Economic Profiling?

Foreign firms are held to greater investor scrutiny for accounting irregularities

Are investors prone to a form of “economic profiling?”

A new study co-authored by Weili Ge and Dawn Matsumoto, professors of accounting at the UW Foster School of Business, suggests that a certain kind of bias can drive trading decisions around accounting restatements made by less-familiar companies.

Dawn Matsumoto portrait
Dawn Matsumoto

Specifically, foreign firms listed on United States stock exchanges experience significantly harsher market reactions than American firms do after disclosing an accounting irregularity.

Moreover, when one foreign firm reports a misstatement in its financial disclosures, investors in US equity markets tend to punish other firms from the same country as well—even when their accounting is above board.

“The fact that we find a country-specific contagion effect suggests that investors, lacking familiarity, perceive a commonality among firms from the same country when it comes to accounting irregularities,” says Matsumoto, the Gerhard G. Mueller Endowed Professor in Accounting.

Disproportionate punishment

Some 17 percent of firms listed on the NYSE, NASDAQ or AMEX are headquartered in countries outside of the United States. These firms—from China, Brazil, India, Canada, Israel, Germany, Liberia, Australia, Mexico and many others—are held to the same regulatory requirements as their US-based counterparts/competitors. But are these foreign firms held to greater investor scrutiny when they are required to restate a financial statement found to contain a material error?

Weili Ge
Weili Ge

To find out, Ge and Matsumoto collaborated with Emily Jing Wang of Hong Kong University of Science & Technology and Jenny Li Zhang of the University of British Columbia.

The researchers viewed the short-term market reaction to firm disclosures of accounting restatements announced by US and US-listed foreign firms from 2001 to 2016. Carefully controlling for the severity of accounting irregularity and other firm characteristics, they found that foreign firms suffered a significantly heavier market toll. Specifically, offending foreign firms had an average initial stock return of -5.5% versus -3% for offending US firms.

A subset of 64 irregularities attributed to firms that cross-listed on a stock exchange in the US and in their home nation revealed that investors at home were more forgiving of the same offense.

“Both analyses suggest that US investors impose a more severe stock market penalty to the accounting irregularities of foreign firms,” says Ge, the Moss Adams Endowed Professor of Accounting.

She adds, though, that investor familiarity with a foreign firm—such as Toyota or Deutsche Bank or Unilever or GlaxoSmithKline, for example—appears to mitigate this effect.

Economic profiling?

In a final study, the research team found that one foreign firm’s restatement triggered a selloff in other firms from the same country—evidence of a contagion effect among unacquainted investors.

Non-restating firms from the same country experienced an average market-adjusted stock price reaction of -0.6% over six days following irregularity announcements. “This suggests that there is some country-specific factor that investors associate with a foreign firm’s accounting irregularity,” says Matsumoto.

Ge explains that this contagion effect suggests that US investors are responding to a perception of greater information risk in firms from a foreign nation—in this case, a fear of the unknown.

Reputational bonding

So, what is a foreign firm to do?

According to prior studies, at least one of the reasons that foreign companies list on US stock exchanges is in an effort to enhance their credibility by legally bonding themselves to the comparatively rigorous US financial regulatory system. But Ge and Matsumoto say that the efficacy of this strategy has its limits.

Practicing impeccable accounting will help develop “reputational bonding.” This takes a lot longer to develop than legal bonding, but ultimately will provide greater compensation for the inherent disadvantages that firms have as lesser-known quantities trading on US markets.

“For foreign firms, being listed in US markets doesn’t mean they are equivalent in the eyes of US investors. And when investors are not familiar with a company from a different culture, they tend to stereotype,” says Ge, the Moss Adams Endowed Professor of Accounting. “To overcome this, our findings suggest that it’s crucial for foreign firms listed in the US to establish credibility in their financial reporting.”

The Price of Being Foreign: Stock Market Penalties Associated with Accounting Irregularities for U.S.-listed Foreign Firms” was published in the summer 2020 issue of the journal Contemporary Accounting Research.

Ed Kromer Managing Editor Foster School

Ed Kromer is the managing editor of Foster Business magazine. Over the past two decades, he has served as the school’s senior storyteller, writing about a wide array people, programs, insights and innovations that power the Foster School community.