Institutional environment and market pricing of firm specific c ash flows

This paper assesses the extent to which the Chinese stock market price and accounting information in an efficient manner and how the institutional environment affects the market pricing efficiency of accounting information. By using Chinese A share stock data, we find that market significantly underprices firm specific cash flows in the current period. We use the ratio of labor population in the private economic sector to total labor population in each province. Fan Gang’s (2011) NERI Index of Marketization of China’s Provinces was used as proxies for the regional institutional environment to assess how the institutional environment affects pricing efficiency. We find that the mispricing of firm specific cash flows still exists in regions with less economic freedom and less developed institutional environment. However, market exhibits efficient pricing of accounting information in regions with more economic freedo m and developed institutional environment. As a micro reflection of the institutional environment, effective execution of accounting policies is considered as an important part of corporate governance mechanism. Ineffective implementation of accounting pol icies exaggerates agency problem and leaves rooms for manager’s opportunistic behaviors. Prior research suggests that managers manipulate cash flows for opportunistic management objectives at the cost of firm perfo rmance. Hence, we further examine the infl uence of managing cash flow manipulation on market pricing of firm specific cash flows. The results show that investors overestimate the influence of managing cash flow manipulation on the market pricing efficiency of firm specific cash flows. Also, we tes t the relation between current period firm specific cash flows and future abnormal stock returns by portfolio sorting and regression analysis. We find that firm specific cash flows are positively associated with future stock returns. As a result, an invest or can exploit the mispricing of firm specific cash flows in the current period and earn significantly positive abnormal returns in the upcoming year with a hedged stock portfol io rebalancing at a yearly frequency. Our contribution lies at least in two asp ects. First, we find different pricing mechanisms of firms’ cash flows components in China in contrast with the US market. Unlike the mispricing of industry level cash flows in the US, we find the correct pricing of industry level cash flows and incorrect pricing of firm specific cash flows in the Chinese market by applying the research methodology of Hui et al. (2016), and this mispricing phenomenon still exists after controlling the effect of accrual anomaly. Moreover, we document that a good institutiona l environment reduces mispricing of accounting information, which adds to the current literature on the institutional environment and market pricing of accounting information. Our results support the conjecture that investors have difficulties using firm s pecific information in Chinese A Share market, and improvement of institutional environment can increase the market pricing efficiency of accounting information. The conclusion of this paper is instructive for security regulators and trading strategy devel opers.