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We examine whether availability of higher quality financial information lessens investor losses during a period seen as a stock market crash. We focus on October 1929, which partly motivated sweeping financial reporting regulations in the 1930s. Using a sample of 540 common stocks traded on the New York Stock Exchange during October 1929, we find that the quality of firms’ financial reporting increases with managers’ incentives to supply higher quality financial information demanded by investors. Moreover, firms with higher quality financial reporting before October 1929 experienced smaller stock price declines during the market crash.

One view that often emerges after a financial crisis is that investor losses would have been lower had managers chosen to supply higher quality financial reporting. Such a view surfaced in 19th-century Great Britain after periods with high business failure rates (Littleton, 1933, pp. 272–287), and in the United States after stock market downturns in October 1929 and 2000–2001 (Pecora, 1939; U.S. House, 2002). In each of these cases, this view partly motivated sweeping changes in financial reporting regulation. This regularity naturally raises the question: To what extent do managers, absent a regulatory mandate, actually supply higher quality financial reporting that mitigates investor losses during a financial crisis? We provide U.S. evidence on this issue by testing whether shareholders of firms with higher quality financial reporting during the late 1920s suffered smaller losses in the stock market crash of October 1929.1 Specifically, we examine two hypotheses. The first concerns the extent to which, in the absence of a regulatory mandate, managers voluntarily supply higher quality financial reporting consistent with investors’ economic interests. Our second hypothesis is whether financial reporting policies selected in an unregulated reporting environment are associated with beneficial investor protection as reflected in less negative common stock returns in October 1929. The available evidence on the association between financial reporting quality and stock returns during a market crash is sparse and based on international data. Johnson et al. (2000) find no relation between country-specific measures of accounting quality and stock market performance in the 1997–1998 East Asian crisis. Using two firm-specific proxies for accounting quality (external audit by a Big 6 auditor and U.S. ADR listing), Mitton (2002) documents a positive relation between reporting quality and firms’ stock returns during the East Asian crisis. Glaeser et al. (2001) compare stock market performance in Poland and the Czech Republic after the fall of communism in 1989. Poland adopted stringent reporting regulation (along with other legal requirements for protecting shareholders) and experienced strong capital market development over 1994–1998. In contrast, over the same period, the Czech financial market was much less regulated and experienced a substantial decline in aggregate market capitalization and number of listed firms. Our focus on U.S. firms in the 1920s offers insights beyond prior studies for three reasons. First, the 1920s’ reporting environment presents considerable cross-sectional variation in financial reporting, even on very basic choices such as disclosure of revenues and operating expenses (Benston, 1969). Hence, we can develop direct firm-specific measures of voluntarily chosen reporting quality and identify more clearly the effects of these choices on investor wealth. Second, the October 1929 market crash is seen as among the most significant financial crises in U.S. history (Galbraith, 1972), and was followed within five years by the most extensive changes in financial reporting requirements in U.S. history (Parrish, 1970). Thus, this setting suits well our need for an event perceived as a financial crisis linked, in part, to deficient financial reporting quality. Third, and most important, pre-1930s’ U.S. financial reporting had developed over a long period as part of the broader evolution of financial markets, contractual and related legal arrangements, and other institutions such as information intermediaries (Gower, 1920; Fisher, 1933; Hawkins, 1963; Miranti, 1986). Financial reporting in the setting we examine thus likely differs fundamentally from that in a newly created, unregulated market such as the Czech Republic in the mid-1990s. We believe our setting provides a powerful economic test of whether managers’ voluntary financial reporting choices can promote beneficial investor protection in the absence of mandatory reporting requirements.2 We model the economic determinants of voluntary financial reporting and test for the presence of beneficial investor protection, while controlling for the endogeneity of reporting policies and other determinants of crash-period stock returns. We first model managers’ choice of financial reporting quality, which we measure as income statement and balance sheet transparency, accounting conservatism and the purchase of an external audit. Our use of transparency measures assumes that finer disaggregation of financial statement data allows users to identify better underlying economic factors responsible for changes in key aggregates such as income and net assets. More conservative financial reporting can enhance information credibility when investors believe that managers might seek to overstate income and net assets for personal gain. Likewise, the purchase of an audit suggests that reported information is more likely free of misrepresentation and thus more reliable. We estimate reporting choice models where the dependent variable is a combination of these quality attributes derived from a principal factor analysis (consistent with Bushman et al., 2004a). Our independent variables include proxies for likely determinants of managers’ financial reporting choices (Watts and Zimmerman, 1986; Healy and Palepu, 2001). These include information costs in equity markets, potential contractual and control conflicts among claimants to the firm's assets, the prospect of shareholder wealth loss due to competitor and government responses to the firm's product market success, and the availability of alternative information for investors to use in valuing claims and monitoring management. Our evidence suggests that these factors are associated with our measure of financial reporting quality. Contracting and control conflicts play an important role in managers’ voluntary reporting policies. For example, our quality measure (as well as the underlying measures of income statement transparency, auditing and conservatism) is positively associated with leverage. Consistent with Ahmed et al. (2002), the presence of a potential income measurement conflict that can affect distributions to claimants also is associated with more conservative reporting.3 These findings are consistent with a longstanding demand for accounting information based on contracting (Watts, 1977 and Watts, 2003; Watts and Zimmerman, 1983). Proxies for information costs in equity markets also are significantly associated with financial reporting quality. Higher financial reporting quality scores, driven largely by greater auditing and conservatism, characterize firms issuing equity. Young firms in technology-based industries that are more difficult to value also have higher reporting quality scores. Firms where alternative information is available, either because of the firm's dividend policy or regulated product markets, exhibit significantly lower reporting quality measures. We also find some support for the conjecture that firms facing higher competitive and political costs choose lower quality reporting, but this evidence is weak and limited to conservatism as a measure of reporting quality. As a whole, our findings suggest that managers select financial reporting quality by factoring in investor demand for information. Our investor protection tests follow from the view that managers’ self-selected higher quality financial reporting can lessen investor losses during a market crash. Like Johnson et al. (2000) and Mitton (2002), we test the hypothesis that firms with higher quality reporting experience less negative stock returns during a market crash. These market-based tests require that we model managers’ self-selection of reporting quality and control for other factors associated with stock returns during the 1929 market crash. We use instrumental variables techniques to model the endogeneity in financial reporting. We also control for firms’ risk and inherent noise in fundamental values likely affecting stock returns during the 1929 market crash (Blanchard and Watson, 1982; Hong and Stein, 2003). We then estimate a cross-sectional model where the firm's October 1929 common stock return is the dependent variable and the independent variable of primary interest is our proxy for financial reporting quality. We predict a positive coefficient on this independent variable; that is, higher reporting quality will be associated with less negative October 1929 returns, all else equal. Our evidence supports the hypothesis that shareholders of firms with higher quality financial reporting experienced significantly smaller losses during the 1929 crash. To get a better sense of the economic magnitude of this effect, we compare the returns of firms in the top quartile of our reporting quality measure with the returns of other firms. After controlling for endogeneity and other factors affecting crash-period returns, we estimate that investors in firms in the top quartile lost on average about 11% (i.e., 1,100 basis points) less during the 1929 crash than did investors in other firms—about half of what other investors lost during the crash. Our market-based tests also indicate that proxies for noisy fundamentals explain a significant proportion of October 1929 returns; these results are consistent with previous research examining the cross-sectional variation in equity returns during a market crash (Chen et al., 2001). Viewed collectively, our evidence suggests that managers respond to investor demand for information and that managers’ voluntary financial reporting choices can promote investor protection. That is, economic forces in advanced markets provide managers with incentives for beneficial financial reporting even in the absence of a regulatory mandate. At the same time, our tests are modest in scope. We do not examine directly the incremental effects of mandatory financial reporting, which may have significant economic value beyond managers’ voluntary financial reporting choices. Thus, our results do not speak to the social value of financial reporting regulation. Measuring the relative effects of voluntary versus mandatory financial reporting quality remains an important issue for future research. As any empirical study, ours is subject to several caveats. First, our tests rely on proxies for unobservable constructs; measurement error could bias our tests against finding statistically significant results. In addition, theories and empirical work on accounting-based cross-sectional differences in stock returns during a market crash are limited (see, e.g., Bowen et al., 1989; Keating et al., 2003). To the extent that we are unable to identify and control for correlated omitted variables, our results may be biased. Finally, the period we examine differs markedly from current times, so it would be inappropriate to generalize our results directly to the present, when extensive financial reporting regulation is in place in the U.S. and in many other countries. The rest of the paper is organized as follows. Section 2 develops our hypotheses and Section 3 describes the sample. Corporate financial reporting, the stock market and equity valuation in the late 1920s are described in Section 4. Section 5 examines the relation between financial reporting quality before October 1929 and managers’ incentives to report consistent with shareholders’ interests. Evidence on the relation between October 1929 stock returns and ex ante measures of financial reporting quality follows in Section 6. Finally, Section 7 offers concluding remarks.

Using a sample of 540 NYSE firms during the stock market crash of October 1929, we provide evidence that managers have incentives to report higher quality financial information absent a regulatory mandate, and that such reporting provides beneficial investor protection. We measure financial reporting quality along the dimensions of financial statement transparency and credibility; we measure investor protection by the reduction in investor losses during October 1929 associated with higher quality financial reporting. Our empirical analyses show that our proxies for financial reporting quality are significantly associated with variables capturing cross-sectional variation in reporting incentives related to equity market information costs, contracting and control conflicts, the potential for competitive and regulatory costs, and the existence of alternative information for valuation and monitoring. This evidence suggests that managers respond to economic incentives to supply higher quality financial reports even in the absence of regulation. Our analyses also show that investor losses during the October 1929 market crash were statistically and economically smaller for firms with higher financial reporting quality, after controlling for endogeneity in managers’ reporting choices, inherent noise in fundamental values and firms’ risk profiles. These findings are consistent with the notion that managers’ self-selected higher quality financial reporting is associated with beneficial investor protection. Our findings speak to issues addressed in several previous studies and suggest additional areas of inquiry. Prior research shows that beneficial investor protection from higher quality financial reporting is observed under mandatory disclosure regimes (Johnson et al., 2000; Glaeser et al., 2001; Mitton, 2002). Our evidence shows that similar effects occur under voluntary disclosure regimes. This implies that private contracting and market arrangements can evolve in ways that promote investor protection. A central unresolved issue is the incremental effects of voluntary versus mandatory disclosure, and the nature of any interdependencies between the two. Additional research could explore investor protection in settings where mandatory disclosure is extended (e.g., the expansion of the Securities Acts to over-the-counter firms in the 1960s) or where new capital markets are created (e.g., the German Neuer Market analyzed in Leuz, 2003). One also could examine the evolution of firms with strong financial reporting to understand, for example, what circumstances led such firms to adopt better reporting and what role regulation played in the process. Conversely, other analyses could explore whether weak reporting firms are affected substantially by regulation, that is, whether financial reporting regulation “pulls up” the weakest firms. Such analyses would provide needed evidence on the role of regulation in improving firms’ disclosures (Healy and Palepu, 2001, pp. 410–415). Our study also links with the accounting choice literature. In a review of this literature, Fields et al. (2001) note that progress has been hampered by various methodological limitations in previous work, such as failing to specify multi-attribute measures of reporting choice, to correct for endogeneity problems, and to model multiple incentives driving a reporting choice. Our analyses and results provide support for their assertion that resolving these issues can yield value to researchers studying firms’ accounting choices. While our methodological choices are tailored to the setting we examine, we believe our results suggest that more general methodological research on accounting choice is important. While not a primary focus of our study, our evidence contributes to research on accounting conservatism, a topic that recently has generated considerable interest among accounting academics (Watts, 2003). Our evidence complements other studies indicating that conservatism is a longstanding feature of U.S. financial reporting (Basu, 1997; Holthausen and Watts, 2001; Sivakumar and Waymire, 2003). Our evidence also suggests that pre-SEC conservatism is related to multiple reporting incentives such as debt contracting and information costs in securities markets. Future research could examine cross-sectional relations between conservatism and its determinants using more recent data. Finally, our study extends previous accounting research examining the relation between accounting information and price behavior during a market crash (Bowen et al., 1989; Keating et al., 2003). Such research investigates the extent to which specific realizations of accounting numbers (e.g., reported earnings levels) influence stock prices during a crash. Our study extends this research by assessing whether the ex ante quality of financial reporting (as opposed to specific realizations) affects crash-period returns. Areas for additional research include the economic and psychological factors influencing investor perceptions of financial reporting quality and the propensity of stocks to exhibit large price increases followed by a sharp price decline.