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For decades beginning in the 1960s, investors witnessed an increase in the average volatility of stock returns for firms in the United States. Research has shown that the phenomenon is not a function of increased volatility across the broad stock market index but rather a surge in idiosyncratic volatility – that is, the volatility linked with particular stocks. The trend has important implications for portfolio diversification as well as a variety of investors ranging from arbitrageurs to those compensated with stock. While researchers have explored a variety of theories to explain the increase, Shivaram Rajgopal, an accounting professor at the Goizueta Business School, and a colleague from Duke University focus on the possible link between idiosyncratic return volatility and the deteriorating quality of financial reporting. The association they find between volatility and lower quality in financial reports adds to concerns in the accounting profession that financial statements have become less useful as the United States economy has transitioned from a manufacturing base to a high-technology, intangible and information-intensive/service-oriented economy.
The researchers investigate earnings quality in two ways: by looking at the extent to which accounting accruals map into operating cash flows; and by examining the degree to which a firm’s accruals deviate significantly from the level determined by changes in firm fundamentals. On both scores, earnings quality has significantly declined from the 1962-65 time frame to the 1998-2001 period, the researchers conclude. They calculate the variance of stock returns over a 40-year period and find an association with the deterioration in financial reporting quality. To bolster the finding, the researchers consider whether the association might be explained by any of three confounding factors: changes in the firms’ disclosure of value-relevant information; changes in the sophistication of investors; and changes in the signaling role of earnings quality for firms’ future cash flows. After controlling for all three factors, the strong association remains. It also persists, the researchers find, after controlling for other factors including: the increase in new stock listings during the 1980s; technology-intensive firms where the quality of accounting information could be lower due to business models; and mergers and acquisitions. In a supplementary analysis, the researchers also show the association in terms of increased dispersion in the forecasts issued by stock analysts. The idea is that if there is a decline in the quality of earnings, analysts will place less weight on those signals and look for other sources of information about a firm’s prospects. The change could add to volatility, the researchers suggest, as different investors follow recommendations from different analysts.
There are limitations to the study. First, it does not necessarily imply a causal relationship between lower earnings quality and increased idiosyncratic volatility. Second, the proxies used for earnings quality in the analysis could be imperfect. Finally, despite many attempts to control for changes in the business environment over the 40-year period, the fact remains that such environmental changes might still provide an alternate explanation for the findings, the researchers say.
“We are among the first to empirically identify the role of deteriorating earnings quality as an important factor associated with the temporal increase in idiosyncratic volatility,” the researchers write. “In that sense, we integrate the literature in finance related to time trends in idiosyncratic volatility with the literature in accounting related to time trends in the informativeness of accounting numbers for market participants.”
ABOUT THE EXPERT
Shivaram Rajgopal joined Goizueta Business School in June 2010. Prior to joining Emory he was a chaired professor in the Foster School of Business of the University of Washington. Shiva’s research focuses in two areas: the investigation of the determinants and consequences of financial reporting strategies, and the exploration of the relationships between executive compensation (stock options) and the executive behavior such as risk taking.
– Chris Snowbeck