Unexpected Disclosure Tone Volatility and Investor Risk Assessment

We examine whether and how the unexpected (i.e., discretionary) portion of firms’ disclosure tone volatility is useful in assessing firm risk, and therefore cost of capital. Unexpected volatility in qualitative disclosure tone should reflect a manager’s effort to convey their firm’s underlying performance in a way that is incremental to quantitative measures. However, managers also face incentives to obscure underlying performance and therefore disclosure tone volatility may not be associated with firm risk. After controlling for traditional quantitative and qualitative measures of firm risk, we find that the unexpected portion of disclosure tone volatility provides information useful in assessing cost of capital. In additional analysis, we find that this association is concentrated in firms that also disclose more useful earnings information (i.e., firms that do not appear to smooth their earnings). This result suggests that firms that obscure quantitative information (i.e., smooth earnings) also obscure qualitative information (i.e., smooth tone). Finally, we find evidence that investors do not fully incorporate the information conveyed by unexpected disclosure tone volatility into their assessments of cost of capital, but instead appear to incorporate the information with delay. Overall, our results suggest that – on average – firms moderate the unexpected (i.e., discretionary) portion of their disclosure tone volatility to meaningfully reflect firm risk, and that investors do not fully react to this signal.

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