Examining the relationship between earning management and market liquidity

The main purpose of this paper is to argue the extent that earnings management lowers liquidity. It should increase information asymmetry and impair trading liquidity. Using a sample of French firms from 2008 to 2011, we find that firms that manage earnings have wider bid-ask spreads. Our results are robust for both of two well-established measures of market liquidity. Therefore, the empirical results indicate that firms that exhibit greater earnings management are associated with lower market liquidity. These findings are in line with adverse selection and shed light on the role corporate governance devices can play in the consideration of shareholder interest’s protection, which leads to improved stock market liquidity levels.     

Liquidity, analysts, and institutional ownership

In this paper, we investigate the empirical relationship between institutional ownership, number of analysts following and stock market liquidity. We find that firms with larger number of financial analysts following have wider spreads, lower market quality index, and larger price impact of trades. However, we find that firms with higher institutional ownership have narrower spreads, higher market quality index, and smaller price impact of trades. In addition, we show that changes in our liquidity measures are significantly related to changes in institutional ownership over time. These results suggest that firms may alleviate information asymmetry and improve stock market liquidity by increasing institutional ownership. Our results are remarkably robust to different measures of liquidity and measures of information asymmetry.     

The 2000 presidential election and the information cost of sensitive versus non-sensitive S&P 500 stocks

We investigate the information cost of stock trading during the 2000 presidential election. We find that the uncertainty of the election induces information asymmetry of politically sensitive firms under the Bush/Gore platforms. The unusual delay in election results creates a significant increase in the adverse selection component of the trading cost of politically sensitive stocks. Cross-sectional variations in bid-ask spreads are significantly and positively related to changes in information cost, controlling for the effects of liquidity cost and stock characteristics. This empirical evidence is robust to different estimation methods.     

Firm Characteristics and Stock Price

This study examines the stock price reaction to the internal control reporting required under Section 404 of the Sarbanes‐Oxley Act of 2002 for three distinct groups of firms. After controlling for general stock price movements, we find that stock returns are most negative for firms that delay filing of their internal control reports, continue to be negative for firms with ineffective internal controls, and are positive for firms with effective internal controls. The decrease in stock prices of the first two groups is more pronounced for those with a lower return on assets, higher growth rate in sales, and no prior disclosure of their internal controls weaknesses. Our results indicate that market participants value the reliability of financial information ensuing from Section 404 compliance, irrespective of firm size and debt proportion. Thus, regulators and policymakers worldwide should consider mandating comparable SOX 404 compliance for all publicly held companies to improve the accuracy and reliability of financial reports.     

Determinants of Trading Profits: The Liquidity Provision Decision

Theories show that liquidity provision implies negative contemporaneous correlation between trades and returns. Dealers on the Taiwan Stock Exchange are granted typical dealer trading advantages without obligations to provide liquidity and, thus, are ideal to test whether these advantages lead to voluntary liquidity provision (earning bid-ask spreads) or information trading (trading in the direction of the market). We find a strong positive correlation in aggregate, implying that these unrestricted dealers prefer information trading. We also find that smaller dealers are more likely to provide liquidity and that small-cap stocks (with larger bid-ask spreads) are more profitable for liquidity provision.     

Investor perceptions of an auditor’s adverse internal control opinion

In response to recent corporate scandals, Congress passed the Sarbanes–Oxley Act of 2002 (SOX) which, among other things, requires that the auditor render an opinion as to the effectiveness of a company’s system of internal controls. The assumption implicit in this requirement is that the new internal control opinion provides investors with value-relevant information. Our evidence suggests that an adverse audit opinion on internal control over financial reporting provides incremental value-relevant information to investors beyond that contained in the financial statement audit opinion alone. Specifically we find that an adverse audit opinion on internal controls over financial reporting relative to an unqualified opinion is significantly associated with investors assessing a higher risk of financial statement misstatement, higher risk of a future financial statement restatement, higher information asymmetry, lower financial statement transparency, higher risk premium, higher cost of capital, lower sustainability of earnings, and lower earnings predictability. Overall, our empirical results support our hypotheses that the auditor’s opinion on the internal controls over financial reporting provides financial statement users with value-relevant information.     

How Effective Is Internal Control Reporting under SOX 404? Determinants of the (Non‐)Disclosure of Existing Material Weaknesses

We study determinants of internal control reporting decisions under Section 404 of the Sarbanes‐Oxley Act (SOX 404) using a sample of restating firms whose original misstatements are linked to underlying control weaknesses. We find that only a minority of these firms acknowledge their existing control weaknesses during their misstatement periods, and that this proportion has declined over time. Further, the probability of reporting existing weaknesses is negatively associated with external capital needs, firm size, non‐audit fees, and the presence of a large audit firm; it is positively associated with financial distress, auditor effort, previously reported control weaknesses and restatements, and recent auditor and management changes. These results provide evidence that detection and disclosure incentives play a role in whether existing material weaknesses are reported, which has implications for the effectiveness of SOX 404 in providing investors with advance warning of potential accounting problems.     

Trade Disclosure,Information Learning and Securities Market Performance

In this paper we examine the effect of information disclosure on securities market performance when liquidity traders are able to acquire information about inside trading. We show that the bid-ask spread increases with the liquidity trader's learning efficiency, which is greater when trade information is disclosed. The bid-ask spread is always higher when trade information is not disclosed. However, the discrepancy between the bid-ask spreads with and without information disclosure narrows when the learning efficiency increases. We also show that the gains of the informed traders in a market without trade information disclosure are reduced in the presence of the liquidity trader's learning. Nevertheless, liquidity traders do not necessarily benefit from increased transparency. In particular, liquidity traders may face higher trading costs.     

Liquidity skewness in the London Stock Exchange

We study liquidity on the London Stock Exchange. We find that the average bid-ask spread declines, but that the skewness of the spread increases. These results are robust to firm size, trading volume and price level. Our findings hold when the bid-ask spread is estimated utilising high frequency data. We find that the bid-ask spread prior to earnings announcements dates is significantly higher than that of post earnings announcements, suggesting that asymmetric information has driven the increase in liquidity skewness. We also find that the effect of earnings announcements is more pronounced in the 2007 global financial crisis, consistent with the notion that extreme market downturns amplify asymmetric information. Our overall evidence also implies that increased competition and transparent trading environments limit market makers' abilities to cross-subsidize bid-ask spreads between periods of high and low levels of asymmetric information.     

Reporting Frequency, Information Precision and Private Information Acquisition

Abstract:  This study examines whether the choice between quarterly and semiannual reporting affects the precision of investors' information and their private information acquisition activities. In the first part of this study, we show that a firm's reporting frequency has no effect on the average precision of investors' information. However, our analysis of announcement-period price variance and share turnover shows that an increase in reporting frequency does make interim and annual financial reports a more important component of investors' information set, relative to other sources of information. In particular, the results of this analysis suggest that investors of semiannual reporters hold more precise pre-announcement information than investors of quarterly reporters. In the second part of our study, we test one explanation for this finding. We argue that an increase in a firm's reporting frequency reduces investors' incentives to acquire private information between consecutive announcement dates and, consequently, should reduce information asymmetry among investors, increase share liquidity, and stimulate trading. Consistent with this reasoning, we find that quarterly reporters have lower average bid-ask spreads and higher abnormal share turnover than semiannual reporters.     

Financial statement comparability and credit risk

Prior research shows that firms’ financial statement comparability improves the accuracy of market participants’ valuation judgments and thus may reduce firms’ costs of capital. Distinct from prior research focusing on the equity market, we develop measures of comparability relevant to debt market participants based on the within-industry variability of Moody’s adjustments to reported accounting numbers for the purposes of credit rating. We examine two sets of adjustments: (1) to the interest coverage ratio and (2) to non-recurring income items. We validate these comparability measures by providing evidence that greater comparability is associated with lower frequency and magnitude of split ratings by credit rating agencies. We predict and find that greater comparability is associated with (1) lower estimated bid-ask spreads for traded bonds, (2) lower credit spreads for both bonds and five-year credit default swaps, and (3) a steeper one- to five-year credit default swap term structure. Our results are consistent with financial statement comparability reducing debt market participants’ uncertainty about and pricing of firms’ credit risk.     

The Sarbanes‐Oxley Act of 2002 and Market Liquidity

Investors rely heavily on the trustworthiness and accuracy of corporate information to provide liquidity to the capital markets. We find that the rash of financial scandals caused a severe deterioration in market liquidity in the form of wider spreads, lower depths, and a higher adverse selection component of spreads vis‐à‐vis their benchmark levels. Regulatory responses including the Sarbanes‐Oxley Act of 2002 (SOX) had inconsequential short‐term liquidity effects but highly significant and positive long‐term liquidity effects. These liquidity improvements are positively associated with the improved quality of financial reports, several firm‐specific variables (e.g., size), and market factors (e.g., price, volatility, volume).     

Firm opacity and the opportunity cost of cash

This paper studies the causal effect of a reduction in firm opacity on asset liquidity and corporate expenditures. We employ the discontinuous requirement of financial reporting introduced by the Sarbanes-Oxley Act, Section 404, as a measure of the change in the firm's information environment. Using a regression discontinuity design, we show that firms that comply with Section 404 exhibit higher stock liquidity and increased access to external financing compared to observationally similar firms. Furthermore, compliant firms hold less liquid assets and exhibit higher R&D expenditures relative to noncompliant firms. This difference sheds light on the impact of SOX 404 on firm opacity and the magnitude of the opportunity costs of holding cash.     

Information Asymmetry Around Earnings Announcements

This study examines bid-ask spreads to determine how the anticipation and release of earnings announcements affect information asymmetry in the stock market. I use regression analysis and find that bid-ask spreads are negatively related to public information availability and positively related to earnings variability and the market reaction to prior unexpected earnings. The results suggest that firms for which earnings is expected to yield a relatively larger stock market reaction have greater information asymmetry than firms for which earnings are expected to yield a smaller market reaction.I also find that bid-ask spreads gradually increase in the four days prior to earnings announcements, and increase sharply the day prior to, the day of and the day after the earnings announcements. Bid-ask spreads seven to ten days after earnings announcements are not significantly different from bid-ask spreads seven to ten days prior to earnings announcements.     

The implications of ineffective internal control and SOX 404 reporting for financial analysts

The mandatory reporting of firms’ internal control effectiveness continues to be debated by equity market participants, U.S. regulatory agencies and oversight committees. We investigate the implications of material weaknesses in internal control and SOX 404 required reporting of such for financial analysts because analysts are important intermediaries in the U.S. capital market and it is not known whether analysts’ forecasts or coverage decisions are affected by firms’ internal control problems or reporting, respectively. Results of our empirical tests indicate that analysts provide less accurate forecasts and there is greater forecast dispersion for firms with ineffective internal control. We also find that firms that disclose internal control problems have less analyst coverage and that analyst following declines after the material weakness in internal control is disclosed. The results are robust to controlling for potential self-selection bias and management earnings guidance. Our study documents the consequences of ineffective internal control for an important class of financial statement users and suggests the required reporting on the effectiveness of internal control is beneficial to understanding the properties of analysts’ forecasts.     

The effect of external audits of internal control over financial reporting on financial reporting for clients of Big 4, Second-tier,and small audit firms

The external audit of internal control over financial reporting (ICFR) is a very expensive and contentious aspect of the Sarbanes–Oxley Act (SOX). Larger public firms were first required to file a management report on and have an external audit of ICFR in 2004. Smaller public firms were first required to file a management report on ICFR in 2007 but are exempt from the audit requirement. Whereas most related prior research investigates the combined effect of management and auditor reports on financial reporting, this study examines the distinct effect of auditor reports on reporting quality. For companies audited by small auditors, we find evidence that financial reporting quality improves with an auditor report on ICFR. We find no evidence that auditor ICFR reports improve reporting quality for clients of Big 4 or Second-tier audit firms. Our study adds to the debate on the applicability of SOX Section 404 to smaller firms.     

Liquidity in auction and specialist market structures: Evidence from the Italian bourse

Several studies find that bid-ask spreads for stocks listed on the NYSE are lower than for stocks listed on NASDAQ. While this suggests that specialist market structures provide greater liquidity than competing dealer markets, the nature of trading on the NYSE, which comprises a specialist competing with limit order flow, obfuscates the comparison. In 2001, a structural change was implemented on the Italian Bourse. Many stocks that traded in an auction market switched to a specialist market, where the specialist controls order flow. Results confirm that liquidity is significantly improved when stocks commence trading in the specialist market. Analysis of the components of the bid-ask spread reveal that the adverse selection component of the spread is significantly reduced. This evidence suggests that specialist market structures provide greater liquidity to market participants.     

Liquidity determination in an order-driven market

We exploit full order level information from an electronic FX broking system to provide a comprehensive account of the determination of its liquidity. We not only look at bid-ask spreads and trading volumes, but also study the determination of order entry rates and depth measures derived from the entire limit order book. We find strong predictability in the arrival of liquidity supply/demand events. Further, in times of low (high) liquidity, liquidity supply (demand) events are more common. In times of high trading activity and volatility, the ratio of limit to market order arrivals is high but order book spreads and depth deteriorate. These results are consistent with market order traders having better information than limit order traders.     

The skinny on the 2008 naked short-sale restrictions

On July 15, 2008, the US Securities and Exchange Commission announced temporary restrictions on naked short sales of the stocks of 19 financial firms. The restrictions offer a unique empirical setting to test Miller’s (1977) conjecture that short-sale constraints result in overpriced securities and low subsequent returns. Consistent with Miller’s overpricing hypothesis, we find evidence of a positive (negative) market reaction to the announcement (expiration) of the short-sale restrictions. Announcement returns are higher for firms that appear to be subject to more naked short selling in the days immediately preceding the announcement of the restrictions. The restrictions are successful in eliminating naked short sales for the restricted stocks, but naked short sales increase dramatically for a closely matched sample of financial firms during the restricted period. We also find that the restrictions negatively impact various measures of liquidity, including bid-ask spreads and trading volume. From a public policy perspective, our findings suggest that, at a minimum, policymakers should pause when considering further short sale restrictions.     

Initial evidence on the market impact of the XBRL mandate

In 2009, the SEC mandated that financial statements be filed using eXtensible Business Reporting Language (XBRL). The SEC contends that this new search-facilitating technology will reduce informational barriers that separate smaller, less-sophisticated investors from larger, more-sophisticated investors, thereby reducing information asymmetry. However, if some larger investors can leverage their superior resources and abilities to garner greater benefits from XBRL than smaller investors, information asymmetry is likely to increase. Using a difference-in-difference design, we find evidence of higher abnormal bid-ask spreads for XBRL adopting firms around 10-K filings in the year after the mandate, consistent with increased concerns of adverse selection. We also find a reduction in abnormal liquidity and a decrease in abnormal trading volume, particularly for small trades. Additional analyses suggest, however, that these effects may be declining somewhat in more recent years. Collectively, our evidence suggests that a reduction in investors’ data aggregation costs may not have served its intended purpose of leveling the informational playing field, at least during the initial years after mandatory adoption.