Corporate Governance, Earnings Quality and Idiosyncratic Crash Risk During the 2007-2008 Financial Crisis

Abstract

This study focuses on the cross-sectional determinants of idiosyncratic crash risk. In specific, we verify the role of financial disclosure quality and internal corporate governance mechanisms associated with the board of directors, executive compensation and audit committee as buffers of crash risk upsurge during financial turmoil. A sample of 1398 firms, mostly from developed countries, is analyzed covering two different periods: July 2005 to June 2007 (the pre-crisis period) and July 2007 to June 2009 (the crisis period). While our results reveal that accounting opacity before the crisis fueled crash risk during the crisis, we fail to find strong evidence of an association between pre-crisis internal corporate governance metrics and crash risk variation during the crisis. Crucially, our results also reject the hypothesis that internal corporate governance mechanisms alleviated earnings opacity or mediated the relationship between internal corporate governance mechanisms and crash risk variation. Finally, robustness tests indicate that these conclusions hold when controlling for selection bias in the definition of the utilized sample.