Transparency empirics: Li, Pincus, and Rego on the market value of financial disclosure

The intellectual case for transparency is easy to make, but it’s hard to demonstrate that transparency has the benefits its advocates (like me) claim. On Kevin Lewis’s List I came across a paper that appears to do a nice job of documenting the benefits of financial disclosure regulation to investors. The abstract is below. Their approach is to look at how the stock market reacted to events surrounding the passage of Sarbanes-Oxley. As SOX came closer to passage, firms that had been “managing” their earnings more closely saw a larger stock price boost than firms that had been doing less book-cooking. The authors appear to interpret this as evidence that SOX-induced financial disclosure benefited investors, since the firms more affected by it saw a larger boost in price.

It’s a result that may be counterintuitive to a lot of people: the BAD firms are the ones that benefited from the regulation. (More intuitive would be a story where the bad guys who had been getting away with something took a hit as it became clear that the free and easy days were over.) But the paper’s interpretation of stock price movements reflects the way financial economists tend to look at these things: investors had already discounted the price of these bad companies based on their questionable financial reporting, so signs that this would stop and that the real value of the firm would become clearer led investors to feel better about the investment and trade away the discount.

If this is how things work, why would firms obfuscate in the first place?

Also, how do we know that the news about SOX being passed was not interpreted by investors the opposite way, ie, “Well, if it’s going to be this lax, then these bad guys are going to get off easy”?

I may come back to this one. Anyway, here is the abstract:

Market Reaction to Events Surrounding the Sarbanes-Oxley Act of 2002 and Earnings Management

Haidan Li, Morton Pincus & Sonja Olhoft Rego
Journal of Law and Economics, February 2008, Pages 111-134

The Sarbanes-Oxley Act (SOX) of 2002 is the most important legislation affecting corporate financial reporting enacted in the United States since the 1930s. Its purpose is to improve the accuracy and reliability of accounting information that is reported to investors. We examine stock price reactions to legislative events surrounding SOX and focus on whether such stock price effects are related cross-sectionally to the extent firms had managed their earnings. Our univariate results suggest that significantly positive abnormal stock returns are associated with SOX events, and our primary analyses reveal considerable evidence of a positive relationship between SOX event stock returns and the extent of earnings management. These results are consistent with investors anticipating that the more extensively firms had managed their earnings, the more SOX would constrain earnings management and enhance the quality of financial statement information.