets perceive and react to the
financial and economic situation and progress of the company

A company’s annual and quarterly reports, apart from being an important communicative
channel and a key corporate governance practice, are increasingly and cleverly being used
by the company’s management as a strategic tool to exploit information asymmetry to
influence stakeholders’ understanding of the company’s performance and to prevent any
negative market reactions to the company’s decisions and their implications.

Tone is a means through which an author may imbue a narrative with a desired connotation
or affect through word choice. Like many elements of style, tone may be deployed to aid the
dissemination of incrementally useful information or can be used strategically to influence
the perceptions of the reader about the subject matter of a narrative [1]​. In absence of strict
regulations and disclosure requirements, especially in the case of voluntary or unaudited
statements, tone management i.e making the tone disproportionately positive or negative to
the concurrent quantitative information can influence investors’ assessment of a firm’s
fundamentals by signaling misleading information and thereby impacting the market trends
giving rise to abnormal market returns.

Failure to distinguish between the fundamentals of a situation and the expectations reflected
in the asset price or by the market movement is the single most common error in investing
business. The desire to follow the trend and the potency of stories constructed to back up
the world view is the hardest to resist. Hence it is crucial to be aware of the extent to which
methods like tone management would hold over investor judgments and get in their way of
having a skeptical, logical, and accurate assessment.

While the non-discretionary tone is directly proportional to the concurrent quantitative

financial information and represents little to no surprise information, the discretionary tone
may align with either decision-useful or misleading information to influence the investors [2]​
​ .
There has been significant research done in understanding the informativeness and
accuracy of reports, we aim to study the discretionary tone of earnings reports and press
releases to assess if it is a reliable signal of future performance and earnings potential of
companies in the Indian context and its impact on the market reaction.

LITERATURE REVIEW:

Financial communication literature suggests that tone is positively associated with a firm’s
financial performance, mainly to reduce information asymmetry. Textual narratives provide
managers with the opportunity to disclose relevant information absent in the quantitative
financial reports, perhaps due to reporting constraints (Huang et al., 2014). Research (Davis
et. al., 2012) also found that the tone of US quarterly earnings press releases increases with
higher future earnings, indicating that managers regularly use tone to communicate credible
information about expected future performance.

Demers and Vega (2011) [3]​ examined the conditions under which tone of US firms’ quarterly
earnings announcements can predict future fundamentals. They found that conservative
GAAP rules prevent the earnings numbers from recognizing even highly likely future positive
news, and that managers use the textual tone to signal them instead. Li (2010) [4]​ ​ , by
analysing MD&A sections of the 10-K and 10-Q filings in the US, argues that the tone of
forward-looking statements signals future profitability, as managers use them to adjust
investor expectations. He also establishes that the tone has greater explanatory power for
future performance than current earnings, stock returns and accruals.

Huang et al. (2014) argued that non-discretionary has either a weak positive or no alignment
with financial performance of a firm while on the other hand, the discretionary tone of a
report is disproportionately positive or negative to its concurrent quantitative information.
Depending upon the managerial motives and ability, it may align with incremental decision-
useful information, misleading information or noise. Market reaction tests have been used to
indicate how investor responses align to the signal in these two tone components.

Both tone management and earnings management can be used as tools for manipulating
investor assessments, where an increase in one can substitute for the other. According to
Huang et al. (2014), to successfully influence investors' assessments of a managed earnings
result, it is important that the textual tone is not disproportionate to the reported earnings,
implying that the effect of tone management should be measured incremental to earnings
management efforts. Barinov et al. (2016) have found that the post-earnings announcement
drift is stronger for firms with a more complex operational structure due to their reduced
transparency levels and higher information asymmetry.

Sheehan Rahman (2014) [5] ​ through his text analysis of US interim reports attempted to
argue that the alignment between the discretionary tone and annual earnings is expected to
be more positive if the disclosure is released towards the end of the year than at the start.
This is primarily due to the reason that the start of the year is a highly susceptible time for
managers to purposefully or unknowingly mislead investors on the year-end results. Over
the course of the year managers learn more information, and so does the market via interim
disclosures or trading updates, which makes discretionary tone less likely to coincide with
misleading information at the end of the year. Henry et al. (2008) [6]​ report that the tone of
earnings releases is more positively correlated with the short window contemporaneous
returns around the date that the disclosures are made, even after controlling for a firm's
financial information and earnings surprises.

Das et al. (2009) [6]

​ suggests that firms which are performing poorly in interim quarters may
seek to increase earnings in the fourth quarter to meet their targets while firms performing
well in interim quarters may seek to decrease earnings in the fourth quarter to build reserves
for the future. Hence, greater earnings management efforts towards the year-end are likely
to diminish tone management incentives, making the alignment between discretionary tone
and annual earnings more positive towards the year-end compared to the start of the year.
METHODOLOGY:

a) Textual Analysis and Tone Scores:

We have chosen the firms included in the NIFTY 50 index in the year 2019 for analysis. Due
to the lack of availability of a comprehensive database of financial reports filed by Indian
companies from where the data download could be automated, like the SEC EDGAR API,
we manually downloaded annual reports of each of the chosen companies from their official
websites in a pdf format. We collected the annual reports of 47 companies for FY’14 - FY’19.

We have tried to obtain tone scores using the popular sentiment analysis tools on the web.
However, as most of these tools use in-built dictionaries and wordlists, they were not yielding
accurate results to be applied in the context of financial statements. Hence, writing a code
became important to use our own wordlist for finance-specific text analysis.

PDFs are notoriously difficult to scrape and data in text files can make analysis significantly
easier and accurate. We developed a Python code for automating the data cleaning process
to generate text to be used for the tone analysis. We primarily used the PDFMiner tool in the
code such that the annual reports can be stored in a directory, whose address can be input
into the code, and it iterates through each of the pdfs stored in the folder and converts them
into text files. On running the code once, it extracts all the text (excluding text in images) in
the pdfs that are to be rendered programmatically as unicode strings, removes all the noise
in the data i.e punctuations, special characters, and numbers, and tokenizes the data into
individual words in each line and writes them onto text files for each onto an output directory.

We used Dictionary-based sentiment analysis for generating tone scores for each report. We
used two well-known lexicons, Bing Liu’s Sentiment Dictionary [7] ​ and Loughran-McDonald
Master Dictionary [8]
​ for tone analysis. Bing Liu’s Dictionary is a list of 2006 positive and 4783
negative words compiled over 15+ years and is widely used in sentiment or opinion analysis
in several fields of study. The LoughranMcDonald Master Dictionary was developed in
conjunction with a paper published in the Journal of Finance 2011 and has been modified
throughout the years to classify words into lists with 2355 negative, 354 positive, 297
uncertainty, 904 litigious, 19 strong modal, 27 weak modal and 184 constraining sentiments.
This sentiment lexicon has been created primarily for the analysis of financial documents.

We developed a Python code for analysis by comparing data in the tokenized wordlist with
both the dictionaries and evaluating the number of matches for the same. We decided upon
analyzing at the word-level as the level of accuracy achieved with it was higher than a
sentence-level or paragraph-level analysis. By running the code once, using the text files
directory as input address, it iterates through all the files to generate the tone output with
respect to each classification in both dictionaries, to an excel file.

We have adopted the method of Rahman et al. (2019) [9] ​ for the tone analysis. Based on the
output number of words indicating the sentiment in each document, we calculated the Tone
score which ranges between [-1, +1] for each firm in each year as follows:

TONE = (Positive - Negative) / (Positive + Negative)

​……… Equation 1
b) Discretionary and Non-Discretionary Tone Score:

We have used the process of Huang et al. (2014) to decompose the Tone Score into
Discretionary (Abnormal) and the Non-discretionary (Normal) tone scores as ABTONE and
NTONE respectively. We did this by regression analysis of TONE with the following
variables from the analysis of Sheehan Rahman (2014) for each firm for each financial year:

TONE = ​𝛂 ​+ 𝛃​1 EARN + 𝛃​2 STDEARN + 𝛃​3 CHEARN + 𝛃​4 RETURNS + 𝛃​5 SIZE + 𝛃​6 SIZE +
𝛃​7​ BTM + 𝛃​8​ LOSS + 𝛃​9​ AGE + ε ​……… Equation 2

Based on this equation, NTONE is calculated as the predicted value while ABTONE is the
regression residual. This analysis was done using MS - Excel VBA tool. The sample set for
the regression was 4 years data for the NIFTY 50 companies whose tone score had been
extracted in the previous step. The relevant financial data was extracted from the database
CMIE Prowess. The required metrics such as returns, age, etc. were computed using the
extracted data. These metrics were then fitted through regression to compute the various 𝛃​i​.

Variable Definition

TONE Net tone score computed as the difference between the number of positive
and negative words in a document divided by their sum

NTONE The normal component of tone, derived from the expected tone model

ABTONE The abnormal component of tone, calculated as TONE - NTONE

EARN Earnings before extraordinary items divided by beginning total assets

STDEARN Standard deviation of EARN over the past five years

CHEARN Annual change in earnings before extraordinary items divided by beginning

total assets

RETURNS Annual buy-and-hold returns

SIZE Natural logarithm of market value of equity

BTM Book-to-market value of equity

LOSS Indicator variable taking the value of 1 if EARN is negative, and 0 otherwise

AGE Natural logarithm of (1+number of years since the firm’s inception)

c) Predicting Future Earnings:

To examine the association between abnormal tone and future earnings, we used the
following regression equation:
EARN​t+1 = [​𝛂 ​+ 𝛃​1 ABTONE + 𝛃​2 NTONE + 𝛃​3 EARN + 𝛃​4 SIZE+ 𝛃​5 BTM + 𝛃​6 RETURNS + 𝛃​7
STDEARN + 𝛃​8​ AGE + ε]​t​ ​……… Equation 3
The 𝛃​i in ​Equation 1 were used not only to get ABTONE score but also to further compute
Regression 𝛃​i for the future earnings in ​Equation 2.​ We used the regression model to predict
the earnings of the next one-year only because prior research suggests that the vast
majority of forward-looking sentiment words in a firm’s report do not extend beyond one
year.

RESULTS:

As mentioned above, the analysis was performed using two different dictionaries of wordlists
(Bing Liu and LoughranMcDonald Dictionaries). For both of them, the regression statistics
and results are presented below in Tables 1 to 4.

The LoughranMcDonald Master Dictionary was used to arrive at the following:

Table 1: Descriptive Statistics for Regression of Tone Scores with Financial Variables
(Equation 2)
Descriptive Statistics of the Mean Std. Dev Median Minimum Maximum
variables’ ​𝛃​i (00s)

TONE 0.03 0.04 0.03 -0.15 0.12

EARN -0.01 0.08 0.00 -0.54 0.00

STDEARN 0.00 0.01 0.00 -0.02 0.03

CHEARN 0.04 0.61 0.07 -2.03 2.96

RETURNS 0.02 0.32 0.00 -0.97 0.78

SIZE -0.03 0.30 -0.22 -0.74 1.17

BTM -0.15 0.61 0.00 -2.93 0.59

LOSS 0.00 0.00 0.00 0.00 0.00

AGE 0.03 0.17 0.00 0.00 1.18

ALPHA -0.68 3.74 -37.25 -10.51 7.91

Table 2: Descriptive Statistics for Regression of Future Earnings with Tone Scores and
Financial Variables​ (Equation 3)
Descriptive Statistics of the Mean Std. Dev Median Minimum Maximum
variables’ ​𝛃​i (00s)

ABTONE 0.00 0.03 0.00 -0.18 0.00

 NTONE 0.00 0.00 0.00 0.00 0.00

EARN -0.01 0.10 0.01 -0.29 0.24

SIZE 0.04 0.44 0.48 -1.74 2.41

BTM 0.02 0.27 0.00 -0.66 1.00

RETURNS -0.02 0.09 0.00 -0.58 0.00

STDEARN 0.00 0.02 0.00 0.00 0.12

AGE -0.01 0.16 0.00 -0.64 0.75

ALPHA -0.60 3.42 -5.47 -12.72 5.66

The Bing Liu’s Sentiment Dictionary was used to arrive at the following:

Table 3: Descriptive Statistics for Regression of Tone Score with the Financial Variables
(Equation 2)
Descriptive Statistics of the Mean Std. Dev Median Minimum Maximum
variables’ ​𝛃​i (00s)

TONE -0.38 0.06 -0.39 -0.58 -0.09

EARN -0.01 0.06 0.00 -0.40 0.00

STDEARN 0.00 0.00 0.00 -0.02 0.01

CHEARN 0.05 0.62 -0.17 -1.38 3.68

RETURNS 0.11 0.34 0.00 -0.40 1.59

SIZE -0.02 0.16 0.00 -0.57 0.34

BTM -0.05 0.35 0.00 -2.05 0.60

LOSS 0.00 0.00 0.00 0.00 0.00

AGE -0.02 0.16 0.00 -1.11 0.00

ALPHA -1.25 4.39 0.44 -23.55 4.80

Table 4: Descriptive Statistics for Regression of Future Earnings with Tone Score and
Financial Variables ​(Equation 3)
Descriptive Statistics of the Mean Std. Dev Median Minimum Maximum
variables’ ​𝛃​i (00s)
 ABTONE 0.02 0.19 0.00 -0.18 1.33

NTONE 0.00 0.00 0.00 0.00 0.00

EARN -0.03 0.22 0.01 -1.37 0.24

SIZE 0.01 0.54 0.60 -2.60 2.41

BTM 0.04 0.34 0.00 -0.66 1.39

RETURNS -0.02 0.09 0.00 -0.58 0.00

STDEARN 0.00 0.03 0.00 0.00 0.17

AGE -0.01 0.07 0.00 -0.38 0.18

ALPHA -0.65 3.89 -0.64 -14.82 7.28

The above results does not suggest any meaningful correlation between annual earnings
and the Tone Scores (ABTONE and NTONE) using both the dictionaries. Because of the
small sample size of testing variables, the results are not concrete. The expected result was
to accurately predict the next year returns through the previous year regressed tone series.
But since we have only 4 years data, the regression was not yielding satisfactory results. A
good sample size would be 15 years data points or to include the 4 years’ interim (quarterly)
reports in the data sample. As discussed in various research papers, the returns should be
predicted with accuracy of 0.5%, while in our results, there is a 0.7% approximate error.
Un-tabulated correlation coefficients indicate that abnormal positivity (abnormal negativity) is
overall in line with the tone of the positive (negative) clauses .

FURTHER IMPROVEMENTS:

The explanatory power and accuracy of the model can be improved in the following ways:

1. Most of the signaling for performance expectations by the companies seems to be

done in the Management Discussion and Analysis section of the reports. Collecting
and analysing only the text only in the MD&A may give a clearer picture of the tone
management being done by these companies.
2. We attempted to create some domain-specific lexicons, wordlists can be improved to
be used in finance-specific use-cases. Accuracy can be tested using software and
tools like DICTION or IBM Tone Analyzer etc
3. The sample set for analysis must consist of companies other than those included in
the NIFTY 50 index. These stocks are heavily audited and regulated, and may have
little tone manipulation in their annual reports. Comparing the extent of association of
abnormal tone and earnings for Non-Nifty vs Nifty stocks can give us more insights
4. Using more data points: Data of at least the past 15 years financial performance (or 4
years’ data including interim reports) needs to be used in the model for obtaining
concrete results in the regression.
 5. Results may be more relevant if Quarterly reports or announcements to the investors
are used for analysis. Research shows that companies tend to manipulate their
performance in the first quarter and in the interim reports which are not very
stringently regulated or audited. By using this model with interim reports, we can
establish the quarter in which a firm’s managers are likely to manipulate investors
and if there is a positive alignment between discretionary tone and earnings at the
end of the financial year where there is a chance of earnings management as well.
6. The regression analysis can be improved using more explanatory variables. Although
we did take into account most of the factors like annual returns, book-to-market value
of equity etc, the model may be more accurate if variables that capture some kind of
analyst expectations can be included. These variables could indicate unexpected
earnings, analyst consensus EPS etc
7. For predicting the correlation with future earnings, some more variables capturing
information or earnings management such as discretionary accruals or pre-managed
profit levels can be used in the regression analysis. Also, rather than trying to predict
the year’s return, the model may be more useful in predicting contemporaneous
market returns.
8. Sample can be divided into categories to derive insights if manipulation through tone
is being done during crises or if it is more prominent in a particular industry or with
firms of a particular size or age.

REFERENCES:

Python Code and Excel Model used in this analysis

1) Merkl-Davies, D., & Brennan, N. (2007). Discretionary disclosure strategies in

corporate narratives: Incremental information or impression management? Journal of
Accounting Literature, 26, 116-194
2) Huang, X., Teoh, S. H., & Zhang, Y. (2014). Tone management. The Accounting
Review, 89(3), 1083–1113
3) Demers, E., & Vega, C. (2011). Linguistic tone in earnings announcements: News or
noise? Working paper
4) Li, F. (2010). The information content of forward-looking statements in corporate
filings—A naïve Bayesian machine learnings approach. Journal of Accounting
Research, 48(5), 1049–1102
5) Rahman, Sheehan. (2019). Discretionary tone, annual earnings and market returns:
Evidence from UK Interim Management Statements. International Review of
Financial Analysis. 65. 101384. 10.1016/j.irfa.2019.101384
6) Henry, E. (2008). Are investors influenced by how earnings press releases are
written? Journal of Business Communication, 45(4), 363–407
7) https://www.cs.uic.edu/~liub/FBS/sentiment-analysis.html
8) https://sraf.nd.edu/textual-analysis/resources/#Master%20Dictionary
9) Rahman, S., Schleicher, T., & Walker, M. (2019). Comparing manual against
automated measures of the tone of interim management statements: A market-based
approach. Working paper. Brunel University London