Analyst forecasts, firm asymmetric information and audit quality

Transcription

1 Analyst forecasts, firm asymmetric information and audit quality Chee Cheong * and Ralf Zurbruegg University of Adelaide Business School Abstract This paper examines the role that audit quality has on the type of information analysts impound onto stock prices across a sample of developed and emerging markets. Specifically, we investigate the amount of firm-specific versus market-wide information analysts reveal by analyzing stock return synchronicity. We find that even under a similar disclosure regime, if the enforcement of the accounting standards is weak then less firm-level information reaches the market. Supporting this, we also find information asymmetries between the firm and the market is heightened when the audit regime is weak. Keywords: financial analysts, information asymmetry, audit quality, emerging markets JEL Classification: G14 The authors are grateful for the feedback and guidance provided by Ferdinand A. Gul, Vernon J. Richardson, Keshab Shrestha, participants at both the 2015 JCAE conference and seminar at Monash University, Malaysia. All errors, however, remain solely that of the authors. * Corresponding Author. Chee.Cheong@adelaide.edu.au, Tel: , University of Adelaide Business School, University of Adelaide, SA 5005, AUSTRALIA 1

2 1. Introduction In this paper we examine how important a country s propensity to comply with financial auditing and reporting standards affects the type of information analysts impound into stock prices. We achieve this by first endogenously controlling for differences in disclosure rules across markets and then look at the impact analysts have on stock return synchronicity. In particular, we examine how the above relationship is moderated for firms that have a high level of asymmetric information. A good audit environment should limit asymmetric information problems. However, if the enforcement standards are weak then the costs to analysts of extracting firm-specific information will be high, limiting the type of information that is revealed to the market. From both a theoretical and empirical perspective, there is evidence to suggest that the information content that is incorporated into stock prices is a function of a country s institutional features. Morck, Yeung and Yu (2000) argue that weaker property rights discourage informed trading and therefore limit the amount of firm-specific information being produced. Supporting this argument, Chan and Hameed (2006) provide similar findings for a sample of emerging markets, but also demonstrate that the impact of analysts following a stock leads to increased stock return synchronicity, implying they are impounding market-wide information into stock prices. Congruent with Morck et al. (2000), they argue that in countries with low disclosure requirements and weak enforcement of them, analysts are more likely to focus on producing market-wide information as the costs of collecting firm-specific information are too high. One drawback from the earlier work of Morck et al. (2000) and Chan and Hameed (2006) is that they are not able to separate the impact of disclosure requirements from the actual compliance regime within the market. For example, Morck et al. (2000) find no evidence that the 2

3 development of a country s accounting standards has an impact on stock return synchronicity. This may, in part, be a result of their inability to separate good accounting standards from the actual compliance with them. It therefore remains an open, empirical question of how important the enforcement regime is, separate to the stated reporting standards, in influencing the type of information that analysts impound into stock prices. In this paper we explicitly examine this issue. On a firm level, information asymmetries arising from the characteristics of a company are also likely to impact the information analysts try to collect. We consider two firm characteristics that may lead to increased information asymmetries that are also particularly related to the quality of the accounting compliance regime within a country. The first is the proportion of intangible assets a firm has. Barth, Kasnik and McNichols (2001) highlight the fact that firms with substantial, intangible assets are more likely to have a greater information asymmetry between managers and investors, leading to more uncertainty on the fundamental value of the firm. This may lead to the costs of analysts acquiring firm-specific information for these companies to change. Additionally, how intangibles are reported is directly related to the accounting and audit quality environment. Accounting for intangibles is a complex matter and more often involves a substantial amount of managers professional judgement in recognizing and estimating intangible assets. For example, under IFRS goodwill undergoes an annual impairment test, which requires managers to make a number of assumptions to determine impairment. In the absence of a strong audit environment, it is therefore possible for managers to exercise such discretion opportunistically by withholding significant private information, thereby leading to higher information asymmetries between managers and investors. The second measure we examine is the ownership structure of the company. Research dating back to Morck, Shleifer, Vishny (1988) and Jiambalvo, Rajgopal and Venkatachalam 3

4 (2002) note that firms with differing levels of strategic investors has an impact on the amount of firm-specific information that is released to the market. With good accounting standards, private information advantages such as this should be reduced. However, if the enforcement and compliance regime is weak then regardless of the accounting standards, the information asymmetry between the strategic investors and the rest of the market will remain. In both of the above cases where firms may have a large amount of intangible assets or that their ownership structure may lend itself to greater information asymmetries, we postulate that the impact this will have on analysts impounding firm-specific information will be largely dependent on how well accounting standards are enforced, separate to whether or not the state claims to have adopted high disclosure standards. While controlling for differences in disclosure practices, we use a sample of firms within 16 developed and emerging markets to show that the amount and type of information analysts reveal for firms that they follow varies with the financial reporting and audit regime within the country. In particular, we show that the financial reporting and audit regime has a strong impact on the type of information analysts collect for firms that have greater information asymmetries. In other words, the importance of having institutional environments that encourage compliance with accounting standards is particularly prominent for firms where there is less information transparency at the firm level. Our paper contributes to the literature in several ways. First, we contribute to the theoretical work dating back to Grossman and Stiglitz (1980) who examine the incentives analysts have to collect private information on firms. Although studies have examined the impact intangible assets (Barth et al., 2001 and Matolcsy and Wyatt, 2006) and strategic investors (Moyer, Chatfield and Sisneros, 1989; Ball, Kothari and Robin, 2000) have on analyst coverage, the influence it has on the type of information analysts collect, based on different compliance regimes, has not been 4

5 investigated. In this paper we examine the impact these inter-related factors have on analysts ability to impound useful information into stock prices. Also, by using a set of markets that have adopted the same disclosure rules by focusing on countries that have mandatory adoption of IFRS, we are able to highlight the importance of the compliance and enforcement regime is in influencing the type of information analysts impound into stocks. Previous work examining return synchronicity across international markets have not been able to explicitly separate the effects of differing disclosure rules from the type of enforcement regime (Morck, et al., 2000 and Chan and Hameed, 2006). Additionally, and despite our paper not explicitly dealing with IFRS issues, we do contribute to the growing literature that shows how the mandatory adoption of a particular disclosure regime alone, such as IFRS, does not imply that the benefits of adoption will be uniform (see Horton, Serafeim and Serfafeim, 2013 and Byard, Li and Yu, 2011). In particular, we find that accounting compliance is, itself, a significant indicator of how effective improved mandatory disclosures in countries will be, insofar as it encourages analysts to seek and collect firm-specific information. Our results can therefore partially explain why analyst forecasts are not as accurate in environments with weaker reporting quality as we relate the empirical evidence from papers showing poorer forecast performance for these environments to be a function of a reduced incentive for analysts to collect firm-specific information. The rest of the paper is organized as follows. Section 2 reviews previous work on the impact that the information environment has on stock return synchronicity and analyst performance, along with our hypothesis development. Section 3 discusses the data and model development while Section 4 provides the empirical results. Finally, Section 5 summarizes our paper with some concluding remarks. 5

6 2. A review of the related literature and hypothesis development Early work by Roll (1988) uses the R 2 from a market model regression as an indicator of stock return synchronicity. The higher the R 2, the greater the stock is synchronous with general market movements. In examining stocks in the U.S., Roll finds that they have low stock return synchronicity, leading him to conclude firm-specific information must be incorporated into these stocks. More recently, Morck et al. (2000) show that a negative relationship exists between stock return synchronicity and the extent to which the government protects private property rights. Using a good government index, they show that stocks in countries where the index has a low value is associated with stocks not impounding as much firm-specific information. Their explanation for this is that weaker property rights discourage informed arbitrage and weaken the benefit of analysts collecting firm-level information. Supporting this finding Wurgler (2000) shows that the efficiency of capital allocations in a country is also negatively associated with stock return synchronicity. Furthermore, Durnev, Morck, Yeung and Zarowin (2003) show that a positive relationship exists between a number of accounting measures of stock price informativeness and firm-specific price variation. In other words, stock return synchronicity is directly related to the degree firm-specific information is incorporated into stock prices. Additionally, from a behavioral perspective, there is evidence to suggest there is a cultural dimension to explaining stock return synchronicity differences across countries. Both Hope (2003) and Nguyen and Troung (2013) use similar measures to capture behavioral biases and differences in risk preferences to show its impact on analyst forecasts and return synchronicity, respectively. Studies have also shown analyst coverage to be a significant item that can influence the degree of stock return synchronicity. Analysts, as information intermediaries, provide earnings forecasts on firms and therefore should have the ability to produce firm-specific information. At 6

7 the same time, as Piotroski and Roulstone (2004) note, they are outsiders to the company and may, in fact, be contributing to the amount of industry-wide information that is relevant for pricing the stock. With analysts following more than one company at a time, they have a relative advantage in terms of exploiting intra-industry information. Supporting the latter argument, Chan and Hameed (2006) find that stock return synchronicity rises for firms with greater analyst coverage in emerging markets. The above research does not, however, differentiate between a market s information disclosure standards relative to the enforcement of them. Chan and Hameed (2006), for example, do not directly measure the level of information disclosure and corporate transparency across countries, but rather just imply these factors can explain why analysts generate forecasts based on market-wide information, as the costs of collecting firm-specific information become too high in regimes with low quality information environments. Likewise, the earlier work by Morck, et al, (2000) found a country s accounting standards had little impact on the level of firm-specific information that is impounded into the stock markets. However, this may be due to the inability to segregate a country s accounting standards relative to the enforcement of them. This leads us to our first hypothesis where we focus on determining the difference that a disclosure regime has on analysts impounding information, as opposed to the compliance regime. Simply put: H 1 : While controlling for differences in disclosure rules, regimes that encourage quality auditing and financial reporting will motivate analysts to impound more firm-specific information. We postulate that analysts will only invest time in collecting firm-specific information if some degree of reliability can be placed on a firm s financial reports. Otherwise, an analyst may be better off focusing on collating and relying on market-wide information to base earnings 7

8 forecasts. Whether the stated disclosure standards are of good quality or not is immaterial if the actual enforcement of them is weak. Supporting this line of reasoning, work by Ball (2006), Hope (2003) and Barniv, Myring and Thomas (2005) all show that incentives for corporate disclosure are just as important as the purported accounting standards a regime claims to follow. In order for us to control for the level of disclosure rules across countries, we exploit the fact that since 2008, 16 markets have adopted mandatory IFRS reporting. Work, to date, has shown that mandatory adoption of IFRS has led to the improvement in analyst forecasts. Tan, Wang and Welker (2011) show mandated IFRS adoption leads to a general increase in analyst coverage and a significant increase in foreign analysts forecast accuracy. They suggest this is due to the comparability benefits across countries that accounting harmonization brings, further increasing the usefulness of accounting information. Likewise, Horton et al. (2013) provide evidence there is an overall improvement in the information environment. They find this is particularly true in countries whose previous GAAP regime differs from IFRS, as analyst forecasting performance improves significantly in these markets. Additionally, both Ball (2006) and Wysocki (2011) note that although reporting standards may now be uniform under IFRS in countries that adopt it, the reporting quality is likely to vary dependent on national institutional features. This is further highlighted by Barth, Landsman and Lang (2005) who argue accounting quality is of vital importance in determining the benefits of adopting a better disclosure regime. The implication of this is that the variation in the performance of analyst forecasts in IFRS countries may, at least, be partially a function of the audit and compliance regime within the country. At a firm level, Hutton, Marcus and Tehranian (2009) show that U.S. firms with a higher degree of opacity, as measured by earnings management, also have a higher R 2, implying less firm-specific information is being impounded in stocks with less transparent financial statements. 8

9 Likewise, Jin and Myers (2006) examine the degree of opacity in firms across a number of countries and find a similar result: namely, for countries where firms are able to be more opaque, the level of return synchronicity increases. They also find the likelihood of market crashes increases in more opaque markets. The level of firm opacity will also have an impact on the type of information analysts collect on the company and reveal to the market. Importantly, this will also be influenced by the accounting compliance regime of the country. Even though a country may impose a set of good quality accounting standards, such as IFRS, it does not mean that individual firms will adhere to them unless there is a good compliance regime to back up the standards. This leads us to our second hypothesis. We expect that the incentives to produce quality accounting reports and financial statements will be positively related to the strength of the audit regime that is prevalent within a market. As such, the costs for analysts of extracting firm-specific information will be more pronounced for firms that might take advantage of firm-level information asymmetries in weak enforcement environments. If this is the case, then we should observe that analysts working in weaker compliance regimes are more likely to impound market-wide information, as opposed to firm-level information, for firms with potentially high levels of information asymmetries: H 2 : Dependent on the compliance regime, the level of a firm s information asymmetries will significantly affect the type of information analysts impound onto the market. In this paper we consider two sources of information asymmetries that the stakeholders of the firm have some control over. They are the proportion of intangible assets a firm has and the degree of strategic investors that are in a firm. In the case of intangibles, Barth, Kasnik and McNichols (2001) highlight the fact that firms with substantial, intangible assets are more likely 9

10 to have a greater information asymmetry between managers and investors, leading to more uncertainty on the fundamental value of the firm. Additionally, how intangibles are reported is directly related to the accounting and audit quality environment which will also have an impact on how easy analysts can extract firm-specific information for these firms. The second measure, the proportion of strategic investors within a firm, focuses on the ownership structure of the company. Jiambalvo, Rajgopal and Venkatachalam (2002) note that firms with a greater proportion of strategic investors discourages the release of private information. Supporting this point, Fan and Wong (2002) show that greater corporate ownership can discourage disclosure as it is not to the advantage of the incumbent investors. This will increase the cost to the analyst in extracting firm-specific information. In the context of our paper, we would expect that there is a likely reduction in the private information advantage these strategic investors have if the auditing environment is strong. If it is weak, then their ability to withhold price-sensitive information will grow. It is also possible that a nonlinear relationship exists. Morck, Shleifer, Vishny (1988) provide evidence that an inverted U-shape relationship can materialize between the proportion of strategic investors and firm information asymmetries. Not only can a large proportion of strategic investors lead to a limitation of firm-relevant information being released to the market, but also if there are too few strategic investors. The incentive to monitor the firm diminishes if ownership is spread very thinly between minority shareholders. In either case, we expect to find that in weaker compliance regimes the ownership structure of the firm plays an important role in the likelihood of analysts collating and revealing firm-specific information to the market. The weaker the compliance regime, the more likely an unfavorable ownership structure will lead to a firm holding price-relevant information to the market. 10

11 We also examine a third measure based on the work of Dasgupta, Gan and Gao (2010). They show that the more time the market has to learn about a firm s time-invariant characteristics, the larger the stock return synchronicity will be. However, we expect this to be the case only for firms located in high quality audit environments, as the benefit of learning over time about a firm s intrinsic quality, for example, can only happen if investors can trust the quality of the financial reports. Following Dasgputa, et al. (2010), we use firm age as our measure and expect that its role in explaining a firm s level of return synchronicity is only significant in a strong audit environment. 3. Data and research method Our sample consists of all 15 countries and one special economic zone that are part of either the G-20 list of nations or the International Monetary Fund (IMF) list of emerging markets 1 that have proceeded with mandatory adoption of IFRS by The reason for picking only countries that have fully adopted IFRS is to ensure that the accounting standards regime is, as much as possible, the same across our sample of countries so that any differences in reporting quality will be a result of institutional features prevalent within the market, separate to the disclosure standards. Our sample consists of five developed markets (Australia, France, Germany, Italy and the United Kingdom) plus five emerging markets (Brazil, China, South Africa and Turkey) from the G-20 list and an additional seven emerging economies from the IMF list (Chile, Hong Kong (which we treat separately to mainland China), Israel, Philippines, Poland, Qatar and the United Arab Emirates (U.A.E.). The cut-off date of 2008 was chosen for a specific reason. Choosing a 1 We obtain the adoption year of each country from the IFRS Foundation and IASPlus websites. 11

12 date earlier than this limits the breadth of the countries we can use and choosing a date after this limits the time series properties of our dataset. With the exception of Turkey, all countries will have had at least one year of mandatory IFRS. 2 We use Worldscope and Thomson Reuters to identify firms within these markets. We are able to identify a total of 13,766 stocks from 2008 until We delete (i) 2,800 firms which do not have Institutional Brokers Estimate System (IBES) codes (as we cannot match analyst coverage with them); (ii) another 5,265 firms that do not fully adopt IFRS during our study period; and (iii) 435 firms that we cannot adequately track appropriate accounting standards for. As we intend to measure analyst coverage by the number of analysts in the IBES database that provide one-year ahead earnings per share (EPS) forecasts on a firm, we further reduce the sample of stocks by another 1,287 firms 3 with no earnings forecasts matched to them. We also delete another 238 firms which do not have a minimum of 40 consecutive trading weeks of stock data to enable our calculation of stock return synchronicity. Additionally, we lose 54 firms due to missing observations for at least one of our firm-specific variables. The final sample of firms equates to 3,684. This amounts to 16,374 firm-year observations with 69,620 EPS forecasts from 37,096 analyst-year observations. Panel A of Table 1 provides details of the year each country in our sample adopted IFRS, the total number of firms in our sample from each country and a breakdown of analyst coverage over time. Chile has the fewest number with 13 analyst-year observations, while the United Kingdom has the largest (9,262). Although dominated by the 2 Dasgupta, et al. (2010) suggests that return synchronicity may increase if the information environment improves as there should be a reduction in price-sensitive surprises for the firm in the future. From our perspective, we want to ensure that our analysis is not influenced by any possible change in synchronicity levels from the transition phase of adopting IFRS, per se, if this leads to an improved information environment. As such, with the exception of Turkey, all of the markets we examine have at least one year of mandatory adoption preceding our chosen sample time period. Also, whether we include Turkey within our sample or not makes no qualitative difference to our results. 3 Our empirical analysis uses three-way interaction terms that produces high multicollinearity if a large proportion of firms have no analysts following. 12

13 developed markets, our sample consists of a sizable minority of analysts following the emerging markets (approximately a quarter) which ensures cross-sectional variation in the explanatory variables we intend to use. Panel B provides a breakdown of firms and analyst coverage by industry classification. Our dependent variable in our regressions is the stock return synchronicity measure, SYNCH. We calculate it following Piotroski and Roulstone (2004) by estimating the linear regression: R i,t = β 0 + β 1 R m,t + β 2 R m,t-1 + β 3 R industry,t + β 4 R industry,t-1 + ε i,t (1) where R i,t is the return of stock i at week t, R m,t is the market return at week t and R industry,t is the industry return at week t. The industry return R industry,t for week t is created using all firms with the same two-digit GICS sector code within a country. As with other papers, we also include one period lags into the model. We estimate this regression for each firm-year using weekly observations over a minimum of 40 weeks. We define synchronicity as: (2) where R 2 is the coefficient of determination from the estimation of Eq. (1) for firm i in year t. A high SYNCH indicates that the firm is highly correlated with the market. Table 2 shows the descriptive statistics, sorted by country, of the stock return synchronicity measure. All the developed markets in our sample, with the exception of Italy, have return synchronicity measures that are smaller than the average SYNCH across our sample of countries (-0.7). This indicates 13

14 that, on average, stock prices in these developed markets are less likely to follow market-wide trends. The table also shows the dispersion of our analyst coverage variable across countries. We use one plus the natural logarithm of the number of analysts (ANALYST) covering company i in year t. For our sample the average number of analysts following stocks in our sample is The number varies across countries, based not only on the size of the overall market but also the number of stocks we use in a country. For some of the smaller markets this explains why analyst coverage may be high. Associated with each country in the table are also the two measures we use to assess the likelihood that a country complies with the auditing and accounting standards of the country. Our direct measurement is AUDITING STRENGTH that comes from a survey question contained in the World Economic Forum Database (WEFD) that asks businesses In your country, how would you assess financial auditing and reporting standards regarding company financial performance?. The answer is based on a Likert scale, with one implying a negative answer to the question, and seven very positive (in terms of auditing strength and quality of financial reporting). This provides us with a measure from businesses of their perception towards the auditing strength within their country. To complement this, and to capture corporate governance factors, we use a measure called INVESTOR PROTECTION taken from the Doing Business Database. 4 The indicator reflects the average score obtained from three dimensions of investor protections, which deal with (i) the transparency of related party transactions (measuring the extent of disclosure); (ii) director s liability, and (iii) shareholders ability to sue directors for misconduct. The data is, again, taken 4 Information about the database can be found at The Doing Business Project provides objective measures of business regulations and enforcement of them in 189 countries around the world. 14

15 from a questionnaire provided to corporate and securities lawyers and is based on securities regulations, company laws, civil procedure codes and court rules of evidence. Table 2 further shows the descriptive statistics for our firm-specific variables of interest and our control variables. The first three are our information asymmetry variables. INTANGIBLES is the total value of intangibles to total assets in a firm, STRATEGIC HOLDINGS is the percentage of total shares in issue of 5% or more, held strategically and not available to common investors, and AGE is the number of years a firm has been listed on an exchange. The remaining six variables form the control set. DIVERSITY is a count of the number of Standard Industrial Classification (SIC) codes a firm s operations are associated with. The larger the number, the greater its diversity of business operations. We expect a positive relationship to exist between this and stock return synchronicity as a business with operations across a number of industries will share more features with the general trend of the market than a firm which is highly concentrated in a particular industry. Secondly, we control for the SIZE of the firm as the natural logarithm of the total assets within a company. The larger the size of the company the more proportionally weighted it will be to the market index. We therefore expect a positive relationship between stock return synchronicity and SIZE. Third, we calculate the natural logarithm of company i s year-t trading volume. We expect the coefficient associated with this measure, VOLUME, to have a positive sign as more actively traded companies are able to react to information more rapidly and in a synchronous manner (see Alford and Berger, 1999). We also calculate the annualized weekly stock return volatility (COMPANY RISK). Private information is more valuable for firms with higher return volatility and therefore this may affect the level of return synchronicity for these firms, as well as the number of analysts following the firm (Bhushan, 1989). We expect a positive relationship between COMPANY RISK and stock return synchronicity. Furthermore, we control for industry concentration by creating a Herfindahl 15

16 revenue-based index, H-INDEX. Piotroski and Roulstone (2004) show that the more concentrated the industry is, the more likely individual firms in the industry will be synchronous with each other in respect to their returns. Finally, GNI is the logarithm of the gross national income of a country on a per capita basis. We use this as a general proxy for the macro-economic wealth of a country. To see if there is a difference in the variables across institutional environments, Table 3 shows the means, medians and results from conducting difference tests in splitting the data by institutional features, rather than by country. Firms are sorted into low and high INVESTOR PROTECTION and AUDIT STRENGTH categories based on whether a firm is located in an environment that is below or above the respective medians of these two variables. Both t-tests on the means and Wilcoxon tests on the medians reveal that there are significant differences across the categories. In particular, and in alignment with our expectations, even when the accounting standards are similar across countries, SYNCH is significantly lower when there is higher investor protection and stronger auditing strength. Table 4 provides a correlation matrix. None of the pairwise correlations are particularly high, with ANALYST and SIZE being the largest at Also, it is worth highlighting that none of the variables we are using to capture the institutional features of a country are highly collinear, implying they are measuring different attributes of the overall information environment within a country. The correlation between INVESTOR PROTECTION and AUDITING STRENGTH is only Even if we split the sample by high and low median values for these two variables, as in Table 3, pairwise correlations between these two variables are no larger than 0.7. When analyzing the correlations between our dependent variable, SYNCH, and the explanatory variables, we notice they hold the correct signs for those measures where we predict a sign. In particular, both institutional variables have a negative relationship with SYNCH, 16

17 indicating the better the institutional features of a country the more firm-specific information is likely to be produced. With analyst coverage, SYNCH has a positive relationship (a correlation of 0.36), similar to the results obtained in other studies (see Chan and Hameed, 2006). Based on the above list of variables, our empirical framework that we use to test our hypotheses has our dependent variable, SYNCH, to be a function of several factors: SYNCH i,t = f (ANALYST i,t, institutional variables, information asymmetry variables, (3) interaction variables, control variables, fixed effects). where the institutional variables are our measures that capture the auditing strength and investor protection within a country, the information asymmetry variables are our measures for intangible assets within a firm, share ownership structure and firm age, and the interaction terms are crossproduct variables from multiplying analyst coverage with one of our information asymmetry variables to examine the impact information asymmetry has on the type of information analysts collect and impound into the market. Additionally, in all our analyses we incorporate both country and period fixed effects to account for the possibility of any omitted variable bias that we have not explicitly controlled for using our set of independent variables. Also, when generating the results from our panel regressions we report heteroskedasticity and contemporaneous correlation corrected standard errors. 17

18 4. Empirical analysis 4.1. The impact of the audit regime and investor protection on return synchronicity In order to facilitate the ease of interpretation of the cross-product terms that we use we transform both our firm asymmetry variables and our institutional variables into dichotomous values, taking the value of one if a particular observation is above the median value of our sample, and zero otherwise. This ensures that all our interaction terms comprise of one dummy variable and one continuous variable. Table 5 focuses on the importance of AUDIT STRENGTH in influencing the type of information analysts impound into the market. Regression 5.1 provides a base-line result using the full sample of data to address our first hypothesis. As with Chan and Hameed (2006) we find that ANALYST coverage increases stock return synchronicity. However, in alignment with the descriptive statistics and correlations presented in Tables 3 and 4, we also find that both AUDIT STRENGTH and INVESTOR PROTECTION reduce this value. Specifically, the coefficient for the dummy variable of INVESTOR PROTECTION (-1.228) is significantly negative at the 10% level, while the interaction term for AUDIT STRENGTH with ANALYST is also negative and significant at the 1% level. In the latter case, the result supports our first hypothesis that in environments with high auditing strength and quality, analysts are more likely to impound firmspecific information into the market and thereby lower stock return synchronicity. The remaining set of regressions in Table 5 are based on splitting the data into high and low audit strength environments in order to examine how this affects the type of information analysts reveal when dealing with firms with differing levels of information asymmetries. Regressions 5.2 and 5.5 show the results from including variables to account for INTANGIBLES and firm AGE. In the case of INTANGIBLES it is negative and significant in the strong audit strength environment (a coefficient of ), but positive and significant in the weak audit strength 18

19 environment (0.0807). This result is interesting. Given that we expect the valuation of firms that have more intangible assets to be more complex and dependent on the reliability of their financial statements for guidance; these results suggest that the audit environment does have a substantial impact on the type of information that is revealed to the market for these types of firms. Where audit quality is good the ability to extract firm-specific information will be easier, and this is reflected in a reduction in stock return synchronicity. Conversely, in a weak audit environment the costs of extracting firm-level information will be much higher if the reliability of a firm s financial reports are questionable, leading to stock returns following more general industry and market trends. Supporting the previous findings, regressions 5.3 and 5.6 include an interaction term for INTANGIBLES with ANALYST which shows that only in the strong audit strength environment does return synchronicity reduce as a result of analysts following a stock. If the financial statements of a firm are unreliable, such as is more likely to be the case in the weak audit strength environment, then the ability for analysts to reveal firm-specific information from these reports will be less likely. In regards to firm age, we find that the coefficient values for the parameter AGE are always insignificant, regardless of the audit strength environment. However, in Regressions 5.4 and 5.7 where we include interaction terms for AGE with ANALYST, we do find the coefficients to be positive and significant, at the 5% levels, regardless of the quality of the audit regime. This would be in agreement with Dasgupta (2010) that older firms will have higher levels of return synchronicity associated with it as the market is more familiar with the intrinsic, time-invariant, properties of the firm. In our case, it would seem this is impounded through analyst coverage with the audit environment making little difference to the result. 19

20 Table 6 presents the same set of regressions as in Table 5, but this time with a focus on INVESTOR PROTECTION. Most of the results are similar to Table 5, but there are some interesting differences. Focusing on the impact that AGE has on synchronicity we find that it only has a significant, positive impact when the investor protection environment is high. Either the coefficient values for AGE are positive (Regressions 6.2 and 6.3) or the combined effect of AGE and its interaction with ANALYST leads to a significant, positive outcome (Regression 6.4). We find no significant relationship when examining the regression results for the low investor protection environment. This result is interesting as it indicates that firm age may only be useful in explaining stock return synchronicity under a beneficial institutional environment. This would, to some extent, be expected given that the ability for firm age to provide investors with a better gauge of a firm s intrinsic value and reduce uncertainty about future surprises can only occur if the compliance regime is strong enough to ensure price-relevant information on the stock is revealed to the market. This would not be the case in a low investor protection environment. Tables 7 and 8 replicate the regressions listed in Table 5 and 6, but now focus on the impact that share ownership structure has on stock return synchronicity. To account for possible differences in the relationship between STRATEGIC HOLDINGS and SYNCH depending on whether there are a lot or just a few strategic investors, we create two dummy variables to represent low strategic holdings (DD_SH_BOTTOM25 is equal to one if the proportion of strategic holdings for the firm is within the bottom quartile of our sample of firms, and zero otherwise) and high strategic holdings (DD_SH_TOP25 is equal to one if the proportion of strategic holdings for the firm is within the top quartile of our sample, and zero otherwise) in our analysis. 20

21 Focusing on Table 7 that looks at weak and strong auditing strength environments, we find that the proportion of strategic investors has no impact on the type of information analysts impound into the market when audit quality is strong. The interaction terms in Regressions 7.1 and 7.2 are always insignificant. The individual effects, however, do reveal differences in stock return synchronicity relating to the concentration of strategic holdings of a firm. Firms with a high proportion of strategic investors have a significantly reduced return synchronicity, whilst firms with relatively low levels of strategic investors have a higher return synchronicity. Our view is that in a good quality audit environment, the ability for the market to extract firm-specific information from companies that have concentrated shareholdings will be easier, leading to a reduction in synchronicity. The ability for larger strategic investors to withhold price-relevant information (Jiambalvo, et al., 2002) will be substantially reduced where the audit quality environment is strong. However, the audit regime cannot reveal additional information if none is collected to begin with. Where there are very few strategic investors, the incentive for stakeholderes to collect firm information is limited if their holdings are small. This will lead, as Morck, et al. (1988) argue, to a general rise in information asymmetries between the firm and the market, and hence the rise in return synchronicity that we observe. When comparing the above results to the weak audit environment there is one main difference that emerges. First, as we would expect, high levels of firm concentration do not lead to a reduction in return synchronicity, as is the case in the strong audit environment. As for the case with low levels of ownership concentration, the result does not change, with return synchronicity rising for the same reasons we expect it does within the strong audit environment. For Table 8, where we split our sample between high and low investor protection, we broadly find the results similar to Table 7. The only significant difference that we observe is that when there are a lot of strategic investors (SH_TOP25) the overall effect is to reduce 21

22 synchronicity in both the low and high investor protection environments. However, the role that analysts play is different. In the high investor protection regime the coefficient for the interaction term of SH_TOP25 with ANALYST is negative and significant ( ), whilst it is positive and significant (0.1226) within the low investor protection environment. We interpret this to imply that analysts can only reveal industry and market-wide information on the stocks when the investor protection environment is weak, but when it is strong they have the ability to extract firm-level information. 4.2 Robustness tests We test a number of alternate model and sample specifications to see if our results are robust to changes in the regression framework. In Table 9 we present the results from a Placebo test where we randomly assign a firm to a country other than where it truly resides. If the institutional environment of a firm is important in determining the return synchronicity of a company, then we should find that randomly placing a firm in another country leads to the importance of that country s institutional features to be irrelevant. Table 9 records the number of positive and negative coefficient values that are also significant (at the 10% level) from conducting the randomization 100 times on Regressions 5.1 and 6.1 on the full sample of data. What we find is that 100% of the time ANALYST is significant and positive. We expect this to be the case as it should not matter where the firm resides that analyst coverage increases a firm s return synchronicity. It is a factor relating to the firm, not the country. When we turn our attention to the institutional variables we find that there is no particular outcome that dominates the coefficient results. At best, we find that 76% of the time there is a significant and positive AUDITING STRENGTH coefficient. However, the sign is, in fact, opposite to what we should expect. Furthermore, the interaction terms do not deliver any strong results either, implying that 22

23 the outcomes are randomly drawn. From this we conclude that a country s institutional features are unique in affecting a firm s return synchronicity domiciled in the country, and is not a result of our sample of firms being stochastically related to the compliance regime. Table 10 is split into three panels and provides the results from either changing the control variables that we use for our regressions or the sample of countries that we include. For brevity, we provide the results only for analyzing the impact that INTANGIBLES has on firm synchronicity. Starting with Panel A, we select an alternative set on controls. For firm size we use the log of the market capitalization of the firm instead of total assets. Instead of firm volatility, we measure general stock market volatility and use a dummy variable that equals one if the firm has business operations spanning three or more SICs and zero otherwise, to represent the diversity of business operations within a company. We also employ a variable called that measures trading volume by total outstanding shares as a measure of liquidity. Finally, we include a macroeconomic variable which is the logarithm of a country s GDP per capita. Our results are not substantially different from Table 5. Regression 10.1 reveals that in a strong audit quality environment, analyst coverage of a firm reveals further firm-specific information to the market. The same is true within a weak audit environment as the interaction term between ANALYST and INTANGIBLES is negative and significant (a coefficient of ), although only at the 10% level, relative to the 1% significance the coefficient obtained in the strong audit regime. However, the coefficient for INTANGIBLES by itself is positive with a value of This implies that within a weak audit regime the impact of intangibles does still lead to an increase in return synchronicity, as would be expected, although analysts are still able to extract firm-level information from the firms. In the case of Regressions 10.3 and 10.4, the results are more clear-cut. Only in the high investor protection environment is there any evidence that return synchronicity is reduced in the presence of analysts following a firm. 23

24 Panel B repeats the above exercise, but this time we remove the largest five firms in each country. It can be argued that in emerging markets a few large firms dominate the stock market and therefore our results may show a bias due to favoring higher return synchronicity from these companies in our sample, despite us already accounting for firm size as one of our controls. The results from this set of regressions provide complement the outcomes that we observe in Panel A, with little deviation. In Panel C of Table 10 we show the results for when we remove countries with less than one hundred firms in our sample (Brazil, Chile, Hong Kong, Israel, Philippines, Qatar, Turkey and U.A.E.) in case a bias originates from there. The overall results are not significantly different from our previous regressions, indicating that our findings are not influenced by a small country sample bias. Only in strong audit and high investor protection environments do we find evidence that analysts are able to impound firm-specific information into stock prices. We also perform a number of other tests to see what happens if we do not include industry returns for our cohort of emerging markets in equation (1) when calculating SYNCH because in smaller markets a few large companies may be driving a whole industry and therefore there will be a high covariance between industry returns and large firms dominating the industry. Although not tabulated, our results, again, do not substantially change. The same is true if we focus on replicating the results from analyzing strategic investors with our alternate set of controls and changes to the sample of firms and countries we select. The core results remain qualitatively the same. 24

25 5. Conclusion As information intermediaries, financial analysts play an important role in disseminating timely information into the financial markets on the current and future value of a stock. In this paper we show that the type of information they collect and then impound into stock prices is dependent on the quality of the audit and financial reporting environment. We also show that audit quality is particularly important where there is more likely to be information asymmetries between the firm and market. Specifically, we find that the compliance regime moderates the type of information analysts impound dependent on the ownership structure of the firm and the level of intangible assets a firm has. Our results demonstrate that a good compliance regime, through the maintenance of a strong audit and financial reporting environment, is extremely important in influencing the type of information analysts impound into the market. From a policy perspective our results provide impetus for regulators to pursue the enforcement of accounting standards to encourage market efficiency and assist the role analysts can play as financial intermediaries within these markets in revealing firm-level information. 25

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