Financial Reporting and Firm Valuation: Relevance Lost or Relevance Regained?

In this study, I examine whether balance sheet and income statement numbers have lost or regained their relevance over the last 30 years. Institutional and macroeconomic factors like the global trend towards strengthening regulation and harmonising financial reporting, the extended use of fair values over historical cost, and the recurring occurrence of accounting scandals, market bubbles, and financial crises make it likely that the role of financial reporting for firm valuation has changed. Following prior research, I estimate four models for the concurrent relation between market value and accounting numbers, and then examine the pattern in explanatory power over time. I find that the loss in relevance of the income statement continues in recent years and is present in a large international sample, in particular in countries with strong institutions. While the overall relevance of the balance sheet remains stable, I find a downward trend during the first sample half, which reverses in the second half, especially in common law countries with strong investor protection, strict disclosure requirements, and integrated markets. Even though several caveats apply, the results suggest that changes in the economy, the institutional environment, and in how firms operate affect the relative importance of accounting information for the use in firm valuation by outside stakeholders

Discussion of Investor Protection and Analysts’ Cash Flow Forecasts Around the World

DeFond and Hung [DeFond, M., & Hung, M. (2007). Review of Accounting Studies, 12 (this issue)] test the conjecture whether financial analysts, due to demand-side pressure, compensate for the limited usefulness of reported earnings by issuing cash flow forecasts. They find that analysts supplement their earnings forecasts more frequently with cash flow forecasts in countries where antidirector rights and legal enforcement quality are poor. In my discussion, I examine their hypothesis development and empirical research design and try to extend their arguments to a time-series setting. As it turns out, the paper’s main contention critically hinges on two assumptions: (1) investors’ unsatisfied demand for accounting information and (2) their willingness to rely on cash flow forecasts as valuable information signals. The descriptive validity of these assumptions in an international context is a priori not obvious. I then test whether substantial changes in investor protection and/or earnings quality relate to changes in the frequency of cash flow forecasts. My analyses show that analysts’ propensity to issue cash flow forecasts increases after the first prosecution under insider trading laws, after non-U.S. firms have cross-listed their shares on a U.S. exchange, or after firms have voluntarily replaced their domestic accounting standards with IFRS or U.S. GAAP. Thus, I conclude that the reasoning behind the levels results does not simply extend to a changes setting

Dividend Payouts and Information Shocks

This paper examines changes in firms’ dividend payouts following an exogenous shock to the information environment. Traditional signaling, agency, and voluntary disclosure models predict that the more is commonly known about a firm and its competitors in the marketplace, the less private information managers will have to reveal themselves via costly signals or cash disbursements. To test these predictions, we analyze the dividend payment behavior for a global sample of firms around the mandatory adoption of IFRS and around the initial enforcement of new insider trading laws. Both events have the potential to improve the general information environment in the economy. We find that following the two events firms are less likely to pay (or increase) cash dividends, but more likely to cut (or stop) such payments. The changes in dividend policy occur around the time of the informational shock and only in countries and for firms subject to the regulatory change. In further analyses we find that the information content of dividends, measured as three-day absolute announcement returns, is lower after the informational events. The findings underscore that firms’ payout policies, among other things, depend on the extent of information about all firms in the economy

Mandatory Disclosure Quality, Inside Ownership, and Cost of Capital

This paper examines whether and how inside ownership mediates the relation between disclosure quality and the cost of capital. Both ownership and more transparent reporting have the potential to align incentives between managers and investors thereby reducing systematic risk. Employing a large global sample across 35 countries over the 1990–2004 period, we show that country-level disclosure regulation is negatively related to (i) inside ownership, and (ii) firms' implied cost of capital and realised returns. We then introduce ownership into the cost of capital model, and also find a negative relation. These relations extend to the systematic component of the cost of capital, estimated from Fama–French portfolio sorts on ownership and disclosure regulation. Thus, while the direct effect of disclosure on cost of capital is negative, the indirect effect via ownership is positive, consistent with disclosure quality and ownership acting as substitutes. Using path analysis to assess the relative magnitude, our estimates suggest that the direct effect of disclosure quality outweighs the indirect effect by a ratio of about five to one.Wharton SchoolSloan School of Managemen

Mandatory IFRS Reporting and Changes in Enforcement

In recent years, reporting under International Financial Reporting Standards (IFRS) became mandatory in many countries. The capital-market effects around this change have been extensively studied, but their sources are not yet well understood. This study aims to distinguish between several potential explanations for the observed capital-market effects. We find that, across all countries, mandatory IFRS reporting had little impact on liquidity. The liquidity effects around IFRS introduction are concentrated in the European Union (EU) and limited to five EU countries that concurrently made substantive changes in reporting enforcement. There is little evidence of liquidity benefits in IFRS countries without substantive enforcement changes even when they have strong legal and regulatory systems. Moreover, we find similar liquidity effects for firms that experience enforcement changes but do not concurrently switch to IFRS. Thus, changes in reporting enforcement or (unobserved) factors associated with these changes play a critical role for the observed liquidity benefits after mandatory IFRS adoption. In contrast, the change in accounting standards seems to have had little effect on market liquidity

Mandatory IFRS Reporting Around the World: Early Evidence on the Economic Consequences

This paper examines the economic consequences of mandatory International Financial Reporting Standards (IFRS) reporting around the world. We analyze the effects on market liquidity, cost of capital, and Tobin\u27s q in 26 countries using a large sample of firms that are mandated to adopt IFRS. We find that, on average, market liquidity increases around the time of the introduction of IFRS. We also document a decrease in firms\u27 cost of capital and an increase in equity valuations, but only if we account for the possibility that the effects occur prior to the official adoption date. Partitioning our sample, we find that the capital-market benefits occur only in countries where firms have incentives to be transparent and where legal enforcement is strong, underscoring the central importance of firms\u27 reporting incentives and countries\u27 enforcement regimes for the quality of financial reporting. Comparing mandatory and voluntary adopters, we find that the capital market effects are most pronounced for firms that voluntarily switch to IFRS, both in the year when they switch and again later, when IFRS become mandatory. While the former result is likely due to self-selection, the latter result cautions us to attribute the capital-market effects for mandatory adopters solely or even primarily to the IFRS mandate. Many adopting countries make concurrent efforts to improve enforcement and governance regimes, which likely play into our findings. Consistent with this interpretation, the estimated liquidity improvements are smaller in magnitude when we analyze them on a monthly basis, which is more likely to isolate IFRS reporting effects

A Tale of Two Supervisors: Compliance with Risk Disclosure Regulation in the Banking Sector

We examine how the presence of multiple supervisory agencies affects firm-level compliance in form and substance with disclosure regulations. This analysis is important because coordination problems among regulators are frequently present in practice but often overlooked in academic research. We exploit that banks are subject to equivalent risk disclosure rules under securities laws (IFRS 7) and banking regulation (Pillar 3 of the Basel II accord) but that different regulators start enforcing the rules at different points in time. We find that banks substantially increase their formal risk disclosures upon the adoption of Pillar 3 even if they already had to comply with the same requirements under IFRS 7. The effects are stronger if the central bank is responsible for bank supervision and bank regulators are equipped with more supervisory resources, but are less pronounced if the securities market regulator is an independent entity. In turn, banks facing more market pressures are more compliant with the rules. We further find persistent liquidity benefits of the increased risk disclosures but only after Pillar 3 became effective and its compliance was enforced by the banking regulator. Our results suggest that formal and material compliance with risk disclosure regulation are a function of both the resources of the supervisory agency and its incentive alignment with the regulated firms. In our setting, the banking regulator seems more effective in fulfilling this role