Executive Summary: We look at how companies use the narrative MD&A in the annual report to compensate for financial statements have relatively lower information contained in the quantitative numbers themselves.
Abstract: Firms are required to provide financial information via the financial statements and the MD&A—a narrative explanation of the financial statements. Our study examines how firms use the MD&A channel when their financial statement channel is inadequate. We proxy for the adequacy of the financial statement channel by the value relevance of book value and earnings. We use several approaches to extract MD&A disclosure attributes: (1) keyword searches to identify non-GAAP disclosure, (2) supervised deep learning models to identify forward-looking statements, and (3) unsupervised topic models as well as text segmentation techniques to identify topics and topic locations. We find that firms with lower value relevance of financial statements (1) are more likely to provide non-GAAP disclosure in the MD&A, (2) include more forward-looking statements in the MD&A, and (3) use larger proportions of the MD&A to discuss intangibles and discuss them more prominently. Our findings suggest that managers use the MD&A, a relatively more flexible channel, to a greater extent to provide information when their financial statement channel is less adequate.
Citation: Brown, S. V., L. Hinson, and J. W. Tucker. 2021. Financial Statement Adequacy and Firms’ MD&A Disclosures. Working Paper.