Hypothesis testing and Regression model

In this project, the main objective is to test whether the tones of outlook narratives are
effective to predict firms future financial outcomes. In particular, by adding
additional tone variables measuring forward-looking statements level of selectivity
and vagueness in prediction model, then to see whether the models ability to separate
firms from improving financial performance firms and deteriorating financial
performance has been significantly improved or not.
The null hypothesis is:
H 0 : By adding tone variables will not make the logistic regression model more
effectively in predicting the sign of the change in next years operating income.
We firstly employ a logistic regression model with financial statement variables, and
then run it again by adding three forward-looking narratives tone variables. The crosssectional logistic regression model shows as following:
+
Y = 0 + i FS i+ pos POS + neu NEU +
i

Where Y is the change of operating income. between 2006 and 2007;

FSi is the ith

financial statement variable; POS, NEU and NEG are the total number of positive,
neutral, and negative forward-looking statements in the annual report outlook section.
The significant level is chosen at 10% for this regression model.
Explanations of Dependent & Independent variables:
In the prediction model, we use financial performance change between 2006-2007 as
a dependent variable to test the models ability to prediction. Particularly, we use
earning as the key element of a firms financial performance, based on Schleichers
study (2007), the permanent earnings is measured by Worldscope item 01250 which is
operating income before all exceptional items, hence, earning is highly correlated
with operating income, and we test next years change in operating income Y. Y is
treated as a kind of dummy variable that when there is an increase in next year
earning (Y =1); otherwise (Y =0) for a decrease in next years earning. We run one

more regression with sales as dependent variable to test

There are two parts of independent variables: financial statement variables and tone
variables. Firstly, in order to obtain financial statements variables we follow a similar
selection procedure as Ou and Penman (1989), after narrow down the 69 potential
candidate variables to 5 significant variables by a univariate regression. Secondly, we
run a multivariate regression include these 5 significant variables from last step to
further narrow down to 3 significant variables. They are ITEM1 Current ratio,
ITEM3 Quick ratio and ITEM55 Working capital/total assets. Then we run two
more multivariate regressions, one with only these 3 significant financial statement
variables, while one adding additional tone variables. The final step is to calculate and
compare the difference in -2LL between the two regressions, and analyze the results
in likelihood ratio test and P-value.