Opaque financial reports, R2, and crash risk☆
Introduction
Financial economists and accountants have long viewed stock price changes as tied to new information about firms’ prospects. However, Roll (1988) finds that only a relatively small portion of price movements can be explained by contemporaneous public news and speculates that traders acting on nonpublic firm-specific information could drive returns. These results have stimulated considerable interest in the relation between information and stock price dynamics and, in particular, between the R2 from a modified index-model regression and the revelation of firm-specific news. For example, Morck, Yeung, and Yu (2000) show that R2 is lower (equivalently, firm-specific return variation is higher) in countries with greater property rights accorded to arbitrageurs who trade on firm-specific information. Following up on these insights, several other papers explore the connection between R2 and various measures of opacity. Their common point of departure is the notion that greater transparency and more complete revelation of firm-specific information should reduce R2.
Opacity could, however, affect more than the second moment of stock return distributions. For example, Jin and Myers (2006) develop a model with incomplete transparency that predicts occasional (individual firm) stock price crashes as accumulated negative firm-specific information suddenly becomes publicly available. In fact, Jin and Myers find that several cross-country indicators of opacity predict crash risk. But, in comparison to the large R2 literature, the empirical relation between opacity and crashes has been largely ignored.
In this paper, we further consider the empirical link between opacity and the distribution of stock returns. Our approach differs from the existing literature in two respects. First, instead of employing marketwide measures of opacity in cross-country comparisons, we develop a measure of opacity for individual firms based on an indicator of earnings management, specifically, the prior three years’ moving sum of the absolute value of discretionary accruals. Second, we consider the empirical link between opacity and the crash risk of individual firms, a relation that is predicted by models such as that of Jin and Myers.
We demonstrate that our measure of opacity reliably predicts both R2 and crash risk. While crash risk is associated with earnings management, the incidence of large positive jumps is not. Therefore, opacity does not predict fat-tailed distributions per se but is associated specifically with crashes. Finally, we show that in the post-Sarbanes-Oxley Act (SOX) years, the relations between discretionary accruals and both R2 and crash risk essentially disappear. This pattern is consistent with the interpretation that opacity associated with earnings management has declined sharply in the post-SOX years.
These findings are significant for several reasons. First, they corroborate earlier research establishing a link between proxies for opacity and R2, but using more direct measures of opacity of particular firms. Second, they shed light on the process by which information is revealed to the market place. While it is well known that stock prices are more prone to big downward moves than upward ones (French, Schwert, and Stambaugh, 1987; Campbell and Hentschel, 1992; Bekaert and Wu, 2000), our findings indicate that this asymmetry is not due entirely to the exogenous stochastic process generating information but likely results as well from the way that firms manage the flow of information to capital markets. In particular, our findings suggest that part of the asymmetry is due to managers who are able to stockpile negative information, hiding it from investors’ view until its accumulation reaches a tipping point sufficient to result in a stock price crash (see Kothari, Shu, and Wysocki, 2007). Third, an understanding of the firm-specific characteristics that can predict extreme outcomes could be useful in portfolio and risk-management applications that focus on tail events, for example, value at risk. Similarly, option pricing depends on skewness and crash risk. So-called smirk curves have characterized the implied volatility of individual stock options as well as index options since the crash of October 1987, and they are widely held to reflect risk of future crashes (see Dumas, Fleming, and Whaley, 1998 or Bates, 2000). Again, understanding the factors that drive cross-sectional variation in such tail risk would be of obvious importance to market participants and allow for sharper option pricing.
In the next section, we review the literature on opacity and stock returns and develop our hypotheses. Section 3 provides an overview of our data, and Section 4 presents tests of our hypotheses. Section 5 summarizes and concludes.
Section snippets
Opacity and stock return distributions
The link between opacity and R2 has been extensively discussed in the literature. When less firm-specific information is publicly available, fewer observable reasons exist for individual stock returns to depart from broad market indexes and stock market synchronicity increases. The link between opacity and crash risk has received comparatively much less attention.
Several mechanisms could engender crash risk or, more generally, negative skewness in returns. For example, it is well known that
Sample development, variable measurement, and research design
This section presents the empirical methodology, including sample selection, variable definitions, and research design.
Regression analysis
In this section, regression analysis is employed to examine the relation between opacity and R2 as well as crash risk.
Conclusions
We confirm that our firm-specific measure of opacity, the three-year moving sum of the absolute value of discretionary accruals, is a reliable predictor of R2. We also examine the more sparsely considered relation between opacity and crash risk. We find that our measure of earnings management reliably predicts such risk. In contrast, positive jumps in stock returns are essentially unrelated to our measure of opacity. Reasonable variation in this measure of opacity changes either R2 or crash
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We thank workshop participants at Boston College, Harvard Business School, and the University of Wisconsin, Madison, for helpful comments. We also thank Ying Duan and Shan He for excellent research assistance. We thank Qiang Cheng and David Farber for their restatement data set.