Board Characteristics and Disclosure Tone Minna Martikainen a Antti Miihkinen b Luke Watson c Version: August 2016 Authors’ contact information: a Hanken School of Economics, (Department of Accounting, Helsinki, Finland) [email protected]b University of Florida (Fisher School of Accounting)/ Aalto University School of Business (Department of Accounting, Helsinki, Finland) [email protected]c University of Florida (Fisher School of Accounting) [email protected]Acknowledgements: We are grateful for helpful comments from participants at the 2016 AAA Annual Meeting and the 23 rd Annual Conference of the Multinational Finance Society.
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Board Characteristics and Disclosure Tone Board characteristics and disclosure tone Abstract We examine the role of corporate boards of directors in shaping disclosure tone.
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We are grateful for helpful comments from participants at the 2016 AAA Annual Meeting and the 23rd
Annual Conference of the Multinational Finance Society.
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Board characteristics and disclosure tone
Abstract
We examine the role of corporate boards of directors in shaping disclosure tone. Boards of
directors play an important governance role (Beasley, 1996), leading us to expect boards of
directors to influence financial reporting narratives. Specifically, we investigate whether the tone
of firms’ narrative disclosures provided in annual 10-K reports is associated with the age, gender
uniformity, human capital, and turnover of its board of directors. Analyzing a large sample of SEC
registrants from 2003 to 2014, the results indicate that directors’ age is negatively associated with
negative, positive and uncertain disclosure tone, but positively associated with litigious tone. These
results are consistent with older directors being risk averse, contributing to cautious reporting.
Meanwhile, directors’ gender uniformity and human capital are positively associated with all four
types of tone: negative, positive, uncertain, and litigious, indicative of richer narrative disclosures.
Board turnover is positively associated with negative and litigious tone yet negatively associated
with positive and uncertain tone, suggesting that new directors bring their own disclosure styles
that fade over time. Overall, our study helps decode the “black box” of disclosure tone which
Loughran and McDonald (2011) show has important economic implications.
Keywords: Board of directors, annual report, 10-K, tone, narrative disclosure
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Board characteristics and disclosure tone
1. Introduction
Disclosures help firms provide relevant and precise information to market participants.
Narrative disclosures such as those found in annual 10-K reports allow firms to place quantitative
disclosures in context and provide additional information. Although earnings and other news
releases occur prior to the 10-K, the additional context offered by the annual report is valuable to
market participants. Specifically, Loughran and McDonald (2011) show that the tone of annual
reports is associated with firms’ future financial performance, volatility, fraud, and material
weaknesses, suggesting that there is important information in annual reports incremental to that
found in earnings announcements. Since annual report tone has economic consequences and is a
product of individuals' writing and editing, how individuals' characteristics contribute to tone is a
natural and important question that we investigate in this paper.
Large sample studies on disclosure tone focus primarily on the economic consequences of
tone and/or style in financial reports, suggesting that tone and/or style matters and provides
additional information in addition to quantitative information (e.g. Tetlock, 2007; Cecchini et al.
2011; Loughran and McDonald, 2011; Yang, 2012). In addition, while neoclassical economic
theory contends that individuals are interchangeable rational economic agents, behavioral finance
research has shown that individuals’ characteristics matter. This strand of literature tends to focus
on the influence of top executives, consistent with upper echelons theory (Hambrick and Mason,
1984; Hambrick, 2007) in which executive characteristics affect firm-level decisions. In
accounting, this literature has used a related argument known as "tone at the top" to suggest that
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managers adopt unique disclosure styles (Bamber et al., 2010; Ge et al., 2011) and also that
managers’ disclosure choices interrelate with investor sentiment (Brown et al., 2012).
Previous literature shows that boards of directors play a governance role with respect to
financial reporting (Beasley, 1996; Beasley et al., 2000), with various board characteristics
affecting the quality of reported earnings (Xie et al., 2003; Klein 2002; Peasnell et al., 2005). Our
paper builds upon this literature by investigating the role of board members in narrative
disclosures. While typically corporate executives, general counsel, and controllers play a large role
writing of annual reports, some of these individuals (especially CEOs) serve as inside directors on
the firm’s board; thus, inside directors likely have some direct involvement in the actual writing
of the 10-K.1 Likewise, outside directors play an advisory and gatekeeping role that includes
reviewing multiple drafts of annual reports, making comments and suggesting revisions thereon.
In particular, the audit committee is charged with overseeing the financial reporting process which
includes preparation of annual reports. Beyond any of these direct roles, the board’s role in the
selection of the firm’s chief financial officer and general counsel, for example, conveys an indirect
effect of the board on the firm’s annual report.
We expect certain attributes of the board to affect the tone of 10-K reports. First, we expect
that older directors’ risk aversion will produce less rich disclosures with more litigious tone as
board members reduce the informativeness of disclosures while also including language that helps
mitigate litigation risk. Second, we expect that the gender uniformity of the board will produce
richer tone as like-minded individuals disagree less and act with fewer checks on their behavior.
Third, we expect that directors’ human capital will produce richer, more informative content as
more competent, valuable directors write more strongly. Fourth, we expect that recent board
1 Inside (outside) directors are also known as executive (non-executive) directors.
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turnover will increase the richness of disclosure as new members bring their own disclosure styles
and reconsider boilerplate text.
We proxy for board characteristics using directors’ average age (capturing risk aversion),
male-to-female ratio (uniformity), education and chief financial officer experience (human
capital), and attrition rate (turnover). We compute these characteristics at three levels within the
board of directors: (i) inside director(s); (ii) outside directors not on the audit committee; and (iii)
outside directors on the audit committee. We examine four specific aspects of tone (negative,
positive, uncertain, and litigious) using the dictionaries developed by Loughran and McDonald
(2011). The target sample consists of SEC registrants between 2003 and 2014. We retrieve board
characteristics from BoardEx and control variables from Compustat, yielding a main sample of
22,748 firm-year observations. We estimate OLS regression analyses of disclosure tone on board
member characteristics and control variables to inform our inferences.
The results show that directors’ experience and risk aversion, as measured by average age,
is associated with disclosure tone. Board age is negatively associated with negative, positive, and
uncertain disclosure tone, with these results being strongest for inside directors. Outside director
age is positively associated with litigious disclosure tone. These results highlight the cautiousness
that comes with experience and risk aversion. That is, older board members make fewer positive
or negative assertions, refrain from uncertain language, and are more likely to discuss the legal
environment.2,3 These results support our prediction that more risk averse, experienced boards
produce disclosures containing less rich language that may not be useful to investors.
2 The dictionary for litigiousness reflects propensity for legal contest. 3 Disclosure tone is ostensibly the end result of management intentions, board member requirements, and the efforts
of the internal investor communication department and/or external investor relations communications agencies. In this
paper we implicitly assume that board members are advisors to management and gatekeepers of information that is
provided to investors.
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Next, we show that uniformity, as measured by the board’s male-to-female-ratio, is
associated with disclosure tone. Our results show that inside director uniformity is positively
associated with uncertain tone. We find that outside director uniformity is positively associated
with negative, positive, and uncertain tone. The associations with negative and uncertain tone are
likewise observed in the audit committee. Our results combine to suggest that director uniformity
leads to richer language in annual reports, consistent with similar viewpoints across the board.
Our next set of tests indicates that board members’ human capital is related to disclosure
tone. Specifically, board members’ average education is positively associated with negative,
positive, uncertain, and litigious tone, suggesting that highly educated board members have greater
ability and/or willingness to provide rich information. We find some evidence of incremental
effects of directors’ experience in chief financial officer (CFO) roles in that non-audit committee
members with CFO experience help produce incrementally more negative and uncertain tone.
Next we examine board turnover using the extent of yearly changes in the members of the
board. The results provide evidence that attrition is positively associated with negative and
litigious tone across all three director groups. We also detect a negative association between inside
director attrition and positive tone. Finally, we find a negative association between director
turnover and uncertain tone. Taken together, the evidence is consistent with our expectation that
new board members bring new disclosure styles to the board. These findings may also be at least
partly attributed to financial distress because board turnover is likely higher in distressed firms,
and financial distress is also likely to increase (decrease) the use of negative (positive) language.
In addition to controlling for financial performance in our main test, we examine this possibility
further by conditioning our sample on the sign of earnings in supplemental analyses. Among loss
firms we find that inside director attrition remains positively and significantly associated with
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negative tone; meanwhile, among profitable firms, a similar association manifests for both inside
and outside directors. These results are consistent with board turnover adding richness to
disclosures regardless of firm performance. We further subject our results to a slate of
supplemental analyses, including Impact Threshold for a Confounding Variable analysis, and find
that our results appear robust. Nonetheless, we emphasize that our findings are associations and
not necessarily causal relations.
Our study contributes to the extant literature by identifying an important role the board of
directors plays in advising and monitoring the firm. We show that disclosure tone is significantly
associated with board member characteristics, which is meaningful given prior research that
reports on the economic consequences of disclosure tone and/or style (e.g., Tetlock, 2007;
Loughran and McDonald, 2011; Yang, 2012). Given this research concluding that tone matters,
we help uncover the drivers of tone. This study also contributes to literature on the role of
individual managers in influencing firms’ disclosure choices and style (Bertrand and Schoar, 2003;
Bamber et al., 2010; Ge et al., 2011), complementing and extending it by examining the role played
by the board. We show that the managerial traits of inside directors that affect disclosure can
manifest incrementally in outside directors both on and off the audit committee. Our results suggest
that future researchers should consider influence of outside directors on firm disclosure and
choices, as we show that their influence is incremental to the more commonly investigated
influence of top executives. Finally, our study relates to the line of research documenting the
effects of board characteristics on firm outcomes in general (e.g., Ahern and Dittmar 2012). These
studies inform corporate boards, shareholders, search agencies, and other parties looking to elect
and retain directors who will benefit the firm across multiple dimensions. We identify specific
director traits that are associated with various aspects of disclosure tone. To the extent that
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stakeholders find these aspects of disclosure tone desirable or undesirable, they should select or
avoid these director traits.
The remainder of the paper is structured as follows. Section 2 reviews prior literature and
develops the hypotheses. Section 3 explains the methodology and variable definitions. Section 4
discusses the sample and descriptive statistics. We discuss the results or our empirical tests in
Section 5 and conclude the paper in Section 6.
2. Literature Review and Hypothesis Development
2.1. Corporate disclosure choices and disclosure tone
Early disclosure literature predicts that information problems in capital markets are non-
existent (Grossman, 1981; Milgrom, 1981) because under the unraveling result theorem, firms are
motivated to disclose all relevant information. These disclosure models generally assume that
disclosures are costless and investors know that a firm has information. Verrecchia (1983) and
Dye (1985) discard such assumptions in pursuit of a theoretical foundation for research on
corporate disclosure. The growing body of empirical research in the area has provided evidence of
a wide array of determinants of disclosure choices (Beyer et al., 2010). Firm size is a common
determinant of disclosure choices (e.g., Brammer and Pavelin, 2006; Lang and Lundholm, 1993;
Miihkinen, 2012). Other documented drivers for disclosure choices include profitability (e.g.,
Prencipe, 2004), external financing needs (e.g. Lang and Lundholm, 1993), and risk characteristics
such as bankruptcy risk, business risk and systematic risk (Jorgensen and Kirschenheiter, 2003;
Linsley and Shrives, 2006; Dobler et al., 2011; Miihkinen, 2012). Recent evidence also identifies
a limited set of corporate governance factors that influence disclosure. For example, Xie et al.
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(2003) conclude that board and audit committee characteristics may constrain managers’
propensity to manage earnings. Gul and Leung (2004) suggest that CEO duality is related to lower
levels of voluntary corporate disclosures, although this association is moderated by the expertise
of the outside directors.
Certain economic consequences of disclosure tone are clearly identified in prior research.
Antweiler and Frank (2004) find that stock-related messages posted on Yahoo! message forums
help predict market volatility. Tetlock (2007) analyses the pessimism of Wall Street Journal
columns and finds that high media pessimism can predict stock prices. Brown and Tucker (2011)
study the informativeness of firms’ Management Discussion and Analysis (MD&A) disclosures
within Form 10-K and find that changes in disclosures are positively related to economic changes.
However, they also find that despite the increasing trend in MD&A length over time, the degree
to which MD&A changes from year to year is decreasing, indicative of a decline in the usefulness
of MD&A.
Loughran and McDonald (2011) demonstrate that MD&A does not provide superior
information to whole 10-Ks. Their analyses of 10-Ks provide evidence that negativity as measured
by the Harvard Psychological Dictionary is not associated with 10-K filing returns but they create
a new dictionary that is able to detect such a relation. They also develop five additional dictionaries
(positive, uncertainty, litigious, strong modal, and weak modal) and provide evidence that these
lists can gauge disclosure tone.4
4 Disclosure tone can be used as a proxy for several developments in the firms’ operating environment. Law and Mills
(2015) use Loughran and McDonald’s dictionary for negative words and show that financially constrained firms (as
measured by the ratio of negative words in the annual reports) pursue more aggressive tax planning strategies.
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To this point, despite many meaningful studies on disclosure tone, research on the
influence of corporate leadership on tone is extremely limited. Patelli and Pedrini (2015) suggest
that tone of the top may be determined by both board of directors and chief executive officers.
They argue that the tone of the CEO letters is one fundamental way for directors to enact
leadership. They also provide empirical evidence that aggressive financial reporting is positively
associated with language that is resolute, complex, and not engaging. Bozzolan et al. (2015) report
that the management of the Fiat Group uses disclosure tone strategically to implement different
disclosure styles to communicate with various stakeholders (i.e., local press, international press,
and financial analysts) with different levels of salience and optimism. Thus, existing literature
implies that management and directors help set disclosure tone. However, to our knowledge, no
study has yet conducted a detailed analysis of the role of the board of directors in setting disclosure
tone. We pursue this research question in the context of certain board characteristics, which we
discuss in greater detail below.
2.2. Board member experience and risk aversion
Prior literature argues that risk aversion increases with age (Vroom and Pahl, 1971). Older
managers are often considered to be more sensible and prudent whereas younger and more
inexperienced managers are prone to take greater risks (Menkhoff et al., 2006). Further, the
experience gained by older directors should be helpful in advisory and monitoring capacities.
Older individuals are less tolerant of uncertainty (Jost, Glaser, Kruganski, and Sulloway, 2003).
For all these reasons, directors’ age could affect aspects of disclosure tone.
We expect that the risk aversion, sensibility and experience of older board members will
result in more moderate (i.e., less negative and less positive) tone. Meanwhile, we expect that the
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conservatism and lack of tolerance for uncertainty that comes with age will result in less uncertain
tone. Last, we expect that the risk aversion and experience of older board members will result in
more litigious tone as the board seeks to resolve doubt about the legal environment. These
expectations lead to the following empirical prediction:
H1: Board member age is associated with disclosure tone.
Whether age actually affects disclosure tone is uncertain for several reasons. Intellectual
curiosity and information processing ability decline with age (Roberts, Walton, and Viechtbauer,
2006), contributing to an increase in conservatism; however, older individuals use experience to
effectively overcome their slower information-processing ability. Older board members who are
close to retirement may be prone to moral hazard problems; for example, they might have already
established status and lack motivation to affect the disclosure choices of the firm. There is also
evidence that managerial turnover is more performance sensitive for younger managers (Chevalier
and Ellison, 1996), suggesting reduced threat of termination and perhaps lower motivation for
older board members.
2.3. Board member uniformity
In general, corporate boards are demographically quite uniform. One potentially important
departure from board uniformity is the participation of female board members. Corporate boards
are slowly becoming more diverse (i.e. less uniform), as females made up less than five percent of
directors in 1984 (Bilimoria and Piderit 1994) but comprise nearly nine percent of our sample.
This emerging diversity has the potential to affect board decisions, and we evaluate its effect on
annual report tone. While psychological studies have disproven many perceived cognitive
differences between the sexes (e.g., Spelke 2005), it is possible that differences arise through
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specific cognitive or experiential means. For instance, Barber and Odean (2001) suggest that men
are generally more overconfident than women in a financial context. Likewise, uniformity makes
it less likely that directors bring a range of experiences and skill sets to the board, making like-
minded thinking more prevalent. Thus, we expect that the overconfidence and similar experiences
of uniform boards result in more emphatic tone, leading to our next hypothesis:
H2: Board uniformity is associated with disclosure tone.
Although we expect uniformity to affect tone, there are reasons to believe otherwise.
Bilimoria and Piderit (1994) indicate that female directors experience sex-based bias that could
limit their effects. Ahern and Dittmar (2011) note that female board members tend to be younger
and less experienced, which could limit their voice in the firm relative to older, more experienced
directors.
2.4. Board members’ human capital
The competence of the board is a function of directors’ knowledge of the firm, their general
managerial capability and human capital (Boyatzis et al., 2002). Board members’ human capital
could positively affect disclosure tone for two main reasons. First, board members’ human capital
is a source of competitive advantage (Khanna, Jones, and Boivie, 2014). Martikainen et al. (2015)
demonstrate that the breadth of risk disclosure coverage is negatively associated with directors’
human capital, suggesting more focused risk discussions consistent with superior judgment. To
the extent that managers and fellow directors recognize these advantages, directors with significant
human capital will be more influential as their peers value their input. Second, human capital is
associated with stronger writing skills throughout one’s adult life (Kaufman, Kaufman, Liu, and
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Johnson 2009). We expect that stronger writing skills associated with human capital will manifest
in the form of richer language either through direct involvement in actual writing or through the
reviewing of multiple drafts. Both of these reasons suggest greater tone across all dimensions:
positive, negative, uncertain, and litigious. We predict the following:
H3: Board members’ human capital is associated with disclosure tone.
We would not expect to find this relation if human capital causes overanalysis, leading to
weaker language. Further, if part of the competitive advantage attributable to human capital is in
protecting trade secrets, disclosures may actually be more opaque and therefore less tonal in the
presence of directors with significant human capital.
2.5 Board member turnover
Board member turnover is likely to affect disclosure tone because following turnover, new
directors are likely to join the board of directors. Their fresh perspective and new experience will
alter the collective makeup of the board. For instance, Hambrick et al. (1993) show that executives’
tenure in the organization, is positively related to commitment to the status quo, suggesting that
board member tenure would be negatively associated with richness of disclosure tone. Therefore,
we expect that the addition of outsiders will also prompt reevaluation of boilerplate disclosures
(Brown and Tucker, 2011), thus increasing the richness of disclosure tone. We predict the
following:
H4: Board member turnover is associated with disclosure tone.
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Despite our expectation, it is not assured that board turnover affects disclosure tone. New
board members’ contributions may be discounted relative to those of established, trusted directors.
New board members also lack familiarity with the specific firm and thus may produce more
boilerplate disclosures.
In the next section, we describe the research design we use to test our hypotheses.
3. Research Design
3.1. Disclosure tone in large sample studies
Beginning with Antweiler and Frank (2004) and Tetlock (2007), disclosure tone has
become a popular method for analyzing the sentiment of disclosures because it can be examined
through automated content analysis in large sample studies. As described in Li (2010b) and
summarized in Purda and Skillicorn (2015), two main streams for analyzing disclosure tone in
large sample studies prevail. The first approach builds on the existing literature in linguistics and
psychology. In this approach, a scholar uses a manually created dictionary that (s)he predicts to be
associated with a particular disclosure sentiment such as negativity. Dictionaries refer to
predefined lists of words, also known as "bags of words.” The appearance of these words in
financial reports is then automatically analyzed. This approach has been used in Tetlock (2007),
Pennebaker et al. (2007), Loughran and McDonald (2011), and Larcker and Zakolyukina (2012),
for example. The advantage of predefined word lists is that they are replicable and their effects
have been scientifically proven. Yet context is important to consider, as words relevant to financial
disclosures may have different meanings or importance in other contexts. Loughran and McDonald
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(2011) show in a large sample of 10-Ks that almost three-fourths of the words identified as negative
by Harvard Dictionary are irrelevant in a financial context, leading them to develop alternative
word lists that better capture tone in financial texts. We follow Loughran and McDonald (2011)
and use their financial-text-specific tone measures.5
The second approach employs statistical methods to let the data determine which words
are relevant. The origins of this method are in computer science but recently it has been used to
analyze the tone of business texts (Antweiler and Frank, 2004; Li, 2010a; Cecchini et al., 2010;
Goel et al., 2010; Humphreys et al., 2011). Data-generated world lists may permit higher
coverage; however, they can be criticized for a failure to specifically address different areas of
disclosure tone, and it can be unclear what their word lists capture. Sometimes both predefined
word lists and data-generated word lists are used in parallel (Goel et al., 2010; Humphreys et al.,
2011). Since we are interested in identifying predicted relations between specific board
characteristics and specific aspects of tone, we employ the first approach.
3.2. Measures of disclosure tone
We use the following four tone measures for firms’ annual reports (10-K and 10-K405)
computed by Loughran and McDonald (2011): negative, positive, uncertainty and litigious. For
example, the dictionary of negative words contains a list of words and word combinations that
normally signify negativity in a financial context (see Equation 1a). We compute the applied tone
measures by dividing the number of specific tonal words in a given filing by the number of total
5 We thank Bill McDonald for making the tone measures and dictionaries available. They can be downloaded from
his website (http://www3.nd.edu/~mcdonald).
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words in that filing. This procedure gives us the following measures which we use as the dependent
variables in the study6:
Negativity_ratio = ratio of negative words to total words in the firm’s annual report
Attrition_ACOM 0.023 0.152 This table reports the ITCV-index and threshold correlation (th_corr) for each statistically significant board characteristic from
each of the four tone regressions in Table 3. ITCV-index is the lowest product of the partial correlation between the outcome
variable and the confounding variable and the partial correlation between the treatment variable and the confounding variable
which makes the coefficient on the treatment variable statistically insignificant at the 5% level. th_corr is the square root of the
absolute value of ITCV-index, which gives the minimum correlations necessary between the confounding variable and both the
outcome and treatment variables for the relation between the treatment variable and outcome variable to become statistically