Expected Mispricing: The Joint Influence of Accounting Transparency and Investor Base

Abstract

We examine how accounting transparency and investor base jointly affect financial analysts' expectations of mispricing (i.e., expectations of stock price deviations from fundamental value). Within a range of transparency, these two factors interactively amplify analysts' expectations of mispricing—analysts expect a larger positive deviation when a firm's disclosures more transparently reveal income‐increasing earnings management and the firm's most important investors are described as transient institutional investors with a shorter‐term horizon (low concentration in holdings, high portfolio turnover, and frequent momentum trading) rather than dedicated institutional investors with a longer‐term horizon (high concentration in holdings, low portfolio turnover, and little momentum trading). Results are consistent with analysts anticipating that transient institutional investors are more likely than dedicated institutional investors to adjust their trading strategies for near‐term factors affecting stock mispricings. Our theory and findings extend the accounting disclosure literature by identifying a boundary condition to the common supposition that disclosure transparency necessarily mitigates expected mispricing, and by providing evidence that analysts' pricing judgments are influenced by their anticipation of different investors' reactions to firm disclosures.

Do Analysts Disclose Cash Flow Forecasts with Earnings Estimates when Earnings Quality is Low?

“…We follow prior research (e.g., Johnson et al., ; Francis et al., ; Elliott et al., ; Bhattacharya et al., ; and Ecker et al., ) and use the variation in discretionary current accruals to measure earnings quality . This measure captures the intuition that quality of accruals and, consequently, of earnings is decreasing in the magnitude of accruals estimation errors.…”

“…In examining the relationship between earnings quality and the analyst propensity to jointly issue cash flow and earnings forecasts, we follow previous literature (e.g., Johnson et al., ; Francis et al., ; and Elliott et al., ) and use the variation in discretionary current accruals (McNichols, ) as our main earnings quality measure. We find that compared to stand‐alone EPS forecasts, the variation in current discretionary accruals is 41% lower when analysts issue cash flow estimates together with EPS forecasts.…”

The Unintended Effect of Corporate Social Responsibility Performance on Investors' Estimates of Fundamental Value

“…Second, unlike archival studies, our experimental approach does not rely on market prices to draw inferences about investors' underlying estimates of fundamental value. This is advantageous as both theory and empirical evidence indicate that price and fundamental value can substantially and systematically diverge (Lee, Myers, and Swaminathan 1999;Lee 2001;Abreu and Brunnermeier 2002;Bosch-Domènech, Montalvo, Nagel, and Satorra 2002;Elliott, Krische, and Peecher 2010). Our experimental approach contributes to the accounting literature by cleanly disentangling the intended from the unintended effects of CSR performance on investors' beliefs about a firm's fundamental value and the price they are willing to pay to invest in the stock of that firm.…”

Investment Experience, Financial Literacy, and Investment‐Related Judgments

“…Accounting researchers may also motivate these investigations by citing the importance of individual investors in capital markets, including the U.S. capital market (e.g., Koonce and Lipe 2010) or particular components of the U.S. capital market (e.g., Jiang et al 2016). Individual investors are presumed to be relatively unsophisticated, and analytic models and empirical analyses of investor sentiment suggest that the presence of less sophisticated investors can affect market prices and expectations (e.g., De Long et al 1990a, 1990bElliott et al 2010;Hirshleifer et al 2006;Kumar and Lee 2006;Shleifer and Vishny 1997). reported history (i.e., nonretirement). To assess the reasonability of the sample, I benchmark this MTurk sample against national samples of financial capability skills in the United States (FINRA Foundation 2009a, 2009b.…”