1 Investor Protection and the Information Content of Annual Earnings Announcements: International Evidence Mark L. DeFond Mingyi Hung Robert Trezevant University of Southern California

2 Motivation Investor Protection Institutions (Laws & Enforcement) Capital Market Development Does “Financial Reporting Environment” Play a Role? Prior research finds…

3 Motivation Investor Protection Institutions (Laws & Enforcement) Earnings Value Relevance Long window studies. Cannot tell us whether market uses earnings information Prior research finds…

4 Motivation We examine Market Reaction to Earnings Announcements (EAs) Tells whether earnings are USED Try to identify Factors that affect Market Reaction

5 Purposes of Paper 1 st Use Investor Protection Literature to identify Structural Factors that influence Information Content 2 nd Test whether Structural Factors are Channels through which Investor Protection Institutions influence Information Content

6 Information Content of Earnings Announcements Investor Protection Institutions Structural Factors in Financial Reporting Environment Framework Our Hypotheses Tests Prior Research Finds… Tests of “Channel”

7 Hypotheses development Higher quality earnings likely to be more useful to investors Hypothesis 1: Countries with higher earnings quality have more informative annual earnings announcements Measured derived from Leuz et al. (2003)

8 Hypotheses Development Stronger insider trading law enforcement prices less likely to already impound the information Hypothesis 2: Countries with stronger insider trading law enforcement have more informative annual earnings announcements Measured as in Bhattacharya and Daouk (2002)

9 Hypotheses Development More frequent financial reporting stock prices impound annual earnings information at an earlier point in time Hypothesis 3: Countries with more frequent interim earnings reporting have less informative annual earnings announcements

10 Hypotheses Development Greater financial disclosure managers likely to disclose more information in earnings announcements (increase reaction) managers likely to disclose more information between announcements (decrease reaction) Hypothesis 4: Greater financial disclosure in a country affects informativeness of annual earnings announcements. Measured with CIFAR index (Bushman et al., 2003, and many others)

11 Data 53,197 earnings announcements 26 countries 1995 – 2002 Earnings and earnings announcement dates -- I/B/E/S databases Daily stock returns – CRSP and Datastream

12 Table 2 – Panel B Abnormal Return Variance

13 Average Abnormal Return Variance Bottom Three vs. Top Three Countries Table 2, Panel B

14 Table 2 – Panel A

15 Investor Protection Proxies Antidirector Rights Index based on company law or commercial code; sum of: (1) Ability to vote by mail (2) Ability to control shares during S/H meeting (3) Possibility of cumulative voting for directors (4) Ease of calling an extra’y S/H meeting (5) Ease of minority investors to sue directors (LLSV 1997; Hung 2000)

16 Investor Protection Proxies Law Enforcement Institutions Mean of (each on scale of 1-10): (1) Efficiency, integrity of judicial system (2) Tradition of law and order (3) Degree of government corruption (LLSV 1998, Leuz et al. 2003)

17 Hypotheses Test Dep Var = Abnormal Return Variance Ind Var = Structural Factors + Controls

18 Channel Tests First, regress Abnormal Return Variance on Investor Protection Variables Second, regress Abnormal Return Variance on Structural Factors AND Investor Protection Variables

19 Table 4, Panel A Country-level Hypotheses Tests

20 Table 4, Panel A Country-Level “Channel” Tests

21 Table 4, Panel B Firm Level Hypotheses Tests

22 Table 4, Panel B Firm Level “Channel” Tests

23 Supplementary Analyses Four Supplementary Analyses #1: Replace Abnormal Return Variance with Abnormal Trading Volume Find Same result

24 Supplementary Analysis #2 Timing of Information Flow

25 Supplementary Analysis #3 Stock Market Efficiency Tests assume stock markets reasonably efficient Large firms, active analysts following Prior research finds efficiency in a variety of countries (e.g., Bhattacharya et al., 2000; others) International institutional investors do not do better than indexes (Cumby and Glen, 1990) Additional analyses Drop country with insignificant Abnormal Ret. Var.

26 Supplementary Analysis #4 ERCs and Investor Protection

27 Robustness Checks Excluding U.S. and Japanese firms Three-day announcement window Controlling for capital market development Controlling for industry effects Controlling for time-series correlation Deleting influential observations Alternative Investor Protection measures Ranked regression

28 Limitations Cross-country research design Small number of degrees of freedom Omitted correlated variables

29 Contributions Literature on X-Country Value- Relevance Short-window methodology allows us to identify Structural Factors Literature on Investor Protection Identify Channels through which Investor Protection influences Information Content of Earnings

30 Contributions Overall Implication : Strong IP engenders Financial Reporting Environments that have Higher quality earnings Equal access to information More frequent reporting The net effect of which is to increase the content of annual earnings announcements.

31 Financial Reporting Environment Communication Process between Managers and Investors Investors Additional disclosure