Reactions of Capital Markets to Financial Reporting

Overview

Literature reviews occur in a two-fold manner; theoretical literature review and empirical literature review. The aim of this research was to carry out a comparative study of the capital markets reactions to financial reporting. This aim was supported by the gaps emanating from the analysis of theories and the empirical findings. To identify the gaps, the research applies an analysis on Agency Theory and the Efficient Markets Hypothesis. The Agency Theory appears useful as it determines the level of difference existing between principals’ and agents’ interaction and their level of trust in determining the comparable differences of information released via financial reporting. On the other hand, the EMH is questioned on how it addresses its inconsistencies based on the existence of difference between different markets. Different markets have different levels of financial release, they exist in different environments and obligations of reporting differ between countries.

Critical Evaluation of the Literature Review

• Scope of previous studies and gaps

Several studies have been carried out concerning the reactions of the capital market to financial reporting. One of the main areas investigated by researchers is the impact financial statements on financial reporting and their extended effects in the reactions of capital markets. According to (Mureşan, 2012, p. 395), the bench mark of these studies has been the financial markets of United States and United Kingdom. The idealness of these markets has been based on the fact that the extensiveness of studies on the two markets has been based on their success on transparency and full disclosure. This fact is also supported by (Pálosi-Németh B., 2007, p. 27). In his work on the emerging capital markets, he identifies the main issue leading to efficiency of the markets to include the defined sets of regulations (standards and principals) as well as the listing requirements. Accordingly, (Pálosi-Németh B., 2007, p. 30)p.30, these have been identified to exist in established markets, with (USA) and UK as examples. In addition, (M. & Man, 2013, p. 77) agrees that efficient market hypothesis has largely been consistent with studies carried out in UK and USA. While all these studies conclude that earnings reporting contained all the relevant information that led to markets responding quickly and efficiently, there has been very limited research on developing countries. There is also the fact that these two markets are considered to operate on transparency due to stringent listing requirements and proper standards and principles, but this has not identified why the same ‘efficient markets’ could not identify rogue practices that led to financial crisis in the US and the Asian Financial Crisis of 1997 as advanced by (Wysocki & Leuz, 2015, p. 1). A gap of inconsistency in the efficiency arises which needs to be investigated. Further, research should be expanded to other developing countries as well as a comparison of the two markets (developed & developing).

• Reaction of Capital Markets vis-à-vis the amount of information relayed as supported by the degree of disclosure

According to (Mureşan, 2012, p. 396) & (Wysocki & Leuz, 2015, p. 1), the amount of information relayed in the financial statements affects the reaction capital markets. While (Mureşan, 2012) identified the main issues related to financial reporting that affect the reaction of capital markets to be the finacial statements, standards and listing requiremnets. This author identifies valuation and comparability to be influenced mainly by the cretria of availability, predictability and reliability. These are supported by International Finacial Reporting Standards (Wysocki & Leuz, 2015, p. 25). While this statement is agreeable, it has some inadequacies and ambiguities. First on the list is the existence of voluntary and involuntary sections, (M. & Man, 2013, p. 75). These have not been isolated with regard to their impact on the reactions of capital markets to financial reporting. This raises the argument that isolation should be carried out. Second, while there is an agreement to the fact that standardized accounting procedures are used (IFRS, International Accounting Standards, IASs and Generally Accepted Accounting Procedures GAAPs), different economic environments exist. Standardized procedures are meant to provide standard interpretation of financial reporting (Wysocki & Leuz, 2015, p. 2). This will however not be the case when environmental aspects differ between different markets, despite application of the same accounting policies and methods. Third, the president of the European Accounting Association contends with the fact that electronic information systems will soon replace the traditional model of financial reporting (Mureşan, 2012, p. 397). While this is universally agreed, that it will provide more information to potential investors via internet, its specific impacts have not been evaluated. This requires more analysis since the level of information available to its consumers actually affects their reaction to capital markets.

Critical Evaluation of the theories        

Two theories will be analyzed; the agency theory and the efficient markets hypothesis. First, the agency theory is critical in explaining the principal-agent theory, their relationship and how it affects financial reporting. According to (Armstrong, et al., 2008, p. 11) capital markets affect corporate behaviour. A change in stock price either, positve or negative movement, corresponds to firm-specific events. The degree to which  the capital markets affects the corporative beaviour is defined principal-agent theory. Since, the principals (owners) have delegated part of their decision making to the directors of the company, they appoint auditors since they do not fully trust that the agents will fully implement their interests in running of the company. Behavioral research in Accounting has been used to study several aspects of Accounting. Behavioral research has been used to study the influence of accounting information on behavior of individuals and its effects on the decision making within the capital markets (Wysocki & Leuz, 2015, p. 49). Organizations are very complex entities; and accounting disclosures affect the reactions of the capital markets owing to the level of tradeoffs of interests that arise between the different stakeholders.  But this is the extent to which the agency problem is analyzed in relation to capital markets’ reaction; which is limited to the behavioral analysis and the consequences emanating from the same. Secondly, in capital markets research, however, there is only a concentration of processes, as the discussions on only two events. The two events are: the release of information and the capital markets reaction. No research explains why agents act as they do to maximize their self-interests. Same reasons are attributed to different behaviors of individuals which should not be the case.

The other theory is the Efficient Market Hypothesis which states that all the available information in the market is fully reflected in the asset prices (Harder, 2010, p. 5). (M. & Man, 2013, p. 77) state that EMH and information content hypothesis agree on the fact that announcement of earnings contains value-relevant information which allows markets to react quickly and efficiently. Whereas this issue has been tested empirically, and found to be largely consistent, no research findings has been found to support this theory from the developing capital markets. According to (M. & Man, 2013, p. 78) in the developing markets, there exists a pool of characterization of investors who are unsophisticated and poorly informed. Further, the markets have poor liquidity, are poorly regulated and have major operational bottlenecks. (Mureşan, 2012, p. 396) further agrees that empirical tests differ when developing and developed markets are compared. Accordingly, EMH will not hold universally due to different levels of capital allocation. Most of the studies are largely based in the UK and USA, especially the initial findings that were aimed to support this theory. However, further tests reveals that abnormal market reactions (inconsistencies) existed from empirical tests by Taffler in the year 2006 were conducted in the UK. Further, this theory, when tested empirically, in Denmark, a developed country, the results were inconsistent with the theory (Sponholtz, 2008, p. 4). Study conducted between 1992-2001 reveal significant abnormal reactions that persisted several days after announcement. There is a need to explain this inconsistency with regard to Denmark’s research. Further research should be carried out through empirical studies to find out what happens within the developing countries sphere; which should perhaps be carried out through a comparative study.

Conclusion                                                                      

The study has covered the major aspects that are involved on the reactions of the capital markets upon financial reporting. The literature review has covered different forms of theories that are involved through the reactions of the capital markets to financial reporting.

The following findings were made. First, further research needs to be carried out to establish the effect of electronic reporting system and how they differ with the traditional reporting. The isolation of voluntary and involuntary pieces of information, as well, the general differences between financial environments need to be incorporated into future researches. Further gaps exist in EMH and the Principal Agent Theories. For EMH, inconsistencies need to be evaluated. On Principal Agent Theory, further research beyond the Behavioral Accounting needs to be undertaken to determine the maximization of self-interests.

References

Armstrong, C., Barth, M. E., Jagolinzer, A. D. & Riedl, E. J., 2008. Market Reaction to the Adoption of IFRS in Europe. Havard Business Review, 09(032), pp. 11-20.

Harder, S., 2010. The Efficient Market Hypothesis and its Application to Stock Markets. München: GRIN Verlag.

M., M. & Man, W., 2013. Stock Market Reactions to the Release of Annual Financial Statements: Case of the Banking Industry in Sri Lanka. European Journal of Business and Management, 5(31), pp. 75-80.

Mureşan, D., 2012. Restrospective of Financial Reporting on Capital Markets. Annales Universitatis Apulensis Series Oeconomica, 14(2), pp. 395-400.

Pálosi-Németh B., 2007. Emerging capital markets in financial globalization, Tiger. Working Paper 100, pp. 1-49.

Sponholtz, C., 2008. The Information Content of Earnings Announcement in Denmark’. International Journal of Managerial Finance, IV(1), pp. 4-36.

Wysocki, P. & Leuz, C., 2015. The Economics of Disclosure and Financial Reporting Regulation. University of Chicago Working Paper, pp. 72-74.