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Is Tone at the Top Associated with Financial Reporting Aggressiveness?

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Abstract

The discussion about the relationship between tone at the top and financial reporting practices has been primarily focused on the oversight role played by the board of directors and other structural elements of corporate governance. Another relevant determinant of tone at the top is the corporate narrative language, since it is a fundamental way in which the chief executive officer (CEO) enacts leadership. In this study, we empirically explore the association between financial reporting aggressiveness and five thematic indicators capturing different traits of ethical leadership from 535 annual letters to shareholders. We find that aggressive financial reporting is positively associated with CEO letters using a language which is resolute, complex, and not engaging. Our empirical findings highlight the importance of examining discretionary corporate narratives for the auditing process and the role of tone at the top in influencing accounting practices.

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Notes

  1. According to Amernic and Craig (2006), it is incorrect to assume CEOs are not the actual authors of CEO letters. Although they could be crafted by professional writers, CEO letters are perceived by stakeholders as expressions of CEOs’ leadership. Moreover, Geppert and Lawrence (2008) show that CEOs employ CEO letters as a reputation management tool and many empirical studies confirm that investors’ decisions rely on narrative corporate disclosure (e.g., Baginski et al. 2004; Henry 2008; Hutton et al. 2003; Matsumoto and Chen 2006).

  2. Dictionaries are consistently rooted in semantic theory and avoid inter-rater reliability problems caused by the use of subjective coding (Davis et al. 2012). Based on multiple linguistic dictionaries (Short and Palmer 2008), DICTION overcomes the synonymy issue affecting most syntactic analyses, especially readability scores (Henry 2008). The synonymy issue affects textual-analysis instruments based on term frequency counts as they fail to capture similarity of terms which are, however, captured by lexical analysis instruments based on dictionaries. This theoretical rigor and objectivity allow for application on large samples and enhance empirical comparability of results. Finally, DICTION leads to interdisciplinary research by bridging the gap between linguistic and business literature (Sydserff and Weetman 2002). Patelli and Pedrini (2013), Bligh and Hess (2007), and Yuthas et al. (2002) offer further explanations of the application of DICTION to corporate narratives.

  3. Specifically, Sydserff and Weetman (2002) used the Chairmen’s statements and managers’ reports of 26 small UK investment trusts, whereas Yuthas et al. (2002) used the CEO letters and Management Discussion & Analysis sections in the annual reports of seven pairs of US publicly traded firms reporting a very bad or very good earnings surprise.

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Acknowledgments

The authors would like to acknowledge Amanda Murphy, Hugh Grove, two anonymous reviewers, the discussant, and participants of the 2013 Accounting Ethics Symposium organized by the Centre for Accounting Ethics of the University of Waterloo for their helpful comments on previous versions of this manuscript.

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Authors and Affiliations

  1. School of Accountancy, Daniels College of Business, University of Denver, 2101 S University Blvd., Suite #360, Denver, CO, 80208, USA

    Lorenzo Patelli

  2. ALTIS-Postgraduate School Business and Society, Università Cattolica del Sacro Cuore, Via San Vittore 18, 20123, Milan, Italy

    Matteo Pedrini

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Correspondence to Lorenzo Patelli.

Appendices

Appendix 1. Example of Quotes from CEO Letters Related to DICTION Master Variables

Activity

«We are demonstrating to the marketplace that Pitney Bowes is broadening its value proposition, from simply making customers more productive to also helping them drive revenue growth. We are moving to establish ourselves as the one company that integrates every customer touch point: mail, the Web, mobile devices, even retail locations. By doing so, we are creating new opportunities for ourselves and our customers»

[Pitney Bowes—Annual Report 2009]

«In addressing these matters, we have taken strong action to bolster our program management processes and functional oversight, applied additional resources and technical expertise and made leadership changes where we believed it was necessary to drive better performance from our teams»

[Boeing Company—Annual Report 2008]

«Another big area of change. We want to make not just this quarter, but this quarter next year, the year after, and 5 years from now. That means always thinking about the future today. That head-set was in short supply last time for a variety of reasons»

[Honeywell International Inc.—Annual Report 2008]

«The major changes taking place in the industry and the Company’s own transformation have not distracted the Lear team from keeping its focus on efficiently managing the business. In all respects, Lear is operating as lean as possible, but we are mindful that the present pace of industry sales and production does not reflect the longer-term run rate»

[Lear Corporation—Annual Report 2009]

Optimism

«We remained focused, disciplined and on point to operate and develop the natural gas infrastructure vitally needed in North America—infrastructure that provides significant, ongoing value to our customers and investors. We delivered on the commitments we made to you last year. More importantly, we set a forward course that will allow us to manage through the chaos and thrive when the clouds clear»

[Spectra Energy Corp.—Annual Report 2008]

«Although we are not immune to the recession, we continued to enjoy strong growth in 2008. Total revenues rose 14.6 percent to $87.5 billion. Driven in part by record operating margins, net earnings increased 21.8 percent. A number of factors fueled our margin gains, with continued growth in generic drugs leading the way. Along with our strong free cash flow generation, I’m happy to report that we faced virtually none of the liquidity issues that sent shockwaves across so much of the business landscape in 2008. CVS Caremark has a solid balance sheet and an investment grade credit rating, and we maintain a commercial paper program currently backed by $4 billion in committed bank facilities»

[CVS Caremark Corp.—Annual Report 2008]

«We look back at 2009 with sincere thanks for all that they accomplished and ahead with great anticipation for what they will achieve. We are well positioned to stay, happy and produce long-lasting results and sustained shareholder value»

[Petsmart Inc.—Annual Report 2009]

«While the challenges of operating a business on a global scale are great, I am confident that our opportunities are even greater, and that we are well positioned to make the most of those opportunities»

[Lauder (Estee) Companies Inc.—Annual Report 2008]

Realism

«I am particularly pleased to report that, despite these challenges, we again delivered strong growth in fiscal 2008, with adjusted results at the high end of our long-term targets for sales and earnings. Sales increased 8 percent 1 to $7.998 billion, and adjusted net earnings per share rose 7 percent to $2.09.2 Our US Soup, Sauces and Beverages business delivered increased sales of 5 percent; our Baking and Snacking business delivered increased sales of 11 percent (6 percent excluding the impact of currency); and our International Soup, Sauces and Beverages business delivered increased sales of 15 percent (4 percent excluding the impact of currency)»

[Campbell Soup Corp.—Annual Report 2008]

«We have reduced our net debt position significantly and have focused our debt prepayments on loans with the highest interest rates and nearest maturities. As a result, all meaningful debt maturities have been satisfied until 2013. Positive free cash flow from operations, primarily generated from our aggressive management of working capital during 2009, along with proceeds from the settlements mentioned above, have enabled us to continue paying our full dividend»

[Huntsman Corp.—Annual Report 2008]

«It will come as no surprise to you that 2009 was a challenging year for businesses around the world. Xerox was no exception. As the recession took its toll, customers pulled back from making new investments in technology, used their current technology less and sought to reduce spending wherever they could. As a consequence, total revenue for the year was $15.2 billion, down 14 percent from the previous year. To help offset this recessionary impact on revenue, we focused intently on reducing costs and generating cash—taking tough actions to weather the storm while prioritizing investments to accelerate growth»

[Xerox Corp.—Annual Report 2009]

«These volatile external headwinds also impacted our operating margin results. For the first three quarters of the year, we tracked ahead of our full-year operating margin goal to approach 2005’s level of 14 %. However, the negative impact of foreign currency exchange and slowing local currency revenue growth significantly affected fourth-quarter profits. As a result, we achieved a full-year 2008 operating margin of 12.5 %, below our original expectation but still a full 370-basis point improvement over 2007’s operating margin of 8.8 %»

[Avon Products Inc.—Annual Report 2008]

Commonality

«In the process, we’ve created a new operating culture—a new environment based on open lines of communication and more effective, analytically-based decision making. This new dynamic contributed significantly to our success in 2009 as we led the publicly traded hospital industry in same hospital admission growth»

[Health Management Associates Inc.—Annual Report 2009]

«We were able to do so because our employees remained focused and executed on our mission. They are to be commended. This year will be challenging as well. We will remain focused on operating excellence, innovative but conservative commercial execution, environmental leadership and customer satisfaction, while continuing to deliver shareholder value»

[Calpine Corp.—Annual Report 2009]

«In closing, I would like to acknowledge the hard work and enthusiastic support of our 197,000 employees. They are the primary reason we have been successful in the past, and they are the key to our future. On behalf of the Safeway team, I can assure you that we are committed to enhancing the customer experience and will work hard to deliver stockholder value in 2009 and beyond»

[Safeway Inc.—Annual Report 2008]

«We thank our 238,000 employees for their hard work and commitment to serving our customers well. And to you, our shareholders, we thank you for your continued interest in Walgreens and for your belief in the Company’s ongoing success»

[Walgreen Corp.—Annual Report 2009]

Certainty

«By capitalizing on our core strengths, we regularly exceed the expectations of our clients. As one of the few “true” large national civil and building general contractors, we rely most on our human capital to lead us through the daily challenges of project execution. We are rich in talent and are ready and able to tackle any project put in front of us»

[Tutor Perini Corp.—Annual Report 2009]

«We believe that we continue to have very exciting growth opportunities in Canada. We operate successfully in six countries and are one of the few American retailers to have expanded profitably internationally. In Europe, where our growth potential is vast, we plan to net 54 additional stores in 2010. Accelerating Store Growth With over 2,700 stores today, we believe we have the potential to ultimately grow to over 4,200 stores with just our current portfolio, in just our current markets»

[TJX Companies Inc.—Annual Report 2009]

«This new digital world is an enormous opportunity, and we continue to change News Corporation to take advantage of it. As we work to provide our customers with the quality they expect from our brands, we are fortunate to have a terrific management team. This team has been strengthened with the return of Chase Carey as president and chief operating officer»

[News Corp.—Annual Report 2009]

«Despite the recession, we achieved year-over-year profit improvement for the last two quarters of 2009, and we generated over $170 million of incremental revenue from new products and services. While the full effects of the global recession are not behind us in 2010, Hertz is a much more efficient company poised for significant growth from new revenue-generating initiatives in the car and equipment rental businesses»

[Hertz Global Holdings Inc.—Annual Report 2009]

Appendix 2. Description of F-Score

F-score is a measure of the likelihood of accounting restatements developed by Dechow et al. (2011). The authors used a sample of Accounting and Audit Enforcement Releases (AAERs) to generate a model that expresses the probability of fraud as a function of changes in the fundamentals and accounting attributes of the firm. F-scores greater than one indicate higher probabilities of misstatement than the unconditional expectation. Based on the study the authors pointed out the below formula to assess the probability of restatements.

$$F - {\text{score }} = \frac{{e^{{ ( {\text{Predicted \, value)}}}} }}{{\left( {1 + e^{{ ( {\text{Predicted \, value)}}}} } \right)}}$$

In the formula the predicted value, on the basis of a sample of 2.190 observation, is the results of seven accounting attributes (RSST accruals, change in receivables, change in inventory, percentage of soft assets, change in cash sales, change in return on assets and actual issuance). Below is the final formula to compute the predicted value.

$$\begin{gathered} {\text{Predicted value }} = {-} 7. 8 9 3 { } + 0. 7 90 \, \times \, \left( {{\text{rsst\_acc}}} \right) \, + { 2}. 5 1 8 { } \times \, \left( {{\text{ch\_rec}}} \right) \, + { 1}. 1 9 1 { } \times \, \left( {{\text{ch\_inv}}} \right) \hfill \\ + { 1}. 9 7 9 { } \times \, \left( {{\text{soft\_assets}}} \right) \, + 0. 1 7 1 { } \times \, \left( {{\text{ch\_cs}}} \right) + \, \left( {{-}0. 9 3 2} \right) \, \times \, \left( {{\text{ch\_roa}}} \right) \, + { 1}.0 2 9 { } \times \, \left( {\text{issue}} \right) \hfill \\ \end{gathered}$$

The following table summarizes the variable definitions and the abbreviations used in the formula.

Variable

Abbreviation

Calculation

RSST accruals

rsst_acc

(Δ WC + Δ NCO + Δ FIN)/Average total assets

Where:

WC = [Current assets − Cash and short-term investments] – [Current liabilities − Debt in current liabilities]

NCO = [Total assets − Current assets − Investments and advances] − [Total liabilities − Current liabilities – Long-term debt]

FIN = [Short-term investments + Long-term investments] – [Long-term debt + debt in current liabilities + Preferred stock]

Change in receivables

ch_rec

Δ Accounts receivable/Average total assets

Change in inventory

ch_inv

Δ Inventory/Average total assets

Percentage of soft assets

soft_assets

(Total assets − PP&E − Cash and cash equivalent)/Total assets

Change in cash sales

ch_cs

[Sales − Δ Accounts receivable]

Change in return on assets

ch_roa

[Earningst/Average total assetst] − [Earningst − 1/Average total assetst − 1]

Actual issuance

issue

An indicator variable coded 1 if the firm issued securities during year t.

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Patelli, L., Pedrini, M. Is Tone at the Top Associated with Financial Reporting Aggressiveness?. J Bus Ethics 126, 3–19 (2015). https://doi.org/10.1007/s10551-013-1994-6

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