When firms talk, do investors listen? The role of trust in stock market reactions to corporate earnings announcements

Abstract

We examine whether the level of trust in a country affects investors' perception and utilization of information transmitted by firms through financial disclosure. Specifically, we investigate the effect of societal trust on investor reactions to corporate earnings announcements. We test two competing hypotheses: on the one hand, corporate earnings announcements are perceived as more credible by investors in more trusting societies and therefore elicit stronger investor reactions; on the other hand, societal trust mitigates outside investors' concern of moral hazard and reduces the value of corporate earnings announcements to them, thereby weakening their reactions to these events. We analyze the abnormal trading volume and abnormal stock return variance during the earnings announcement period in a large sample of firm-year observations across 25 countries, and find that both measures of investor reactions to earnings announcements are significantly higher in more trusting countries. We also find that the positive effect of societal trust on investor reactions to earnings news is more pronounced (1) when a country's investor protection and disclosure requirements are weaker, suggesting that trust acts as a substitute for formal institutions, (2) when a country's average education level is lower, consistent with less educated people relying more on trust in making economic decisions, and (3) when firm level information asymmetry is higher, supporting the notion that trust plays a more important role in poorer information environments.

Linking Societal Trust and CEO Compensation

“…The mean (median) value in our sample for trust measure is 0.337 (0.316) and is comparable to other studies using this measure (e.g., Pevzner et al 2014 The variables are defined as follows: T_Comp is the total compensation in millions of U.S. dollars, L_TC is the log of total compensation, PCTEQ follows compensation variable from Bryan et al (2010) and is the ratio of total equity-based compensation (options awards given and stock awards given) to total compensation, SIZE is measured as log of total assets at the end of the year, LEV is book leverage measured as value of current book equity scaled be total assets at the end of the year, MTB is the market value to the book value at the end of the year, GDP is log of annual GDP in US dollars, ROA is net income at the end of the year scaled by end of the year's total assets, LEGAL is principal component factor derived from three legal measures rule of law (RULE_OF_LAW), efficiency of the judicial system (EFF) (both from the La Porta et al 1998) and law and order index (LAWORDER) from the Economic Freedom of World annual reports, ID is income disparity and represents total compensation paid to the CEO scaled by the average employee compensation, R&D is research and development expense scaled by total assets, TAX RATE is highest marginal personal tax rate at the country level, RISK-equity beta is the firm annual beta reported in Bloomberg, CEO TENURE is in number of years, and RATED is a dummy variable which equals 1 if firm has Standard & Poor's long-term issuer credit rating. Table 6 reports the results of hypotheses 1a (columns 1-4 for Model (1)) and 1b (columns 5-8 for Model (2)).…”

“…Similar to Nanda and Wysocki (2011) and Pevzner et al (2014), we proxy societal trust using responses from uniformly and consistently conducted World Values Survey (WVS) that capture scores from nationally representative surveys in almost 100 countries representing around 90 % of the world's population. Our results are based on most recent year's country-level data available in WVS Longitudinal 1981-2014 data file.…”

Social Trust and Corporate Misconduct: Evidence from China

“…For example, Berglund and Kang (2013) and Jha and Chen (2015) suggest that auditors are aware that managers in high social trust areas are more likely to be honest in financial reporting and consequently charge lower audit fees for these clients. Pevzner et al (2015) argue that investors perceive managers in high social trust countries as more honest and less likely to engage in opportunistic activity and earnings manipulation. These authors find that investors' response to corporate earnings announcements is greater in high social trust countries.…”

Disproportionate insider control and board of director characteristics

“…32 Mediation analysis has been used in a variety of contexts using historical financial data to examine whether one variable (here: board characteristics) serves as a significant channel through which another variable (here: disproportionate insider control) affects a particular dependent variable (here: firm value, Tobin's Q). Examples from the literature include the relationships between underinvestment, family firms, and underperformance (Lins et al (2013)); information asymmetry, prior lending relationships with underwriters, and the market reaction to the issuance (Duarte-Silva (2010)); earnings quality, societal trust, and earnings announcement reactions (Pevzner et al (2015)); and liquidity, transparency, and firm value (Lang et al (2012)). 33 Because we do not discern a significant association between WEDGE and board size or CEO/chairman, reported in Table 4, we exclude these two variables from our mediation analysis.…”