Purpose: The purpose of this paper is to examine whether the stock market in India is efficient in the semi-strong form.
Design/methodology/approach: The study uses financial and stock market data of 1,135 listed Indian companies (non-financial) during 2003–2011 collected from Capital IQ to estimate discretionary accruals (DA) using modified Jones model (1995). The study also examines using the widely used Mishkin (1983) test to whether equity market prices accruals in India. The study is conducted for profit/loss-making firms separately as well as for a hedge portfolio of firms based on the lowest to highest accruals.
Findings: The empirical study of DA of 1,135 listed Indian companies (non-financial) during 2003–2011 shows that the estimated average DA of the corporate sector in India comes to 1 percent of the total assets of these firms. An empirical analysis whether equity market prices DA in India finds no evidence of investors/market pricing DA. Empirical evidence also finds that the results are invariant for profit/loss-making firms as well as portfolio of firms based on the lowest to highest accruals in the Indian context. The empirical evidence shows that the Indian equity market is inefficient with regard to the incorporation of accruals in expected returns of stocks
Accounting principles provide managers considerable discretion in managing earnings. Earnings management (EM) is possible either by manipulating accruals (more by altering DA) or by manipulating real activities (operational activities). Accruals are adjustments which accountants/managers which cause book earnings to differ from cash earnings (Dechow et al., 1995). The numerous scandals at the global level, especially the high-profile cases like Enron, WorldCom, Parmlat, Waste Management, Olympus, etc., and Satyam in India, have shown how managers managed earnings to meet market expectations or derive rents in the form of executive compensation. DA is widely considered as a proxy for EM. India has seen its own massive EM episodes. In 2009, Mr B. Ramalinga Raju, the Chairman and founder of Satyam Computer Services, a firm listed in US NASDAQ stock exchange, revealed a $2,260m fraud that he had perpetuated over the prior five years (2003–2008) (Mohapatra et al., 2015). Satyam was listed in both Bombay Stock Exchange (BSE) and National Stock Exchange (NSE) when it became public in 1991; it was also listed in NASDAQ in 1999 and in NYSE in 2001 (Chakrabarti and Sarkar, 2010). In his confession letter to the BSE, Mr Raju famously states that the five years of falsifying Satyam’s accounts was “[…] like riding a tiger, not knowing how to get off without being eaten.” Episodes like Satyam raises questions on how reliable is financial information reported by firms in emerging market economies (Li et al., 2014). One of the hotly debated issues is whether investors/market has the ability to process cash flow and accrual components of earnings information. The debate is centered on the issue whether market is able to isolate information related to cash flows and accruals. Research by Sloan (1996) shows that stocks of high accrual firms earns negative abnormal returns in the subsequent periods. Fama and French (2008, 2015) identify accrual anomaly as one of the widely prevalent financial anomalies. The accrual anomaly is widely interpreted as evidence of market inefficiency. How does market react to accrual and cash flow component of earnings is an actively researched question. But most of the empirical studies are in the context of developed countries, and there is very little work with respect to emerging market economies. The study by Pincus et al. (2007) showed that cash flows and accruals are often undervalued in emerging economies. The subsequent study by Chen et al. (2010) in the context of Taiwan also confirms these conclusions – the use of DA to manage earnings is pervasive and investors tend to lose confidence in accounting earnings and thus tend to under-value earnings. This is inconsistent with the predictions of efficient market hypothesis (Fama, 1991). The study by Cupertino et al. (2012) with regard to Brazil (non-financial firms), on the other hand, confirms that the market correctly prices both accruals and cash flows. This conflicting evidence on accrual anomaly warrants a fresh look at the empirics especially in the context of emerging market economies like India. We examine this issue in the context of India which, in recent years, is the fourth best-performing stock market in the world and is unique in terms of ownership structure, investor participation and long institutional reform process to enhance market efficiency (Dash and Mahakud, 2013, 2015; International Monetary Fund, 2013). The country is still based on Indian GAAP accounting standards, which provide considerable latitude for managers at arriving at the final earnings number and thus hide the underlying financial condition of the firm. Available evidence on testing stock market efficiency (weak form) finds that Indian stock market do not follow random walk, i.e. it is inefficient (Gupta and Basu, 2007; Thomas and Kumar, 2010; Harper and Jin, 2012).