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The relation between firm performance and discretionary disclosure is a basic but important question to financial market participants and regulators, but there is still only limited understanding of the association between earnings performance and discretionary disclosure (Miller, 2002). Research has shown that this relation is complex and dependent on many factors. Various theoretical models of discretionary disclosure produce different predictions of disclosure outcomes, and empirical research often finds conflicting evidence. Skinner (1995) suggests two reasons for the conflicting findings: the focus on management earnings forecasts as a measure of discretionary disclosure, and changing legal environment. This study addresses both factors by examining the association between earnings performance and a broader measure of disclosure: the price sensitive disclosures issued by publicly listed firms to the Australian Stock Exchange (ASX), under the Australian continuous disclosure regime (henceforth the CDR).
One of the most important factors affecting corporate disclosure is a country's legal environment. The litigation cost hypothesis is often used to explain the link between bad news and voluntary disclosure (Skinner, 1994). The Australian disclosure environment, with its unique combination of half-yearly reporting, low private litigation threats, and stringent statutory backed continuous disclosure requirements that are primarily enforced through a central stock exchange (ASX) and a regulatory body (the Australian Securities and Investments Commission), provides an unique opportunity for the study of corporate disclosure. Given the strong public concerns about corporate governance and the latest legal reforms in Australia and the United States after the latest spate of corporate failures, evidence from the Australian environment may help both Australian and overseas regulators and market participants evaluate the effectiveness of the Australian disclosure regime, the need for further legal reform, and/or the type of reforms required. For example, there has been continuing interest by the government and the public in the effectiveness of the CDR, and recent CLERP9 reforms introduced on-the-spot fines for breaches of the CDR to strengthen ASIC's enforcement powers. However, there has only been limited research on the disclosure practices under the CDR.
In recent theoretical research, the idea that market returns endogenously affect liquidity has received attention. For example, in Brunnermeier and Pedersen (2005), market makers obtain significant financing by pledging the securities they hold as collateral. A large decline in aggregate market value of securities reduces the collateral value and imposes capital constraint, leading to a sharp decrease in the provision of liquidity. Liquidity dry-ups arise when the worsening liquidity leads to call for higher margins, and feedback into further funding problems. Since this supply of liquidity effect affects all securities, Brunnermeier and Pedersen also predict larger commonality in liquidity following market downturns. Anshuman and Viswanathan (2005), on the other hand, present a slightly different model where investors are asked to provide collateral when asset values fall and decide to endogenously default, leading to liquidation of assets. Simultaneously, market makers are able to finance less in the repo market leading to higher spreads, and possibly greater commonality in liquidity.
Several other recent papers link changes in asset value to liquidity. In Morris and Shin (2003), traders sell when they hit price limits (which are correlated across traders) and liquidity black holes emerge when prices fall enough (the model in analogous to a bank run). Their model emphasizes the feedback effect of one trader’s liquidation decision on other traders. According to Kyle and Xiong (2001), a drop in stock prices leads to reduction in holdings of risky assets because investors have decreasing absolute risk aversion, resulting in reduced market liquidity (see also Gromb and Vayonos (2002) for a model of capital constraints and limits to arbitrage). In Vayanos (2004), investors withdraw their investment in mutual funds when asset prices (fund performance) fall below an exogenously set level. Consequently, when mutual fund managers are close to the trigger price, they care about liquidity, especially during volatile periods. Hence, these theoretical models also emphasize shifts in demand for liquidity with changes in asset prices as liquidation of assets generates more selling pressure. Additionally, some of the above models also suggest cross-sectional differences in the liquidity effects: a drop in asset value has a greater impact on the liquidity of stocks with greater volatility exposure, a phenomenon related to flight to liquidity (see e.g. Anshuman and Viswanathan (2005), Vayanas (2004) and Acharya and Pedersen (2004)).
