Linguistic Tone and Internal Control Reporting: Evidence from Municipal Management Discussion and Analysis Disclosures

Abstract

We study the textual content of MD&A disclosures. Specifically, we model the determinants of linguistic tone (based on the fraction of positive or negative words) in municipal MD&A sections and test for associations with the reporting of future internal control weaknesses. Our evidence suggests that factors such as high unemployment, general fund deficits, and less funding from higher levels of government are associated with negative tone, based on a sample of 362 MD&A disclosures in fiscal year 2011. Our internal control analysis is consistent with positive (negative) tone in municipal MD&A disclosures being associated with fewer (more) subsequent-year internal control weaknesses after controlling for other governance, demographic, and performance factors. Our analysis also suggests that positive tone is associated with a lower probability of future general fund deficits. Our findings suggest that municipal MD&A content contains important information regarding the quality of future municipal financial reporting through internal control quality. JEL Classifications: H83.

Linguistic tone of management discussion and analysis disclosures and the municipal debt market

“…Following prior studies (Mayew et al , 2015; Rich et al , 2016; Allee et al , 2020), we import the Loughran and McDonald (2011) dictionary into the Linguistic Inquiry and Word Count (LIWC) software because of its applicability to a financial context [3]. Given the importance of a dictionary with the proper context (Grimmer and Stewart, 2013), we augment the Loughran and McDonald (2011) list with the government-specific words suggested in Appendix B of Rich et al (2018). Then, we identified the positive and negative words that appear in more than five percent of the sample and evaluated each for the governmental context.…”

“…Similar to corporate research, there is some evidence suggesting that MD&A tone is informative for assessing a government's financial reporting quality and organizational performance. Municipality MD&A tone is found to be negatively associated with both future reporting delay (Rich et al , 2016) and future internal control weaknesses (Rich et al , 2018). The analyses within Rich et al (2018) also show that MD&A tone is negatively associated with general fund deficits and positively associated with general fund intergovernmental revenues.…”

“…Municipality MD&A tone is found to be negatively associated with both future reporting delay (Rich et al , 2016) and future internal control weaknesses (Rich et al , 2018). The analyses within Rich et al (2018) also show that MD&A tone is negatively associated with general fund deficits and positively associated with general fund intergovernmental revenues. As governments are expected to provide services instead of being profit driven, these findings suggest that finance officers display concern when expenditures exceed revenues but express confidence when additional funding bolsters financial condition.…”

“…As governments are expected to provide services instead of being profit driven, these findings suggest that finance officers display concern when expenditures exceed revenues but express confidence when additional funding bolsters financial condition. Unlike some of the corporate studies investigating associations tone and external outcomes, Rich et al (2016, 2018) only analyze internal associations with tone. Since research has not addressed stakeholders' reactions to linguistic tone in a governmental reporting context, this study is relevant to determine how discretionary narrative disclosures are associated with several bond characteristics.…”

“…Davis et al , 2012), cost of capital (Kothari et al , 2009) and bankruptcy probability (Mayew et al , 2015). While the study of linguistic tone is less prevalent in the municipal sector, the prior literature does suggest that more positive municipal MD&A tone is associated with less future report delay (Rich et al , 2016) and fewer future internal control exceptions (Rich et al , 2018). These results imply that the positivity (negativity) of tone is associated with favorable (unfavorable) future outcomes.…”