Research Summary

Financial reporting quality and its consequences

by Gwen Yu

Description

Does reporting quality have real economic consequences? Professor Yu addresses this question in her research, which examines the channels through which reporting quality affects the behavior of economic agents, namely managers and investors. Her particular focus is on how changes in certain accounting regimes or in the reporting behavior of a firm influence the way different agents view the firm.

Professor Yu’s current research highlights three aspects of financial reporting and its consequences.

In light of the recent global push toward accounting harmonization, and particularly the adoption of International Financial Reporting Standards (IFRS), she has investigated accounting standards and cross-border holdings. She has found that reducing differences in accounting standards increases foreign holdings of international mutual funds by directly reducing the information processing cost of foreign investors. Even more important is her finding that harmonizing accounting standards reduces the effect of other private information barriers by making investors rely more on public information sources and less on private ones.

Professor Yu also examines the ability of accounting to predict major events, such as currency crises. While neoclassical models suggest that improving the quality of financial information tightens the link between the realization of the information and the underlying fundamentals, models of recent crises suggest that higher information quality can generate multiplicity, divorcing the signals from the fundamentals. In the first empirical study of its kind, Professor Yu has discovered that accounting signals predict crises only in countries with low accounting precision, suggesting that precise public signals can coordinate traders’ beliefs and therefore increase volatility and generate multiplicity.

The third avenue of Professor Yu’s research examines hedge fund returns. As these funds have grown larger, could they hamper their own ability to hedge risks and generate superior returns? By making the critical distinction between the returns of hedge funds themselves and the returns of investors in these funds, Professor Yu has found that, based on the specification and time period examined, investors’ annualized, dollar-weighted returns are 3 to 7 percent lower than those on corresponding buy-and-hold returns. The implication is that, after considering risk, hedge-fund investors’ returns are much lower than generally expected.