As information intermediaries, financial analysts play an integral role in the capital market, providing earnings forecasts, buy/sell recommendations and other information to brokers, money managers and institutional investors. As financial analysts specialize in producing firm-specific information, analyst coverage constitutes a crucial part of the firm’s information environment. The significance of analyst coverage is well recognized in the accounting and finance literature. An extensive body of research has developed on the determinants of analyst coverage (for instance, Bhushan, 1989; Moyer, Chatfield, and Sisneros, 1989; O’Brien and Bhushan, 1990; Lang and Lundholm, 1996; Barth, Kasznik, and McNichols, 2001; Lang, Lins, and Miller, 2004; Baik, Kang, and Morton, 2007; Chen, Weiss, and Zheng, 2007; Autore, Kovacs, and Sharma, 2008). The evidence in the literature demonstrates that analyst coverage offers a myriad of benefits, such as a reduction of information asymmetry and an improvement in liquidity.
Built on the previous literature on analyst coverage, this study explores how analyst coverage may be influenced by the overall quality of corporate governance. Corporate governance is specifically designed to safeguard shareholder rights, improve disclosure and transparency, and facilitate effective oversight of the management team. Weak corporate governance tends to exacerbate information asymmetry between managers and shareholders because poor governance promotes inadequate information disclosure and thus a higher degree of information opacity. Because analysts function as information intermediaries, the extent of analyst coverage is critically related to the information environment of the firm.
The transparency or opacity of the firm’s information environment, in turn, is determined, at least in part, by the quality of corporate governance. Therefore, we hypothesize that there is a significant association between analyst coverage and corporate governance quality. Analyst following is especially interesting because it is not directly chosen by the firm nor is it mandated by laws and regulations, but it is instead determined (at least in part) by factors beyond the firm’s control (Lang, Lins, and Miller, 2004).
Although theory suggests that there should be a relation between analyst following and
corporate governance, it is not clear whether the relation is positive or negative. We advance two
competing hypotheses. First, the outcome hypothesis posits that, in firms with weak governance,
managers are more able and likely to expropriate shareholders’ wealth. Therefore, they have
incentives to promote information opacity. As a consequence, fewer analysts are attracted to
such firms because managers are reluctant to provide analysts with information useful to their
analysis.
On the contrary, the substitution hypothesis argues that analyst coverage functions as a
governance mechanism that helps mitigate agency conflicts and information asymmetry. Firms
with stronger governance tend to incur less agency cots, thus lessening the need for an outside
mechanism such as analysts’ monitoring. In other words, governance and analyst coverage serve
as substitutes for each other in alleviating agency conflicts.
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Does Corporate Governance Affect Analyst Coverage? Evidence from ISS
