Research On The Impact Of Security Analyst Coverage On The Risk Of Material Misstatement In Financial Statements

The establishment of the order in capital markets is based on true and reliable information,among which accounting information is not only basic knowledge for investors and other stakeholders to make economic decisions,but also a crucial factor to maintain the order and effective operation of capital markets.However,due to the inadequate market supervision,the weak legal enforcement,among others,some listed companies still disclose large amount of materially misstated financial reporting information that has seriously misled users of financial accounting information to make wrong investing decisions.This hinders the development of market productivity and damages the legitimate rights of capital market participants.Therefore,in order to lower the risk of material misstatement(hereafter,RMM),discovering new monitoring mechanism from groups outside of the extant system and strengthening the monitoring force happen to be the most important fundamental conditions for efficient allocation of resource in China’s capital market.Under the theory of Information Economics,accounting information flows from the internal system of enterprises to the capital market,forming an information chain whose “production” process includes “information production – production control – production attestation – production released(or disclosed)”.In this chain,every market participant plays a role,including listed companies,external auditors,investors,and regulators.The mandatory regulatory system is made of certified public accountants,GAAP,regulators and related laws.An effective system can help with detecting fraudulent financial reporting.However,due to the weak legal enforcement and low level of investor protection in China,the mandatory regulatory system is not enough.Finding some other monitoring mechanism to maintain effective working of capital market and lower the information asymmetry is a key factor.Security analysts,also known as financial analysts,have crucial impact on the regulation of capital market.According to Dyck et al.(2010),who collect fraud cases in U.S.capital market,the detection rate of analysts for fraudulent financial reporting is much higher than that of both SEC and auditors.In recent fraud cases in China,Muddy Waters finds out that “Hui Shan” has inflated its assets;Analyst Pu realizes that “Yin Guang Xia” is manipulating its production earnings after talking with one of its managers.These cases indicate that analysts are capable of detecting the RMM and disclose the news to market and regulators.Compared with auditors and government regulators,analysts have more various ways to obtain information concerning their following listed companies.They could get access to more private information by attending conference calls,shareholder meeting,or simply private communication with executives and management,thus benefiting from low cost of information searching.Compared with public investors,analysts have more investing experience and more professional analytical skills.Although previous literature focuses on the impact of analyst coverage or following on the quality of financial reporting,they have not achieved a consistent result.From my point of view,there might be two reasons.First,since the securities analysis profession is still developing,regulatory agency has not formed an adequate supervision system for analysts.Therefore,the inconsistent conclusions from extant studies may result from the gaps between different regulatory regimes.Second,existing literature lacks studies that picture the whole scene from the perspective of accounting information chain.As a result,the relationship between analyst coverage and the quality of accounting information cannot be examined wholly and systematically.Based on previous research and existing theories,this study examines the impact of analyst coverage on accounting information,specifically the RMM of financial reporting,from the perspective of the “Accounting Information Chain”.This paper concludes three main findings.First,on the phase of “production”,the study measures RMM from two aspects.One is out of directness,so I use AAER or financial restatement as the proxies for RMM.The other one is out of indirectness,so I use information risk of earnings management(hereafter,IREM)as the proxy for RMM.I find that,listed companies followed by more analysts have lower probabilities of financial fraud or restatement;also,such companies have lower level of IREM than their counterparts with fewer analysts following.Second,on the phase of “control”,when something is going wrong with internal monitoring system,analysts might choose to communicate with managers.If there is no effective response,the analysts will choose to stop following the firm.Therefore,I consider that analyst coverage improves the governance environment of the firm,decreasing the “rationalization” for fraudulent behavior.The results show that firms with more analyst coverage are more inclined to disclose internal control report,have valid internal control,and have lower probabilities of having defects in internal control system.Third,on the phase of “attestation”,due to the previous monitoring effect in previous two phases,analyst coverage lowers the cost of external auditors(i.e.,audit fees).In the same token,more analyst coverage implies a better corporate governed company who has higher chances of receiving a “clean” audit opinion.The study makes several contributions as follows:First,this research extends the related literature by building a new framework that explains the impact of analyst coverage on RMM,contributing to the existing theoretical analysis by forming the influence of analyst on financial reporting information as a production chain.In this study,financial reporting information is considered as a product made by a company and delivered or sold to “customers”(i.e.investors)capital markets.Before the delivery or sales,the “product” has to experience the whole process of “production(i.e.financial reporting preparation)– control(i.e.internal control)– attestation(i.e.external auditing)”.However,the majority of extant literature pays lots of attention on studying the impact of analyst coverage on earnings management or stock price that they ignore the importance of analysts’ monitoring on this whole information chain.Second,according to the different phases of the chain,this study frames a new list of RMM measurements.The most frequent used measurement of previous studies is enforcement action by China Securities Regulatory Commission(hereafter,CSRC),or discretionary accruals.However,they have weakness on both sides.One is that the absence of an enforcement action cannot be interpreted as not having RMM.This is because due to the monitoring costs,CSRC only carries out investigation to egregious failures,which does not necessarily means that the rest of companies are “innocent”.The other is that measures like discretionary accruals do not directly identify RMM and are relatively less egregious than the enforcement actions by CSRC.Therefore,this study uses diversified variables according the information chain,in order to make the results more robust.Third,the conclusions of this study mainly emphasize on the impact of Security Analysts,who are considered as information intermediaries in capital markets,on the chain of accounting information.With the dramatic increase of China’s capital market,securities analysis professions transform from non-standard “security critics” to a professional industry which has 2,309 registered analysts up to March of 2017.The importance of their impact on the quality of financial reporting will be more and more realized by regulators and other capital market participants.In conclusion,the major contribution and main practical significance of this study is to attract the attention of regulators to think about how to make good use of the professional skills and information advantage of analysts for improving the quality of disclosed accounting information of listed companies and facilitating the effective capital allocation in this emerging market.Also,the conclusions might be reference to improving regulatory rules and suggestions for investing decisions of the public.