Tick Size and Financial Reporting Quality in Small‐Cap Firms: Evidence from a Natural Experiment

• Date: 01 September 2020
• Author: ANWER S. AHMED,NINA XU,YIWEN LI
• Published date: 01 September 2020
• DOI: http://doi.org/10.1111/1475-679X.12331

DOI: 10.1111/1475-679X.12331

Journal of Accounting Research

Vol. 58 No. 4 September 2020

Printed in U.S.A.

Tick Size and Financial Reporting

Quality in Small-Cap Firms:

Evidence from a Natural

Experiment

ANWER S. AHMED,∗YIWEN LI,∗AND NINA XU†

Received 13 September 2019; accepted 25 June 2020

ABSTRACT

Using a natural experiment (the SEC’s 2016 Tick Size Pilot Program), we in-

vestigate the effects of an increase in tick size on financial reporting qual-

ity. The tick size pilot program reduces algorithmic trading (AT) and in-

creases fundamental investors’ information acquisition and trading activities.

This in turn increases the scrutiny of managers’ financial reporting choices

and reduces their incentives to engage in misreporting. Using a difference-

in-differences research design, we find a significant decrease in the magni-

tude of discretionary accruals, a significant reduction in the likelihood of just

meeting or beating analysts’ forecasts, and a marginally significant decrease

in restatements for the treated firms in the pilot program. Furthermore, we

find that the change in financial reporting quality is concentrated in treated

firms experiencing decreases in AT and increases in information acquisition

activities. We also find that the mispricing of accruals is significantly lower for

∗Texas A&M University; †University of Connecticut

Accepted by Haresh Sapra. We appreciate helpful comments and constructive suggestions

from the associate editor, an anonymous reviewer, Matt Ege, Brent Garza, Jeremiah Green,

Brad Hepfer,Trent Krupa, Korok Ray, Dave Weber,Sunny Yang, Chris Yust, and workshop par-

ticipants at TexasA&M University. Anwer Ahmed and Yiwen Li gratefully acknowledge support

from Mays Business School at TexasA&M University and Nina Xu acknowledges support from

the University of Connecticut School of Business.

869

© University of Chicago on behalf of the Accounting Research Center, 2020

870 a. s. ahmed, y. li, and n. xu

treated firms. Taken together, our results suggest that an increase in tick size

has a causal effect on firms’ financial reporting quality.

JEL codes: G12, G14, M40, M41

Keywords: tick size pilot program; financial reporting quality; information

acquisition

1. Introduction

The SEC implemented a 5-cent tick size pilot program for a set of randomly

selected small-cap stocks in 2016, with the goal of improving market-making

and liquidity for small-cap stocks (2016 Tick Size Pilot Program). Lee and

Watts [2020] document that the increase in tick size for the treated sample

of stocks led to a reduction in algorithmic trading (AT) and an increase in

fundamental investors’ information acquisition before earnings announce-

ments. We build on their findings and examine the causal effect of the tick

size increase on financial reporting quality. We document robust evidence

of an increase in financial reporting quality for the treated stocks relative

to stocks in the control group during the pilot program period.

Studying the effects of a tick size increase on financial reporting quality

is important for several reasons. First, prior work typically examines how

financial reporting quality affects financial market structure and outcomes

(e.g., Ng [2011], Lang et al. [2012], Chen et al. [2017]). Whether market

structure affects financial reporting quality has not been widely studied.

Second, while two prior studies, Chen et al. [2015] and Huang et al. [2017],

examine the effects of tick size changes on earnings management using the

1997 minimum tick size change and the 2001 decimalization, respectively,

AT was not significant in the time periods examined by these studies. In

contrast, AT represents over 50% of the stock market trading volume in

the period we study.1Therefore, inferences from these prior studies do not

necessarily apply to our setting.

Another notable difference between our study and prior studies using

the 1997 and 2001 tick size changes is that previous tick size changes ap-

plied to all stocks, whereas we utilize a randomized experiment that helps

mitigate endogeneity concerns. Our study is based on the SEC Tick Size

Pilot Program, which was enacted in October 2016 and implemented on

a staggered basis over a two-year period. The SEC pilot program randomly

selected a list of treatment and control firms from the eligible stocks. The

control group of 1,400 stocks continues to be traded and quoted in $0.01

increments, while the treatment group of 1,200 stocks experiences a widen-

ing of their quoting and trading increments. The affected firms in the Tick

Size Pilot Program cannot self-select into or out of the assigned groups,

1In the United States, AT has grown dramatically over the past decade. For example, in the

early 2000s, AT only consisted of about 15% of market volume, but now accounts for 70–80%

in recent years (Glantz and Kissell [2013]).

tick size and financial reporting quality 871

therefore the randomization of the treatment presents a clean setting to

examine the effect of an exogenous shock to financial market microstruc-

ture on firm financial reporting quality.

The intuition underlying our main hypothesis is straightforward. The tick

size widening increased trading costs for AT as well as reduced the speed

advantage that AT has over human traders. Furthermore, the increase in

tick size reduced trading costs for fundamental traders through greater

market making activities, reduced counter party risk from trading against

algorithmic traders, and reduced the risk of undercutting (or front run-

ning).2The net effect of the tick size increase was to reduce AT and in-

crease fundamental investors’ trading as shown by Lee and Watts [2020].

This, in turn, increases fundamental investors’ incentives to acquire infor-

mation and scrutinize financial reports more closely, increasing the speed

with which misreporting is detected and reducing managers’ net benefits

of manipulating financial reports.

Although we expect the tick size increase to lead to higher reporting

quality for treated firms, it is conceivable that we do not find evidence sup-

porting our prediction. First, the increase in information acquisition by

fundamental investors may not be large enough to have a significant ef-

fect on managers’ reporting choices. Second, the experiment could have

spillover effects such that reporting quality improves for both treated and

control stocks (Rindi and Werner [2019]). Finally, Chen et al. [2015] find

a negative relation between the tick size reduction and accrual-based earn-

ings management, while Huang et al. [2017] document a positive relation

between the tick size reduction and accrual-based earnings management.

Given the mixed findings in these prior studies, the extent to which the tick

size change influences financial reporting quality, a priori, is unclear.

We implement a difference-in-differences design using the two-year Tick

Size Pilot Program to test whether the tick size increase improves financial

reporting quality. We show a significant decrease in the absolute value of

discretionary accruals for treated firms relative to control firms in the pilot

program. This finding is robust to using various measures of discretionary

accruals. We then examine two alternative measures of financial reporting

quality. We find that treatment firms are less likely to have restatements and

less likely to just meet or beat analysts’ earnings forecasts. The effects of

the tick size increase are significant after controlling for numerous control

variables, as well as firm and year-quarter fixed effects. Collectively, these

results suggest that managers in treated firms increase financial reporting

quality relative to control firms during the pilot program.

The effects of tick size increase on financial reporting quality are eco-

nomically large. We find that, relative to control firms, after the increase

in tick size, treatment firms experience: (1) a decrease in the absolute

2Undercutting (or front running) is the practice of a broker or trader attempting to step

in front of other limit orders. Because of its speed advantage, AT has better ability to undercut

other limit orders from informed traders.