The effects of annual accounting data on stock returns and trading activity: A causal model study

This study develops a structural equation model linking both abnormal stock returns and abnormal trading volume to unexpected changes in accounting ratios that result from the issuance of annual accounting data. The three contributions of this study are as follows: (a) a simultaneous investigation of both the price and the trading activity stock market reactions to the issuance of annual financial statements; (b) the application of a measurement model to depict the changes in a firm’s financial characteristics, which result from the issuance of financial statements; and (c) a causal model structure is developed, estimated, and tested. Through overidentification of the model, the hypothesized model structure is evaluated. Instead of investigating the price and trading activity reactions separately, as was done in previous studies, the two reactions are modeled simultaneously and are linked. A measurement model is hypothesized to aggregate the unexpected changes in 13 financial ratios into the unexpected changes in 4 latent financial dimensions: liquidity, leverage, profitability, and activity. The structural model then links the unexpected changes in the financial dimensions to abnormal stock market returns and trading volume. The 13 equations of the measurement model and the 2 structural equations are estimated simultaneously using LISREL, a full information maximum likelihood estimation procedure. The model is estimated, and the hypothesized model configuration recreates 82% of the generalized variance in the observed data. The individual parameter estimates show that the major source of variation in abnormal returns is the unexpected changes in profitability. None of the unexpected changes in the financial dimensions are found to be significantly linked directly to abnormal trading volume. Instead, the link is indirect through the relationship between abnormal returns and abnormal volume.