The Information Content Of 10-K Narratives: Comparing MD&A And Footnotes Disclosures
University of Cambridge – Judge Business School
University of Cambridge – Judge Business School
July 10, 2016
This paper examines the characteristics and variations within firms’ 10-K filings over a 20 year time period. We find that investors’ reaction to the MD&A narrative in 10-Ks is much stronger and more timely than their reaction to the notes to the financial statements. Textual characteristics of the MD&A and footnotes are predictive of future returns, volatility, and firm profitability. Our evidence suggests that investor pay limited attention to the footnotes compared to the MD&A and that firms exploit biases in investors’ information processing through their disclosure choices within 10-K filings.
The Information Content Of 10-K Narratives: Comparing MD&A And Footnotes Disclosures – Introduction
Are companies’ annual 10-K filings informative to investors? And if so, what parts of a 10-K are informative? By the time 10-K reports are filed most of the key financial information such as earnings, sales growth etc., is already in the public domain. Not surprisingly, early evidence fails to find any significant market reaction to 10-K filings (Easton and Zmijewski, 1993) or only finds a limited reaction to these filings once prior earnings releases are taken into account (Li and Ramesh, 2009). On the other hand, more recent evidence from textual analyses of 10-K reports finds incremental information content in the tone of the text in the 10-K (Feldman, Givindaraj, Livnat, and Segal, 2010; Loughran and McDonald, 2011), in its readability (Li, 2008; Loughran and McDonald 2014), in year-on-year changes to the MD&A section (Brown and Tucker, 2011; Cohen, Malloy, and Nguyen, 2015) and in specific footnote disclosures (Peterson, 2012; Peterson, Schmardebeck, and Wilks, 2015).1 These findings seem to suggest that there is incremental information about a firm’s prospects beyond the financial statements in the narrative text of the 10-Ks.
Previous research has focused primarily on the stock market’s reaction to individual components of 10-K filings, such as the MD&A alone or particular types of footnotes (e.g. pensions, stock options, significant accounting policies) in isolation, or conversely to the 10-K filing as a single piece of homogeneous information. Yet, the psychology literature provides ample evidence that attention diverts depending on the salience of stimuli––their prominence and contrast with other information in the environment (Fiske and Taylor 1991). As a result, it matters not only what is disclosed, but also where and in combination with what else. For example, if salience of the footnotes to the financial statements in the 10-K is low (or lower than of the Management Discussion and Analysis), investors might fail to process the information provided in them; or if information is abstract and heavily loaded with statistical and quantitative data, people tend to underweight it in their decision making (Kahneman and Tversky, 1973; Nisbett and Ross, 1980). As a consequence, some information in 10-Ks might be revealed less completely and less immediately in market prices because investors under-react to it (Hirshleifer 2001; Bloomfield 2002).
In this paper we examine and compare the information content of several characteristics of two of the most prominent narrative sections in 10-Ks: the Management’s Discussion & Analysis of Financial Condition and Results of Operations (commonly known as Management’s Discussion & Analysis, or the MD&A) and the Notes to the Financial Statements (footnotes). Unlike previous work, we study 10-K filings in their entirety, while controlling for correlated information within a filing (i.e., information that is reported in both the footnotes and the MD&A). Jointly examining MD&A and footnote disclosures allows us to infer which part of the narrative in a 10-K filing investors pay attention to, controlling for information characteristics in different parts of a 10-K. We study the cross-sectional variation in the market reaction to firms’ MD&A and footnote disclosures and their informativeness about future stock returns and profitability concentrating on textual characteristics of these sections within industries, within firms, and across time.
Prior evidence suggests that investors have limited attention and suffer from information processing biases when interpreting company disclosures (Hirshleifer and Teoh, 2003; Peng and Xiong 2006) and that placement and categorization of accounting information plays an important role for their interpretation (Libby, Bloomfield, and Nelson, 2002). Limited attention leads investors to use short cuts, and use information in the way it is displayed or presented instead of adjusting it if necessary (Slovic, 1972; Payne et al 1993). Information might thus not be fully processed or only processed with errors by investors.
Investors’ limited rationality then affords managers the opportunity to strategically report information to their advantage (Schrand and Walther, 2000) and to exploit differences in the visibility of disclosure outlets. For example, managers might strategically shift or omit pessimistic language from a more visible disclosure outlet to another less salient one (Davis and Tama-Sweet, 2012) or opportunistically structure annual reports to hide adverse information from investors (Li, 2008).
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