Opaque financial reports and R2: Revisited

• Author: Vivek Singh,Mai Iskandar‐Datta,Sudip Datta
• Published date: 01 January 2014
• Date: 01 January 2014
• DOI: http://doi.org/10.1016/j.rfe.2013.08.001

Opaque financial reports and R

2

:Revisited

Sudip Datta

a,

⁎, Mai Iskandar-Datta

a

, Vivek Singh

b

a

Departmentof Finance, School of BusinessAdministration,Wayne State University,5201 Cass Avenue, Detroit,MI 48202, USA

b

Departmentof Finance and Accounting,College of Business,University of Michigan-Dearborn, Dearborn,MI 48126, USA

abstractarticle info

Articlehistory:

Received8 October 2012

Receivedin revised form 3 July 2013

Accepted1 August 2013

Availableonline 8 August 2013

JEL classification:

C1

D89

G19

M41

Keywords:

Earningsmanagement

Opacity

R

2

Discretionaryaccruals estimation

In this study, we revisit the link between R

2

(synchronicity) and earnings management (opacity) because of the

importance of the ongoingdebate on the relation between idiosyncratic riskand earnings management in the

finance and accounting literatures. Hutton et al. (J. Financial Economics, 2009) provide evidence of a positive

link between opacity and R

2

. They interpret their finding to imply that firmswithhighR

2

(high synchronicity)

have less firm-specific informationimpounded in their stock price. Our results for this relationship fail to unequiv-

ocally support the results reported in Huttone tal. (2009). We show that their re sultsare not only time variant but

also not robust to the alternative empirical technique recommended for panel data by Petersen (2009) and alter-

native estimation of discretionary accruals adjusted for firmpe rformanceprescribed by Kothari et al. (2005). We

also findno support for a convexrelation betweenidiosyncraticrisk and opacity. The findingsdocumentedin this

study substantiallyrevise some of Huttonet al.'s findings in this important and growing area of research.

© 2013 ElsevierInc. All rights reserved.

1. Introduction

Recently,Hutton, Marcus, and Tehranian(2009) (henceforth, HMT)

examine the link between stock return synchronicity with the market

and the opacity of financial statements. They argue that when less

firm-specific information is publicly available, individual stock returns

follow the broad market more closely, resulting in higher stock price

synchronicity with the market. Synchronicity is measured by R

2

obtained from the market model, which regresses the firm's stock

returnson the market returns.Hence, higher R

2

implies higher synchro-

nicity. HMT's evidence shows a positive linkbetween opacity, proxied

as earningsmanagement, and synchronicity. They interpretthis finding

to imply thatfirms with higher synchronicityhave less firm-specificin-

formation impounded in the stock price. In addition, they conclude

from their analysis that opaque firms are more likely to experience

stock pricecrashes. Given the importanceof this topic and the continu-

ing debateon the relationship betweensynchronicity and the informa-

tion environment of the firm, we replicate HMT's analysis and also

apply prescribed alternative empirical methodologies and estimation

techniquesto revisit this issue. Our resultson the relation between idi-

osyncratic riskand opacity fail to support the findings documented by

HMT. We show that the results and conclusions drawn by HMT are

not robust to theapplication of other empiricalestimation techniques,

in addition tobeing time-variant.

The debateinitiated by Roll (1988)regarding whether synchronicity

or low idiosyncratic volatility is associated with more transparency or

more opacityof firm-specific informationcontinues to generatesignifi-

cant research interest. There is empirical evidence supporting both

sides of this debate. One strand of research documents support for the

view that low R

2

is associated with greater information transparency

(see, Durnev, Morck, Yeung, & Zarowin, 2003; Jin & Myers, 2006;

Morck, Yeung,& Yu, 2000; Piotroski & Roulstone, 2004).

However, this view is not beyond dispute. There is a significant

countervailing body of research that supports the opposite argument

of a positive association between information transparency and stock

price synchronicity captured by R

2

(e.g. Ashbaugh-Skaife, Gassen, &

LaFond, 2006; Bartram, Brown, & Stulz, 2012; Chan & Hameed, 2006;

Dasgupta, Gan, & Gao, 2010; Rajgopal & Venkatachalam, 2011). West

(1988) attributes low R

2

to a greater level of non-informational noise

in stock returns,and Ashbaugh et al. (2006) show that Durnev et al.'s

(2003) resultsare not generalizablein an international setting. Recent-

ly, Griffin, Kelley, and Nardari (2010) have shown that countries with

better information environments have higher R

2

s, contrary to what

Morck et al. (2000) suggest. In addition,Teoh, Yang, and Zhang (2009)

and Kelly (2007)document that U.S. firmswith poor informationenvi-

ronments display greater volatility and conclude that low R

2

is not an

index for stock price informativeness. Other researchers attribute

Reviewof Financial Economics 23 (2014)10–17

⁎Corresponding author at: Department of Finance - Prentis 216, School of Business

Administration, Wayne State University, 5201 Cass Avenue, Detroit, MI 48202, USA.

Tel.: +1 313 577 0408;fax: +1 313 577 0058.

E-mailaddress: sdatta@wayne.edu (S. Datta).

1058-3300/$–see front matter © 2013 ElsevierInc. All rights reserved.

http://dx.doi.org/10.1016/j.rfe.2013.08.001

Contents listsavailable at ScienceDirect

Review of Financial Economics

journal homepage: www.elsevier.com/locate/rfe