Financial reporting language in financial statements: Does pessimism restrict the potential for managerial opportunism?

Abstract

This study shows that the proportion of total pessimistic language is higher for companies with lower earnings manipulation and higher leverage. In contrast, high growth companies display less pessimism. Companies with higher levels of pessimism tend to display higher conservatism even if they experience bad news or low cash flows. Companies that use pessimistic language tend to display stronger corporate governance. The use of pessimistic language is positively associated with forecast accuracy and analyst coverage. Annual reports tend to be more pessimistic in order to guide analysts downward and reach target earnings. Companies that meet or just beat analysts' forecasts tend to use less pessimistic language. On the other hand, they are likely to use pessimistic language in order to reduce the magnitude of a negative market reaction to underperformance. This study also shows that the change of the reporting tone to pessimistic as well as the use of unexpected pessimistic language reduces the cost of equity. © 2016 Elsevier Inc.