A Manager’s Word Choice May Help Predict Bankruptcy

January 13, 2015

Professors Bill Mayew and Mohan Venkatachalam research early warning signs of company distress

There may be a more accurate way to predict a company’s chances of bankruptcy than looking solely at its finances.

Duke University Fuqua School of Business professors Bill Mayew and  Mohan Venkatachalam, along with Ph.D. candidate Mani Sethuraman, discovered analyzing the language managers use in the reports that accompany annual financial statements can enhance bankruptcy prediction by almost 50 percent over reviewing the numbers alone.

“This suggests that management’s opinion has an important role to play in predicting bankruptcy,” Mayew said.

Their findings, “Management, Discussion & Analysis Disclosure and the Firm’s Ability to Continue as a Going Concern,” are published in the journal The Accounting Review. The team set out to measure the predictive power of voluntary disclosures in existing reports to help inform an ongoing debate in the United States over mandatory reporting.

In August 2014, the Financial Accounting Standards Board decided to begin requiring managers to report each quarter on any uncertainties that could affect their firm’s ability to survive — to remain what’s known in the accounting world as a "going concern." The order, which will become mandatory at the end of 2016, came after six years of disagreement and indecision over whether it was necessary. Supporters of the change argue managers have a duty to inform investors and creditors of what they know about the prospects of impending failure, particularly since bankruptcies often occur seemingly without warning from management or auditors. Opponents contend the information is already available in existing reports. They say the new requirement is redundant, intrusive and an unnecessary expense.

“The SEC mandates that firms should disclose risks and uncertainties, but there is always concern that companies comply with the letter of the law and not the spirit of the law,” Mayew said. “The extent to which managers provide boilerplate disclosures that are not sufficiently descriptive of the true risks the firm faces is unclear. The purpose of our study is to assess the nature of the information — if any — current disclosures provide about pending bankruptcy.”

The researchers looked at thousands of the management disclosures in annual reports, including 460 from firms that filed bankruptcy between 1995 and 2012, to see how accurately they could be used to predict bankruptcy in the following year.

The group studied four aspects of the reports, including financial statements and the auditor’s opinion plus two areas not addressed in previous research: explicit mention by management of the possibility the firm could cease operations, and the linguistic tone of the managerial disclosures.

Mayew, who in the past has studied how vocal pitch affects career prospects and leadership, is interested in how firms communicate with outside markets and the nature of that information.

“It’s the study of the words around the numbers,” he said.

The team flagged certain negatively-toned words — not just obvious harbingers such as “fail,” “bankruptcy” and “catastrophic,” but also more subtle signifiers like “renegotiate,” “unforeseen” and “challenging.”

The researchers found the textual disclosures in management reports “provide unique information to the capital market,” Mayew said. Auditors are currently tasked with assessing a firm’s ability to continue as a going concern, yet textual disclosures added predictive power over and above both financial numbers and the auditor’s going concern.

“I didn’t think it would be that powerful, to be quite honest,” Mayew said.

Mayew said the research should not be taken as supporting mandatory disclosure, pointing out that such a decision requires a careful cost benefit analysis. But, he added, the insight offered by the research adds to the debate.

“What this shows,” Mayew said, “is there’s quite a bit of potency in what managers are already saying.”

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