Linguistic Tone and Internal Control Reporting: Evidence from Municipal Management Discussion and Analysis Disclosures

We study the textual content of MD&A disclosures. Specifically, we model the determinants of linguistic tone (based on the fraction of positive or negative words) in municipal MD&A sections and test for associations with the reporting of future internal control weaknesses. Our evidence suggests that factors such as high unemployment, general fund deficits, and less funding from higher levels of government are associated with negative tone, based on a sample of 362 MD&A disclosures in fiscal year 2011. Our internal control analysis is consistent with positive (negative) tone in municipal MD&A disclosures being associated with fewer (more) subsequent-year internal control weaknesses after controlling for other governance, demographic, and performance factors. Our analysis also suggests that positive tone is associated with a lower probability of future general fund deficits. Our findings suggest that municipal MD&A content contains important information regarding the quality of future municipal financial reporting through internal control quality.

JEL Classifications: H83.