In this paper, we investigate the impact of accounting standards on the information content of stock prices, particularly the extent to which stock prices incorporate firm-specific information in an accurate and timely manner. We find that the adoption of high-quality accounting standards, such as International Financial Reporting Standards (IFRS) or U.S. Generally Accepted Accounting Principles (GAAP), per se is not related to the information content of stock prices. Such accounting standards are helpful only in countries that have proper reporting incentives and are characterized by better shareholder protection, more effective legal systems, and stricter enforcement.
Prior studies have demonstrated the importance of reporting incentives in determining the quality of accounting numbers, the level of earnings management, market liquidity, and the cost of equity (e.g., Ball et al., 2000; Ball et al., 2003; Leuz et al., 2003; Burgstahler et al., 2006; and Daske et al., 2008). Our study, therefore, makes an important contribution to this growing body of literature by demonstrating that the adoption of high-quality accounting standards alone without genuine implementation mechanisms is unlikely to be effective in improving the informativeness of stock prices.
In a well-functioning market, stock prices ought to reflect not only economy-wide information but also, and more importantly, firm-specific information. French and Roll (1986) and Roll (1988) find that a significant proportion of stock return variation cannot be explained by market-wide information, thus suggesting the important role played by firm-specific information. The proportion of firm-specific return variation (idiosyncratic volatility) in total return variation therefore measures the level of firm-specific information that is incorporated in stock prices.
A growing body of empirical studies supports the use of firm-specific return variation as a measure of the information content of these prices. Morck et al. (2000) were the first to report that the degree of firm-specific return variation in emerging markets is low, concluding that it is the lack of proper property rights protection in these markets that explains the low level of information content in stock prices. Jin and Myers (2006) confirm their findings, but offer an alternative explanation for this low level of information content.
They argue instead that it is due to information asymmetry between corporate insiders and outside investors. Wurgler (2000) reports that capital is more efficiently allocated in countries with more firm-specific information in their stock prices, based on the measure developed by Morck et al. (2000). Studies using U.S. firms also show that a high degree of firm-specific return variation is associated with the more efficient allocation of capital (Durnev et al., 2004; Chen et al., 2007) and with more information about future earnings impounded in the stock prices (Durnev et al., 2003).
