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Apr 24, 2014

The negative side of positive language

A roundup of academic research from the world of IR studies

Faced with the prospect of reporting poor earnings, firms may be tempted to mute market reaction by couching disclosures in positive language embedded in hard-to-read text – and existing market-level research suggests this can be an effective technique. A recent study in the Journal of Accounting Research, however, paints a more complex picture of the relationship between language sentiment, readability and investor sophistication.

In an experiment with MBA students, researchers find that language sentiment influences investors’ earnings judgments when readability is low, but not when readability is high. Specifically, when readability is low, disclosures brimming with positive language lead to higher earnings judgments for less sophisticated investors but lower estimates for more sophisticated ones.

The study’s authors suggest that when readability is high, the substance of a disclosure can be easily understood and the language used to frame the message becomes less relevant irrespective of investor sophistication. Language sentiment in low-readability communications, however, has a marked effect.

‘Less sophisticated investors will more readily respond to sentiment tone as they are less able to deeply process the issues being considered,’ explains study co-author Elaine Wang, an assistant professor of accounting at the University of Massachusetts Amherst.

Speed speaking

Unconscious cognitive biases can and do influence perceptions and expectations for a company. One area where these biases can be manipulated is in the structure of management’s prepared remarks during earnings conference calls.
Analyzing 36,000 conference call transcripts, Kristian Allee, assistant professor of accounting and information systems at University of Wisconsin-Madison, and Matthew DeAngelis, a doctoral student at Michigan State University, find that when CEOs spread out good news while lumping together losses, analysts’ tone during the Q&A is more optimistic and subsequent market response more positive. ‘If a manager wants to communicate bad news to the market, he/she should say it as fast as possible,’ says Allee. ‘It’s just like pulling off a Band Aid.’

The researchers find evidence that managers tend to segregate gains while integrating losses in disclosures, but Allee says they do it less than he expected. He is now turning to the question of whether strategically integrating losses is more effective at different points during a CEO’s presentation.

World o’ research 
  • Firms that practice more integrated reporting attract more long-term-oriented investors and repel the transient variety, finds a Harvard University study. George Serafeim, assistant professor of business administration, says it is changes to integrated reporting that lead to changes in investors, not the other way round. 
  • Foreign companies trading in the US present more numerical data and write more readable text in their management discussion & analysis than comparable US firms, say investigators at the University of British Columbia. They conclude that foreign firms are attempting to mitigate a home-country bias that makes US investors reluctant to hold foreign equity.
  • An experiment conducted at the University of Illinois suggests the imposition of range disclosure requirements for a manager’s communication of asset value estimates effectively disciplines managers exhibiting traits of psychopathy, narcissism and Machiavellianism. But researchers detect no change in the overall rate of investor actions against these or other managers less likely to capitalize on enhanced reporting discretion.