Information Content of Earnings Opacity on Firm Value

Abstract

This study use a panel data set of balance sheet and income statement of US firms within manufacturing and services industries for the period 1987-2015 to examine the impact of two dimensions of earnings opacity on firm value – earnings aggressiveness (i.e. measured by accounting accruals) and earnings smoothing (i.e. measured by the correlation between accruals and operating cash flows). Specifically, the paper investigate if earnings opacity affects equity markets and if there is a differential effect of earnings opacity on equity markets across manufacturing and services industries. Information asymmetry in contract theory and economics expound on the positive role of information in averting price disequilibrium in the capital markets and a potential capital market failures due to an imbalance in accessing information. A capital market sufficiently characterized by efficiency and informational symmetry is expected to embody distinctive qualities in facilitating accurate interpretation of market relevant information and a subsequent timely re-evaluation of prior equity valuations. The empirical results of these panel data tests, after controlling for key influencers on equity price, shows that on average, an increase in earnings opacity is linked to an increase in market value for firms within the manufacturing industry. In contrast, the results shows that on average, an increase in earnings opacity leads to a decrease in market value for firms within the services industry. Furthermore, the results suggest that firms utilize both dimensions of earnings opacity in a sustained manner as implied by the coefficients on time-trend and the interaction of time-trend and earnings opacity.