Examining the Effect of Linguistic Style in an MD&A on Stock Market Reaction

This article investigates the impact of linguistic style in the Management Discussion and Analysis of Financial Condition and Results of Operations (hereafter MD&A) section of a company's annual report on stock market response. It provides a new technique for combining qualitative with quantitative information by applying the partial least squares–structural equation modeling. In this article, we model the influence of verbal tone from the MD&A section on stock market reaction. The quantity predicted is the cumulative abnormal return as a proxy of market return, while the capital assets pricing model and volatility are a proxy of market risk. Furthermore, Future of Return on Assets is a proxy of expected future financial performance. Results show that the model for predicting future performance is considered moderate, while it is considered poor for predicting market reaction. As for the path coefficients, we find no evidence that the linguistic style in an MD&A has a significant effect on market reaction in general. The results reveal an insignificant difference between the effects of the long MD&A and the short MD&A on market reaction. However, based on the disclosure year of an MD&A, there is a significant difference between 2010 and 2012 in terms of impact on expected future performance by net optimism. Nevertheless, descriptive statistics designate that the verbal tone in an MD&A was not adequately consistent with financial performance. Therefore, it can be concluded that management writers create an MD&A as part of an annual routine just to satisfy the shareholders. Due to some limitations, these findings must be interpreted with caution