Effects of Intra-Industry Connectedness on Corporate Information Environment

Understanding corporate information environment and factors affecting it has an important role in analyzing financial reports and setting accounting standards and laws regarding financial reporting. One of the phenomena studied in financial markets is intra-industry information transfer. Prior research on intra-industry information transfer shows that industry peers’ reports provide informative information about individual firms and documented significant stock price responses to industry peers’ announcement of earnings, (e.g. foster, 1981) management earnings forecasts, (e.g. Han, Wild and Ramesh, 1989) dividend, (Laux, Starks and Yoon, 1998) bankruptcy (Lang and Stulz, 1992) and earnings restatements. (Gleason, Jenkins and Johnson, 2008) Furthermore, the evidence in prior studies suggests that industry peers’ performance is more informative in some industries than in others. (e.g. Freeman and Tse, 1992) considering different theories suggesting effects of intra-industry information transfer phenomenon on manager’s behavior and demands for information, an important question that arises is whether financial reporting and its quality is different in industries with high intra-industry connectedness and firms operating in correlated environments.
In this study, we examined the relationship of intra-industry connectedness with firm’s earnings quality, management forecasts accuracy, firm’s disclosure quality and information asymmetry.
Research Questions or Hypothesis: In industries with high intra-industry connectedness industry peers’ reports are likely to provide useful information to evaluate the performance of individual firms. Under information perspective, since there is more useful information from industry peers in industries with high intra-industry connectedness, demand for voluntary disclosure is likely to be lower and it leads to less voluntary disclosure. On the other hand, herding perspective suggests two opposite effects on corporate information environment in these industries. First, firms operating in correlated environments are more likely to exhibit herding behavior (Demski and Sappington, 1984; Scharfstein and Stein, 1990). Scharfstein and Stein (1990) show that in correlated environments, managers mimic the decisions of their peers, even at the expense of ignoring their own private information. Hence, it’s likely that in industries with high intra-industry connectedness firms manage their earnings so that their earnings are closer to industry peers’ earnings. On the other hand, under herding perspective in industries with high intra-industry connectedness firm managers may have stronger incentives to herd in providing voluntary disclosures to enhance their reputation (Graham, Harvey, and Rajgopal, 2005).
Based on the above-mentioned theories, we can expect both positive and negative effects on corporate information environment. In this study we examined the following hypotheses:H1: There is an association between intra-industry connectedness and earnings quality.
H2: There is an association between intra-industry connectedness and management forecasts accuracy.
H3: There is an association between intra-industry connectedness and disclosure quality.
H4: There is an association between intra-industry connectedness and information asymmetry.
In this study we used panel data regression analyses for hypothesis testing. Our sample includes 178 firms listed in Iran stock markets operating in industries with at least 10 firms. We measured intra-industry connectedness as the absolute value of the covariance of sales change across all firms in the same industry for each industry. This covariance factor is calculated based on decomposition of the aggregate volatility of sales, presented and used in prior studies, (e.g. Comin and Philippon, 2005; Kim and Kwon, 2016; Pollack, 2013; Chiu, 2014). Our measure of earnings quality is based on the Dechow and Dichev (2002) model. Following Francis et al (2005) and Chiu (2014), we used the standard deviation of firm’s residuals over prior five years as a measure of earnings quality. Disclosure quality is measured based on scoring witch have been published by Tehran Stock Exchange each year and information asymmetry is measured by the bid-ask spread.
Our results show a significant negative relation between intra-industry connectedness and earnings quality, a positive relation between intra-industry connectedness and management forecasts accuracy, a negative relation between intra-industry connectedness and disclosure quality and a negative relation between intra-industry connectedness and information asymmetry.
Discussion and The negative relation between intra-industry connectedness and earnings quality can be explained from herding perspective. In industries with high intra-industry connectedness, managers have intensives to mimic other managers and bring their earnings closer to those of other firms by earnings management. This herding explanation can be backed up by results of Kedia et al (2015) study which shows firms are more likely to begin managing earnings after the public announcement of a restatement by another firm in their industry. This herding behavior can happen about management earnings forecast too; when a manager mimics others in declaring goals and earning forecast, he would try to achieve that earnings by earnings management if it’s not possible to achieve them normally. The tendency to bring earnings closer to management forecasts explains positive relation between intra-industry connectedness and management forecasts accuracy. The negative relation between intra-industry connectedness and disclosure quality can be explained by information perspective. In these industries providing useful information from industry peers can reduce demand for disclosure by individual firms and lead to lower disclosure quality. Overall, results of first three hypotheses can explain the negative relation between intra-industry connectedness and information asymmetry. It would not be surprising to find out the tendency to earnings managements and low-quality disclosure in industries with high intra-industry connectedness lead to low information asymmetry.
Findings of our research can be used as a warning to investors, accounting standard setting board and lawmakers to be careful and take in account the tendency of managers to mimic others in industries with high intra-industry connectedness.