Earnings Components, Stock Return Variability, and the Impact of Corporate Governance

Using the Vuolteenaho’s (2002) return variance decomposition methodology, this study assesses the value implication of corporate governance in the US stock market. We analyze the valuation effect of corporate governance by measuring its impact on the contribution of earnings news to the variability of unexpected equity returns. Our empirical results indicate that both earnings news and expected- return news significantly contribute to the variance of unexpected returns. When we disaggregate earnings news into cash-flow news and accrual news, we find that cash-flow news, accrual news and expected-return news are all value relevant and cash-flow news is the most dominant information component in explaining a cross-section of return volatility. More importantly, we find that earnings news and expected-return news are more value relevant in well-governed firms than in poorly-governed firms. We further show that the positive association between governance effectiveness and the value relevance of earnings news arises from the effect of corporate governance on cash-flow news rather than its effect on accrual news. Our findings support the claim that corporate governance positively impacts the value relevance of earnings information.