The Information Content of Corporate Earnings: Evidence from the Securities Exchange Act of 1934

The Security Exchange Act of 1934 ( “the Act”) is the most expansive secondary market regulation enacted in the history of the United States. The Act was the first federal law to mandate disclosure of audited financial statements, it established the Securities and Exchange Commission (SEC), and is still the basis of much financial litigation. However, according the 2003 Economic Report of the President, “whether SEC enforced disclosure rules actually improve the quality of information that investors receive remains a subject of debate among researchers almost 70 years after the SEC’s creation.” Some even argue that the Act did not improve the quality of information at all. In our new study, The Information Content of Corporate Earnings: Evidence from the Securities Exchange Act of 1934, we revisit the passage of the Act and, using novel data and methodology, conclude that the Act’s implementation of a mandatory disclosure system and increase in enforcement of accounting standards and financial regulation made earnings disclosures more informative to investors.

Past research has examined unconditional stock returns around the Act, and generally documented no change in returns but a decrease in return volatility. Critics of the Act interpret these findings as evidence that while the Act did not affect shareholder welfare, it did crowd out small, volatile firms that could not afford to comply with the Act’s new requirements for publicly listed firms. In contrast, advocates of the Act argue that fraud and violations of security law were prevalent in the pre-1934 period and that mandatory disclosure regulation and strong enforcement promoted by the Act successfully mitigated these deficiencies. Further, advocates argue that the finding that volatility decreased after the Act is more likely due to an improved information environment with a more continuous flow of information after the Act, relative to sporadic, large, unexpected news releases before the Act; The Act thus made investing in securities markets less risky and thereby benefitted investors. The scarcity of evidence and the sharp disagreement about interpreting existing evidence leads Easterbrook and Fischel to conclude that “there is no good evidence that the disclosure rules are beneficial [, but] there is [also] no good evidence that the rules are harmful, or very costly.”

These prior studies generally rely on long-run returns tests, which measure the net benefit of the Act, and which are unable to speak to specific costs and benefits (e.g., whether firms’ financial disclosures became more informative as a result of the Act). We attempt to address these shortcomings by hand-collecting financial statement data and earnings announcement dates for the six-year period around the Act and directly analyzing whether the Act changed investors’ reactions to the information released during corporate earnings announcements.

We use three outcome variables to measure informativeness: Earnings response coefficients (ERCs), abnormal stock return volatility, and abnormal trading volume. Earnings response coefficients measure how much investors bid up (down) stock prices upon the announcement of favorable (unfavorable) news, and ERC magnitude increases in the quality of earnings disclosures. Thus, if the Act increased financial reporting informativeness through promoting higher disclosure quality, ERCs will increase. Similarly, assuming that different individuals interpret a given piece of information differently, a given amount of earnings information can increase return volatility and trading volume more if the Act makes firms’ earnings disclosures more informative.

We begin our analysis by studying cumulative returns of perfect foresight hedge portfolios that go long in stocks of firms that report an earnings increase and short in stocks of firms that report an earnings decrease. These hedge portfolio returns during earnings announcements are higher after than before the Act. While these tests improve upon prior research by calculating market responses over a very short horizon to mitigate effects of other confounding events, the possibility persists that contemporaneous structural developments unrelated to the Act changed the informativeness of financial reports.

To address this concern, we take an additional step and employ a fully interacted difference-in-differences design that includes firm and time fixed effects. We define the treatment group as firms that released financial statements before the Act but did not report sales information, potentially because of concerns related to proprietary costs arising from product market competition. We define the control group as firms that released financial statements that included sales information in their reports before the Act. The Act forced firms to disclose sales numbers, mandated a set of generally accepted accounting standards, and considerably strengthened enforcement. If these measures resulted in more informative financial reporting, we expect that an increase in investor reaction to financial information will increase more for treatment than for control firms.

Consistent with the Act increasing the informativeness of treatment firms’ earnings announcements, we document that ERCs, abnormal stock return volatility, and abnormal trading volume around earnings announcements all increase more for treatment than for control firms. The economic magnitude is large. While control firms’ ERCs remain approximately unchanged after the Act, treatment firms’ ERCs more than double. The magnitudes for abnormal return volatility and abnormal trading volume are also large. Robustness tests indicate that our underlying parallel trends assumption is satisfied for all outcome variables. ERCs and abnormal volatility and volume reactions do not significantly differ for treatment and control groups in the pre-Act period, but become larger for treatment firms in the post-Act period.

Lastly, we confirm that our results vary in the cross-section in the manner suggested by economic theory. First, we find that the increase in ERCs is largest for large firms that are subject to more public scrutiny and regulatory enforcement. Second, we find that the increase in ERCs, abnormal ERCs, and abnormal volatility reactions to earnings news is pronounced for firms likely subject to high agency costs. Third, we consider whether our findings are symmetric for good and bad news. We do not find any evidence such a differential impact, which is notable given that authors often associate the Act with an upsurge (and even mandatory enforcement) of conservatism.

In sum, we find strong evidence that the Act’s implementation of a mandatory disclosure system and the substantial increase in enforcement of accounting standards and financial regulation made earnings disclosures more informative to investors. The complete paper is available for download here. Comments and suggestions are highly appreciated.