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Investor protection and price informativeness about future earnings: international evidence

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Abstract

This study draws on the investor protection literature to identify structural factors in a country’s information environment that are likely to explain cross-country differences in the extent to which future earnings information is capitalized in current stock returns. Using a sample of 55,900 firm-years from 32 countries, we find that greater financial disclosure, higher quality earnings, and greater information dissemination through news media are associated with stock prices that are more informative about future earnings, whereas strong enforcement of insider trading laws is associated with stock prices that are less informative about future earnings. We also find that, on average, price informativeness about future earnings is greater in countries with strong investor protection. Our results illuminate the importance of structural factors constituting a country’s information environment in explaining cross-country variation in price informativeness about future earnings.

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Notes

  1. We use the terms “informativeness of stock prices (or current returns) about future earnings” or “price informativeness about future earnings,” interchangeably throughout the paper.

  2. For example, see Ettredge et al. (2005), Gelb and Zarowin (2002), Lundholm and Myers (2002), Tucker and Zarowin (2006), and Choi et al. (2011).

  3. The CIFAR index was originally created by rating a set of companies’ 1993 annual reports with respect to the inclusion or omission of 90 items that fall into seven categories (general information, income statements, balance sheets, fund flow statements, accounting standards, stock data, and special items). It is widely used in prior literature to capture the extent of corporate disclosure at the country level (Bushman et al. 2004; DeFond et al. 2007; La Porta et al. 1998).

  4. We consider the CIFAR index as representing the general disclosure environment in a country while Bushman et al.’s index (DISC) better reflects the disclosure environment on a firm’s proprietary information.

  5. Managers may use discretionary accruals to convey value-relevant information (Watts and Zimmerman 1986; Badertscher et al. 2010). However, it is unclear whether such an informational perspective can be extended to an international setting outside the US (Leuz et al. 2003).

  6. Following Kothari et al. (2005), we regress total accruals (TA) on the change in sales (∆Sales), gross property, plant, and equipment (PPE), and return on assets (ROA), where all of the variables except ROA are scaled by lagged total assets. We estimate this regression model cross-sectionally for each 2-digit SIC industry and year combination.

  7. We also adopt the aggregate earnings management scores from Leuz et al. (2003) as an alternative proxy for earnings quality and find qualitatively similar results.

  8. Two other commonly used measures of private information acquisition are the trading and trade-generating activities of financial analysts and institutional investors, both of which actively participate in collecting, processing, and interpreting private information (Bushman et al. 2004). We use the country-level average number of analyst following as an alternative measure in the sensitivity analysis and find an insignificant relation between analyst following and price informativeness. Our results on the other structural variables remain qualitatively unchanged. We are not able to empirically examine the trading activities of institutional investors due to the data constraint.

  9. DeFond et al. (2007) provide compelling evidence that strict enforcement of insider trading laws strengthens the informativeness of annual earnings announcements in their event study because effective insider trading regulation prevents earnings information from being impounded into stock prices before the announcements are issued. Although we predict that enforcement of insider trading rules reduces price informativeness about future earnings, our underlying rationale for the prediction is consistent with that of DeFond et al. (2007), which states enforcement of insider trading laws constrains insider trading and, consequently, reduces the likelihood that information about future earnings has already been impounded in stock prices.

  10. Alternatively, we deflate lagged earnings, current earnings, and future earnings by the average market value of equity for year t−1, year t, and years t+1/t+2/t+3, respectively. The results are qualitatively unchanged. Note that year refers to a fiscal year throughout the paper.

  11. Morck et al. (2000) and Jin and Myers (2006) show that stock market synchronicity as an inverse measure of firm-specific information varies significantly across countries and over time. Piotroski and Roulstone (2004) and Chan and Hameed (2006) further suggest that industry peers show significant co-movement in the informativeness of stock prices. Thus, it is crucial to control for potential differences and changes in operating and stock performance across industries and countries over the sample period before drawing any inferences from our empirical analyses.

  12. Model (2) does not include country fixed effects because they are linearly dependent on the time-invariant country-level structural variables (i.e., DISC and MEDIA). For the same reason, we do not include country fixed effects in model (4).

  13. In addition, firm-specific variables provide finer and more detailed data than country-average variables. Garrett (2003) suggests that a firm-level regression is likely to provide a better specification as it measures variables for each firm (i.e., disaggregated), whereas in a country-level regression the dependent and independent variables are based on the average within each country (i.e., aggregated).

  14. The Asian financial crisis, which occurred in 1997, influenced the past, current, and three-year future earnings of the deleted observations between 1994 and 1998. However, the results are qualitatively similar without the exclusion of these observations.

  15. Our results are robust when we do not delete the extreme earnings observations.

  16. We use all firm-year observations that have the requisite return and earnings data to calculate the industry-adjusted variables. The full sample in Table 1 that requires structural and control variables is smaller than the initial sample that we use for the industry adjustment. Hence, not all of the industry-adjusted variables have a zero mean in Table 1, although they do in the initial sample.

  17. Alternatively, we transform each of the return and earnings variables into rank variables within each industry-country-year group. The results from rank-transformed regressions are qualitatively similar to those reported in this paper.

  18. Country-level structural variables exhibit small variations compared with firm-level variables. For example, 15 out of 32 countries have the highest financial disclosure index (i.e., DISC = 100), and 12 countries prosecuted their first insider trading case over 3 years from 1994 to 1996. In addition, the standard deviations of earnings quality (EQ) and media coverage (MEDIA) are much lower than their mean absolute values. As a result, the power of the tests is likely to be low.

  19. Our additional analysis indicates that country-level clustering of standard errors is more serious than firm-level clustering in our cross-country analyses. For example, when we adjust standard errors for firm and year clustering, the t-statistics for the coefficients on X t and X3 t in the pooled sample analysis are 15.87 and 13.54, respectively, which are substantially higher than those reported in Table 3, Panel A (2.92 and 3.53, respectively). Thus, our reported t-statistics appear to be more conservative.

  20. Similar methodology is used in DeFond et al. (2007) and Morck et al. (2000).

  21. We repeat the same analysis using an alternative measure of capital market development: the average of the ratio of stock market capitalization held by small shareholders to GDP in the 1996-2000 period (La Porta et al. 2006). Though not tabulated for brevity, the results are qualitatively similar to those reported in this paper.

  22. Following Tucker and Zarowin (2006), we measure the degree of income smoothing by the inverse correlation between a firm’s change in discretionary accruals and its change in pre-discretionary income over a four-year window ending in year t. We transform firm-level IS into fractional ranks within each industry-country-year group for the firm-level regression and transform the country mean of IS into country-level fractional ranks within each year for the country-level regression.

  23. Consistent with Tucker and Zarowin (2006), the coefficient on IS t *X3 t is positive and significant at the 10% level when we include income smoothing as the sole determinant of price informativeness or when we include country-level structural factors as well as income smoothing (without firm-level control variables) in the FERC model. As shown in column (1) of Table 6, however, the significant effect of income smoothing disappears when we include both structural factors and firm-level characteristics. The effect of income smoothing on price informativeness could be weaker for the non-US firms operating under varying degrees of investor protection than for the US firms examined by Tucker and Zarowin (2006). However, we should be cautious in making an inference on IS t *X3 t because a much smaller subsample is used for the income smoothing test in this international setting. Our additional tests show that this subsample is significantly different from the full sample used to test our hypotheses along firm dimensions such as firm size, profitability, growth opportunity, performance volatility, operating cycle, leverage, financing needs, and equity issuance.

  24. The results are qualitatively similar when we weigh the country-year FERC by the inverse of its standard error.

  25. The results remain unchanged if we apply weighted least squares (WLS) procedures to the regressions in Table 5.

  26. We also investigate whether there has been any prosecution against insider trading in those countries in recent years. We search for new enforcement cases against insider trading using the Lexus-Nexus database and find no instances of new cases in these countries.

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Acknowledgments

We thank Richard Sloan (editor), two anonymous referees, Bin Ke, Larry Lang, Gordon Richardson, T.J. Wong, and workshop participants at Chinese University of Hong Kong, Shanghai University of Finance and Economics, and the First International Symposium of Accounting and Finance at Shantou University for constructive comments and suggestions. In-Mu Haw gratefully acknowledges financial support from Texas Christian University. Bingbing Hu and Jay Junghun Lee gratefully acknowledge financial support from Hong Kong Baptist University. Woody Wu gratefully acknowledges financial support from Chinese University of Hong Kong.

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Authors and Affiliations

  1. Department of Accounting, Neeley School of Business, Texas Christian University, Fort Worth, TX, 76129, USA

    In-Mu Haw

  2. Department of Accountancy and Law, Hong Kong Baptist University, 34 Renfrew Road, Kowloon Tong, Hong Kong SAR

    Bingbing Hu & Jay Junghun Lee

  3. School of Accountancy, Chinese University of Hong Kong, 12 Chak Cheung Street, Shatin, Hong Kong SAR

    Woody Wu

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  1. In-Mu Haw
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Correspondence to In-Mu Haw.

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Haw, IM., Hu, B., Lee, J.J. et al. Investor protection and price informativeness about future earnings: international evidence. Rev Account Stud 17, 389–419 (2012). https://doi.org/10.1007/s11142-012-9181-z

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