Disclosure Levels, Stock Market Liquidity, and Earnings Quality: Evidence from Taiwan

Review Article

Austin J Account Audi Financ Manag. 2014;1(1): 11.

Disclosure Levels, Stock Market Liquidity, and Earnings Quality: Evidence from Taiwan

Horng-Ching Kuo1*, Hsiu-Chin Lin2

1Department of Accounting, National Chengchi University, Taiwan

2Deloitte, Taiwan

*Corresponding author: :Horng-Ching Kuo, Department of Accounting, National Chengchi University, Taiwan.

Received: June 19, 2014; Accepted:July 19, 2014; Published: July 22, 2014

Abstract

In 2003, authorities in Taiwan launched a system to annually rank listed firms according to disclosure levels to encourage increasing disclosure levels so as to reduce the cost of capital. This study explores the relation between disclosure levels (as proxied by the ranking results of the system) and market liquidity (as measured by effective bid-ask spreads) to empirically test whether the objective of the system can be achieved. In examining the relation between disclosure and the cost of capital, Francis et al. [1] find that the relation between the constructs is caused because disclosure is merely seen as a proxy for earnings quality. Following Francis et al. [1], this study examines whether earnings quality plays a role in the relation between disclosure and liquidity. The results of the study reveal that market liquidity is better for firms with higher levels of disclosure. In addition, this study finds that market liquidity is higher (lower) for firms with higher (lower) earnings quality. Finally, in contrast to Francis et al. [1], this study finds no significant difference in the relation between disclosure levels and liquidity after controlling for earnings quality, which indicates that, aside from earnings quality, information disclosure is also affected by other factors.

Keywords: Disclosure; Information transparency; Earnings quality; Liquidity

Introduction

In response to calls for increased information transparency, which were prompted by the financial scandals that had continued to come to light since Enron (2001), authorities in Taiwan launched a system (the Information Transparency and Disclosure Ranking System, the ITDRS) in 2003 to annually rank listed firms according to their disclosure level, with one of its objectives being to encourage raising disclosure levels so as to reduce the cost of capital. In the literature, while most prior research holds that greater disclosure is associated with a lower cost of capital, empirical studies have documented mixed results concerning the relation between the two, largely due to the complexity and alternative operationalizations of the constructs examined. Some researchers suggest that, given a lack of consensus on how best to measure the cost of capital, market liquidity can be used instead to infer the relation between disclosure and the cost of capital, which bypasses the potential measurement bias problem. Therefore, this study explores the relation between disclosure levels (as proxied by the ranking results of the ITDRS) and market liquidity (as measured by effective bid-ask spreads) to empirically test whether the objective of the ITDRS can be achieved as asserted.

In an earlier study, Francis et al. [1] investigated the relations among voluntary disclosure, earnings quality and the cost of capital, and found a negative association between disclosure and the cost of capital. The disclosure effect on the cost of capital, however, substantially diminishes or disappears after they controlled for earnings quality, which implies that disclosure is merely a proxy for earnings quality. Following Francis et al. [1], this study examines whether earnings quality plays a role in the relation between disclosure and liquidity. The results of the study reveal that market liquidity is better (1) for firms covered by the ITDRS relative to firms unranked for regulatory problems, (2) for firms with greater voluntary disclosure, (3) for high ranking firms relative to low ranking firms, and (4) for firms that are consistently ranked high by the system. In addition, this study finds that market liquidity is higher (lower) for firms with higher (lower) earnings quality. Finally, in contrast to Francis et al. [1], this study finds no significant difference in the relation between disclosure levels and liquidity after controlling for earnings quality, which indicates that, aside from earnings quality, information disclosure is also affected by other factors.

Literature Review and Hypothesis Development

Traditionally, theories that link disclosure to market liquidity suggest that greater disclosure reduces the information asymmetry between firm insiders and shareholders or among potential buyers and sellers of firm shares, and it increases liquidity in equity markets. The stated relation between disclosure and liquidity is considered valid because uninformed investors generally price protect against potential losses from trading with better informed market participants [2], and market liquidity (often measured by bid-ask spreads) provides a measure of such price protection that uninformed market participants demand as compensation for the perceived information risk associated with trading in equity markets [3]1. As a result, increases in disclosure, which can lower information asymmetry, tend to promote investors’ willingness to trade, which increases the demand for the stock and stock liquidity. Moreover, Diamond and Verrecchia [4] claim that greater disclosure reduces the amount of information revealed by a large trade. When the adverse price impact of such a trade is reduced, investors are willing to take larger positions in a firm’s securities, which then increases the demand for or the liquidity of the securities.

Empirically, Welker [3] documents a negative association between disclosure levels and relative bid-ask spreads, and shows that the spreads for firms with disclosure rankings in the bottom third of the sample are approximately 50 percent higher than the spreads for firms in the top third. Healy, et al. [5] focus on firms with large and sustained increases in their disclosure strategies over an eleven-year period, and find that expanded disclosure is accompanied by improved stock liquidity. Heflin et al. [6] also find financial analysts’ ratings of firm disclosures to be inversely related to bid-ask spreads, both unconditional and conditional on order size and quoted depth (which are also considered to impact on disclosure levels). Finally, Leuz and Verrecchia [7] find that firms that adopt accounting standards characterized by higher levels of disclosure exhibit lower bid-ask spreads than firms that adopt standards requiring less disclosure.

The theoretical and empirical research, discussed above, support the following Hypothesis:

H1:

The higher the disclosure levels, the better the stock market liquidity.

Financial accounting plays a role in conveying useful information to the public, and earnings are arguably the vehicle that companies use most commonly to convey the information, based on which investors and analysts make their decisions. More important, for the information to be useful, earnings must be of good quality, which implies that current financial statement information must be closely related to future firm performance [8]. In the literature, many studies find that managers choose accounting policies or actions to try to affect earnings so as to achieve some specific reported earnings objectives. Under the circumstances, investors are likely to be misled if they take this information at face value without seeing through the reported figures, and thus it is essential that earnings be of good quality for investors to consider the information both credible and useful. Empirically, Teoh et al. [9] report that issuers of initial public offerings, with unusually high accruals in the IPO year, experience poor stock return performance in the subsequent three years. Dechow et al. [10] find that firms manipulating earnings experience significant increases in their costs of capital when the manipulations are made public. Sengupta [11] documents that firms with high disclosure quality ratings from financial analysts enjoy a lower effective interest cost of issuing debt. Finally, Francis et al. [12] find that poorer accruals quality is associated with larger costs of debt and equity. In essence, the research referred to above examines how the cost of capital or stock performance is affected by earnings quality, and yet the immediate reaction from investors to high or low quality earnings figures remains to be seen. There is no doubt that investors benefit from better-quality information in so far as this helps reduce the risk facing investors and assess the risk and return more accurately. However, whether investors actually place earnings quality among the most important criteria to influence their investment decisions merits further investigation. Consequently, we formulate the second hypothesis to see whether companies with better quality of earnings benefit from higher stock market liquidity.

H2:

The better the quality of earnings, the better the stock market liquidity.

In regard to the relation between disclosure levels and information quality, two different views can be found in the literature. On the one hand, there are researchers who argue that firms with poor earnings quality will issue more expansive disclosures because information asymmetry is higher in these firms, and the value of additional information to reduce the information asymmetry is greater [13- 15]. On the other hand, there are also researchers who believe that firms with poor earnings quality will disclose less because investors will treat their disclosures as less credible any way. By contrast, companies with good earnings quality will disclose more because investors would otherwise interpret nondisclosure as unfavorable news and consequently discount the value of the firm [13,14,16]. Generally, past empirical results [16-18] support the view that disclosure increases as earnings quality increases. In addition, both Imhoff and Cox [19,20] provide evidence that companies that voluntarily publish management earnings forecasts have significantly more stable earnings than non-forecasting companies. In sum, the evidence presented in these studies is consistent with the view that firms with better earnings quality tend to disclose more. Building on the previously established positive relation between disclosure and earnings quality which is also documented in their study, Francis et al. [1] demonstrate that the relation between disclosure and the cost of capital is fundamentally driven by the first-order effect of earnings quality on the cost of capital. After the earnings quality effect on the cost of capital is controlled for, the disclosure effect is either substantially reduced or disappears. Along this line of reasoning, this study examines whether the link between disclosure and market liquidity is affected by how disclosure relates to earnings quality, which leads to the following hypothesis.

H3:

Controlling for earnings quality, variation in disclosure levels is related to variation in market liquidity.

Measurement of Test Variables

Disclosure levels

In the literature, researchers use management forecasts, conference calls, and self-constructed, or externally generated scores (e.g., scores reported by the Association for Investment Management and Research or the Financial Analysts Federation) to proxy for disclosure policies or practices. In Taiwan, the Securities and Futures Institute, entrusted by the authorities, established a system (the IRDRS) in 2003 to evaluate the level of information transparency for practically all listed firms.2 Each year, based on disclosure levels, local listed firms are ranked as “Grade A+”, “Grade A”, “Grade B”, “Grade C”, and “Grade C” firms. Although there are other financial information providers that release similar information, we use the ranking results published by the IRDRS because the selection criteria that this system uses provide a more comprehensive evaluation of disclosure practices in Taiwan. Specifically, to evaluate the level of information transparency, the IRDRS identifies 114 disclosure items as evaluation criteria, which are then grouped into five categories (compliance with mandatory disclosures, timeliness of reporting, disclosure of financial forecast, disclosure of annual report, and corporate website disclosure). It should be noted that, in addition to ranking listed firms according to disclosure levels, each year the IRDRS also publishes a listing of firms whose voluntary disclosures are considered more transparent. The classification of firms based on whether their voluntary disclosures are deemed more transparent is also used in this study.

Earnings quality

While different measures have been used to proxy for earnings quality (accruals quality, earnings variability, and absolute abnormal accruals), Francis et al. [21] report that the three measures are essentially the same in terms of their capital market effects. This study chooses to use the modified Jones Model to estimate the absolute value of abnormal accruals (or discretionary accruals) to proxy for earnings quality, with the detailed estimation procedure of discretionary accruals described as follows:

where, α0, α1and α2 in step 2 are the parameters estimated from step 1.

Stock market liquidity

As pointed out by Dubofsky and Growth [22], there is no universally accepted measure of liquidity, and each measure that has been used has its limitations. Recently, Huang and Stoll [23] argue that, because the prices at which trades take place are likely to be inside the bid and ask quotes, the use of a difference between bids and ask quotes to calculate spread may overestimate execution costs. Given that trades can occur inside the spread, they suggest that a better measure of execution costs and liquidity would be effective spread, which is based on trade price. As a result, this study uses effective spread to measure liquidity, which is calculated as follows:

Where Pt is the trade price at time t.

Control variables

Several control variables are included in this study: firm size, share price, the variability of stock return, number of transactions, and transaction size. Among these, firm size (as a proxy for information asymmetry), number of transactions and transaction size (as proxies for trading activity) are all predicted to be negatively related to effective spreads, while share price and the variability of stock returns are predicted to be positively related to effective spreads3 [3,6,24]. The control variables mentioned here are measured as follows:

  1. Firm size (ln Size): the natural log of the daily average number of shares outstanding times the daily average share price for the year.
  2. Share price (ln Price): the natural log of the daily average price quote midpoint for the year.
  3. Variability of stock returns (Vr): the standard deviation of the daily stock returns for the year.
  4. Number of transactions (ln Trans): the natural log of the daily average number of transactions.
  5. Transaction size (Transize): the daily average number of shares traded (measured in thousands).

Sample Selection and Data Collection

Sample period

The IDTRS started to evaluate Taiwanese firms’ disclosure practices in 2003. However, in 2003 and 2004, the system provided only a list of companies with more transparent disclosures. In addition, in 2005, considering that the listed firms might not be quite ready for the evaluation, the ranking category of “Grade C” was excluded from the system for the year. Consequently, to be able to compare ranking results between the years involved, our sample period covers 2006-2008. Data from more recent years were excluded for comparability reasons because further changes were made in the ranking system, which occurred in the years following the selected period.

Sources of data

Each year’s ranking results of disclosure are available from the website of the Securities and Futures Institute, and the Taiwan Economic Journal provides the rest of the data needed for the study.

Sample companies with complete data for the three-year period (2006-2008) are summarized in Table 1, which shows the year-by-year distribution of listed firms across the different disclosure scores.