Did the EU Transparency Directive improve financial reporting transparency? An examination of stock price informativeness and earnings quality Olena V. Watanabe School of Accountancy Robert J. Trulaske Sr. College of Business University of Missouri-Columbia [email protected] Draft Date: February 7, 2012 Preliminary and incomplete Please do not quote ___________________________________________________________________________ I am especially grateful to my dissertation chair, Inder Khurana, for his support and guidance in developing this paper. I thank the other members of my committee: Jere Francis, Raynolde Pereira, and Stephen Ferris, for their helpful comments. I also thank Vairam Arunachalam, Kyonghee Kim, Elaine Mauldin, Ken Shaw, Patrick Wheeler, May Zhang, Quihong Zhao, and workshop participants at the University of Missouri-Columbia, and Binghamton University for their comments and suggestions. All errors are my own. Did the EU Transparency Directive improve financial reporting transparency? An examination of stock price informativeness and earnings quality Abstract This paper examines the impact of a transparency regulation on stock price informativeness and earnings quality. Specifically, it focuses on the Transparency Directive (TPD), a key securities regulation implemented by EU countries in recent years, which strives to increase and improve the flow of firm-specific information by mandating broader disclosure requirements, including greater reporting frequency by public companies listed in the EU member countries. I test whether TPD improved stock price informativeness and financial reporting quality. Using a sample of 4,768 firms from 25 EU countries during the 2001-2010 time period, I find stock price informativeness improved following the implementation of TPD and that the positive relation between TPD and stock price informativeness is more pronounced for firms in countries with (i) better staffed regulatory authorities and (ii) stronger implementation and enforcement. The analysis of accrual quality and accounting conservatism is currently in progress. Overall, my findings highlight the role of enforcement in documenting the effects of regulations requiring more transparency. JEL Classification: F30, G15, G30, M4 Keywords: Synchronicity, Transparency, Securities Regulations, Disclosure, Enforcement 1 Did the EU Transparency Directive improve financial reporting transparency? An examination of stock price informativeness and earnings quality 1. Introduction Mandatory disclosure in the form of securities regulation is an attribute of most financial markets across the world. Extant research provides several reasons why mandatory disclosure is desirable. Disclosure can increase comparability across firms and aid in valuation, particularly for firms within single industry (Admati and Pfleiderer, 2000). Disclosure can also reduce the incidence of the diversion of resources by the corporate insiders (Ferrell, 2007), increase investor protection and facilitate financial development (Black, 2001; Frost, 2006). Overall, mandatory disclosure can serve to improve a firm’s information environment.1 An implicit assumption underlying this prediction is that any regulation mandating more disclosure will be sufficiently enforced to ensure firm compliance. However, enforcement regimes vary across countries and this can influence the extent to which disclosure regulation improves firm transparency (e.g. Ball et al, 2003; Leuz and Wysocki, 2008). I empirically evaluate how mandatory disclosure affects information environment in the context of the Transparency Directive adopted by the European Union (EU) in 2004. The Transparency Directive (hereafter TPD) was issued with the goal of improving disclosure for public companies trading on the EU Stock Exchanges, and achieving greater harmonization with respect to financial reporting among the EU member countries in order to improve investor protection and market efficiency (Directive 2004/109/EC). The most notable changes in financial reporting include an increase in the frequency of financial reports, additional 1 While voluntary disclosure can also provide similar benefits as mandatory disclosures, extant theory points to the existence of an internal optimal level of voluntary disclosure because of costs such as the costs of information production and dissemination (Admati and Pfleiderer, 2000), and proprietary costs (Verrechia, 1993). Managers may also limit voluntary disclosure in order to conceal consumption of firm resources for personal benefit (Hope and Thomas, 2008). 2 semi-annual disclosures of risks and uncertainties, a statement by company executives or directors in regards to the fairness of financial information presented in the reports, and the release of a company’s annual report no later than four months after its fiscal-year end (Directive 2004/109/EC). Furthermore, TPD specifies that a competent and independent authority must be created or designated by the EU member countries to supervise compliance with directive’s provisions (Directive 2004/109/EC). Therefore, as a consequence of TPD implementation, there is a significant shift in the reporting requirements for public companies in the EU. In this paper, I first examine the effect of TPD on stock price informativeness, which reflects the comovement of a firm’s stock return with market and its industry returns (Chen et al., 2007). I focus on stock price informativeness because prior research (e.g., Ferreira and Laux, 2007; Fernandes and Ferreira, 2008) has identified it as a good candidate for a summary of information flow. Other recent research (e.g., Hutton et al., 2009) shows that an earnings-based opacity measure is associated with lower stock return informativeness, indicating less revelation of firm-specific information in opaque firms. Moreover, my interest in stock price informativeness around TPD adoption stems from prior research (e.g., Tobin, 1984; Morck et al., 2000; Durnev et al., 2003; Wurgler, 2000) that views stock price as an important signal for asset allocation and regards it as crucial for efficient resource allocation. My analysis builds on prior literature that argues and finds stock price informativeness to increase in the presence of more firm-level transparency (Grossman and Stiglitz, 1980; Jin and Myers, 2006; Veldkamp, 2006; Haggard et al., 2008). I posit stock price informativeness (stock price synchronicity) to improve (decline) following the adoption of TPD.2 Given that greater oversight by newly appointed bodies and administrative penalties associated with a firm’s failure to comply with TPD are 2 To vary the exposition, I use the terms stock price informativeness and synchronicity interchangeably. Note that an increase in synchronicity implies a decline in stock price informativeness. 3 important factors that motivate firms to expend effort in implementing TPD, I posit the effect of TPD on stock price informativeness to be greater in countries which have a stronger enforcement regime in place. To evaluate the potential source of improvement in firms’ information environment, I also examine the impact of TPD on financial reporting quality. Schipper (1989) argues that earnings manipulation is possible in the presence of information asymmetry and limited disclosure. Consistent with this argument, prior research finds an expanded disclosure policy is associated with lower earnings management (e.g. Lobo and Zhou, 2001; Shaw, 2003; Jo and Kim, 2007; Francis et al., 2008). The implication is that disclosure constrains managerial reporting discretion and improves financial reporting quality. Thus, I posit accruals quality and asymmetric timeliness of loss recognition to increase following the implementation of TPD.3 I also expect the effect of TPD on financial reporting quality in the form of accruals and asymmetric timely loss recognition to be more pronounced in countries which have a stronger enforcement regime in place. I use a sample of 4,768 unique firms in 25 EU countries over the 2001-2010 time period to conduct empirical tests relating to stock price informativeness. The analysis of financial reporting quality metrics is currently in progress. Regarding stock price informativeness, I find a negative association between stock price synchronicity and the adoption of TPD, which is supportive of the argument that greater mandated disclosure contributes to greater stock price informativeness. However, I find the effect of TPD is not uniform across countries. Specifically, the relation between stock price synchronicity and TPD is more pronounced in countries with better staffing of their regulatory agencies and in countries with stronger TPD enforcement. 3 I focus on accruals quality because it provides an overall evaluation of a firm’s financial reporting quality. I focus on asymmetric timeliness of loss recognition because it captures the ability of firms to conceal bad news (Basu, 1997; Lobo and Zhou, 2006; Ball et al., 2000; Ball et al., 2003; Bushman and Piotroski, 2006). 4 Additional sensitivity analyses indicate that my results are robust to the inclusion of macroeconomic controls, such as GDP per capita growth and inflation, as well as firm fixed- effects. My findings are also not sensitive to the exclusion of financial firms, omission of UK firms from the sample, or alternative industry fixed-effects specification. My results are also robust to exclusion of pre-IFRS years. Furthermore, there is no change in qualitative inferences when I include non-EU firms