A content analysis of discretionary narrative disclosures

Explores whether the firm's discretionary narrative disclosures measure its financial risk of bankruptcy. Specifically examines the existence of an association between the content of the chairman's statement and firm failure. Show that these statements are closely associated with financial performance, reinforcing the argument that such unaudited disclosures contain important information. The results have implications both for the form and content of future narrative disclosures by management. Introduction Annual reports might variously be viewed as `̀ an undisguised advertisement'' or as `̀ platforms for preaching [management's] philosophies and [for] touting themselves and their companies'' (Ingram and Frazier, 1983, p. 49). Conventional wisdom sees accounting narratives in such reports as `̀ carefully crafted public relations documents with little, if any, substantive content'' (McConnell et al., 1986). Research evidence, however, suggests that discretionary narrative disclosures in annual reports are of great importance even for skilled users such as financial analysts who are among the prime users of financial accounting information (Schipper, 1991). Rogers and Grant (1997, p. 3), for example, in their detailed comparison of the content of company annual reports and associated sell-side analyst reports conclude that the narrative sections of the annual report (the president's letter, management discussion and analysis (MD&A) etc.) provide almost twice the amount of quoted information as do the basic financial statements. On average narrative sections of the annual reports they study contain no less than 40 per cent of the information cited by their analysts (p. 21). Abrahamson and Amir (1996), in their study of the information content of the president's letter to shareholders, highlight the importance of textual portions of This paper has benefited from comments and suggestions from participants at research seminars at Murdoch University, Polytechnic University of Hong Kong, City University, London and The London School of Economics and at the British Accounting Association, European Accounting Association, ICAEW Research Board, AAANZ and Institute for Quantitative Investment Research conferences. The authors are also indebted to GaeÂtan Breton, David Citron, Keith Houghton, S.P. Kothari, Baruch Lev and two anonymous referees for comments on earlier drafts. Discretionary narrative disclosures 625 annual reports to investors. In a parallel study Bryan (1997) suggests firms' MD&A disclosures can assist in assessing their short-term prospects. This paper is concerned explicitly with the question of whether the firm's discretionary narrative disclosures are able to measure financial risk of bankruptcy, a key dimension of concern to annual report users. Specifically we explore the association of the chairman's statement alone with subsequent corporate failure. Whereas there is an extensive literature (see e.g. Jones (1987) and Altman (1993) for surveys) demonstrating the information content of formal financial disclosures in the form of accounting ratios for prediction purposes, little comparable attention has been paid to the potential information content of the firm's discretionary narrative disclosures, although Smith and Taffler (1992) demonstrate a link between readability of narrative and corporate bankruptcy. The study most directly related to this paper is that of Tennyson et al. (1990) who explore the relationship between the firm's narrative disclosures and bankruptcy using a content analysis approach. However, their empirical results are disappointing, attributable, inter alia, to the method they use. This research, in contrast, finds that the chairman's statement alone is highly associated with the event of firm failure, reinforcing the argument that such unaudited narrative disclosures contain important information associated with the future of the company and are not just reporting on past performance. A second contribution of the study is methodological both in building on and overcoming the problems in previous applications of content analysis in accounting and finance, and comparing the operational utility of alternative approaches. The next section reviews previous work, discusses the content analytic method, and derives our hypotheses. The research method section then details sample selection, choice of variables, data collection and statistical procedures. The following section presents our statistical models and formally tests our hypotheses, and the results are discussed. The paper concludes with a summary of our findings and a review of their implications for accounting practice. Literature review Jones and Shoemaker (1994) provide a general overview of empirical accounting narrative analytic studies. Kelly-Newton (1980) adopts a content analysis procedure to the measurement of themes in her analysis of the general comments section of a sample of replacement cost footnotes examining management reaction to disclosure requirements. Ingram and Frazier (1980) conduct a content analysis of firm environmental disclosures and the same authors (Ingram and Frazier, 1983) also report an explanatory study linking narrative disclosures with firm performance across three industries. Frazier et al. (1984) explore the use of the WORDS package, originally developed for use in a psychoanalytic environment, in the analysis of accounting narrative. In the managerial literature Bettman and Weitz (1983), Staw et al. (1983), Salancik and Meindl (1984), Clapham and Schwenk (1991) and Abrahamson and