Financial Reporting Quality and Market Liquidity Relationships

Abstract

This research investigates the nuanced relationship between financial reporting
quality and market liquidity by introducing a novel methodological framework that
integrates principles from information theory, computational linguistics, and network
analysis. Departing from traditional accounting-based metrics, we propose a multidimensional quality construct that captures the semantic richness, predictive coherence, and contextual transparency of financial disclosures. Our methodology employs
a hybrid approach combining natural language processing techniques to analyze the
narrative sections of annual reports with quantitative analysis of traditional financial
metrics. We develop a proprietary corpus of 10-K filings from S&P 500 companies spanning 1995-2004 and apply latent semantic analysis, sentiment trajectory mapping, and
information entropy measures to extract previously unexamined quality dimensions.
The research addresses three primary questions: (1) How do qualitative narrative elements of financial reports influence market makers’ pricing decisions beyond quantitative metrics? (2) What specific linguistic and structural features of disclosures most
significantly affect bid-ask spreads and trading volumes? (3) How does the temporal
consistency of information presentation across reporting periods impact liquidity provision? Our findings reveal that syntactic complexity, forward-looking statement density,
and risk factor clustering explain significant variation in liquidity measures beyond traditional accruals-based quality metrics. We document a non-linear relationship where
moderate increases in disclosure complexity initially improve liquidity, but excessive
complexity beyond certain thresholds creates information processing costs that reduce
market efficiency. The study contributes original insights by demonstrating how the
architecture of financial information—specifically its narrative organization and temporal coherence—serves as a critical but previously overlooked determinant of market
liquidity. These findings have important implications for regulators, standard-setters,
and corporate disclosure practices seeking to optimize the liquidity benefits of financial
reporting.