Please rotate your device to landscape mode to view the charts.

Bankruptcy in the UK: Do managers talk the talk before walking the walk?

Journal: British Journal of Management

Date: 2024

Author: Yousry Ahmed, Mohamed Elsayed, Bin Xu

Abstract:
This study examines whether managers employ the annual report textual disclosures as a conduit to communicate the probability of future corporate bankruptcy or to intentionally mislead stakeholders due to impression management incentives. We conduct various examinations around the information content of the tone conveyed by textual disclosures in the unstructured UK annual reports and the probability of corporate bankruptcy. We document that firms that communicate a more net positive tone are associated with lower bankruptcy risk. Importantly, this association is found to be stronger for firms whose managers have a lower incentive to mislead investors due to better board monitoring, stringent stock market regulation, and Big 4 audits. We also offer complementary evidence that firms conveying a more net positive tone exhibit higher future performance and earnings persistence, and lower future performance volatility. These firms are also less likely to exhibit extreme corporate policies and receive a qualified auditor’s opinion. Overall, this study sheds light on whether managers tend to inform or misinform (bury their heads in the sand) about corporate bankruptcy.

Link: Google Scholar

Background and Context

UK Bankruptcy Crisis

UK company insolvencies rose by a fifth to hit a 13-year high in 2022, raising concerns about whether corporate disclosures effectively signal bankruptcy probability.

Research Focus

This study examines whether the tone (positive vs. negative language) in UK annual reports communicates useful information about bankruptcy risk or misleads stakeholders.

Methodology

Researchers analyzed 6,900 observations from 1,424 UK-listed firms during 2003-2014, measuring how net positive tone in annual reports relates to future bankruptcy.

More Positive Tone is Associated with Lower Bankruptcy Risk

Annual Report Tone Early Warning Signal Bankruptcy Risk
  • The study found a consistent negative relationship between positive tone and bankruptcy risk across all analyses.
  • Firms that communicate a more positive tone in annual reports are significantly less likely to go bankrupt.
  • This relationship holds true when predicting bankruptcy 1-3 years ahead, showing long-term predictive power.

Chairman's Statement Has Strongest Predictive Power for Bankruptcy

  • The Chairman's Statement (Tone_Chair) has the strongest predictive power with a coefficient of -2.375.
  • All sections of the annual report show significant predictive power for bankruptcy risk.
  • Firms with top-quartile Chairman's Statement tone are 2.65 percentage points less likely to go bankrupt.

Tone's Predictive Power is Stronger Under Better Governance

  • Tone better predicts bankruptcy when firms have stronger governance mechanisms that limit impression management.
  • Main Market listing (vs. Alternative Investment Market) shows the strongest governance enhancement effect.
  • This suggests managers with less incentive to mislead provide more honest disclosure tone about bankruptcy risk.

Positive Tone Predicts Better Future Financial Performance

  • Firms with more positive tone show significantly higher future financial performance across multiple measures.
  • A one-standard-deviation increase in Tone_All is associated with a 3.3 percentage point increase in ROA.
  • Positive tone also predicts higher market-to-book ratios, supporting tone as an indicator of financial health.

Firms with Positive Tone Show Lower Performance Volatility

Positive Tone Higher Earnings Persistence Lower Return Volatility Lower Earnings Volatility Negative Tone Lower Earnings Persistence Higher Return Volatility Higher Earnings Volatility
  • Tone predicts future performance stability, with positive tone associated with lower volatility measures.
  • A one-standard-deviation increase in tone is linked to a 47.2 percentage point decrease in earnings volatility.
  • Firms with more positive tone exhibit higher earnings persistence, confirming their greater financial stability.

Contribution and Implications

  • Managers do not "bury their heads in the sand" but communicate bankruptcy risk through narrative tone.
  • Regulators and investors can incorporate textual analysis in early warning systems to identify financial distress.
  • All narrative sections of annual reports contain valuable predictive information about bankruptcy risk.
  • The tone of unstructured annual reports has predictive power beyond traditional financial metrics.
  • Better corporate governance enhances the reliability of tone as a predictor of financial health.

Data Sources

  • Visualization 1: Conceptual illustration of the relationship between report tone and bankruptcy risk.
  • Visualization 2: Based on Table 2, showing coefficients of different tone measures in predicting bankruptcy.
  • Visualization 3: Based on Table 3, showing how governance factors enhance the predictive power of tone.
  • Visualization 4: Based on Table 5, showing the relationship between tone and future firm performance measures.
  • Visualization 5: Based on Table 7, illustrating how positive tone relates to lower performance volatility.