Prior studies show that equity value has convex relations with earnings and book value of equity due to the options of growth and adaptation opportunities (Burgstahler and Dichev 1997; Zhang 2000). In this study, we investigate whether these relations vary with the degree of a country’s economic freedom that protect managers’ decision rights and limits government intervention. We hypothesize that (1) investment flexibility is greater in countries with greater economic freedom, and (2) the relations between equity value and earnings and book value of equity are more convex in countries with greater economic freedom. Using the index of economic freedom from the Fraser Institute, we test our hypotheses with data from 34 countries during the period from 2000 to 2006. The empirical results are consistent with our hypotheses. In addition, we use a changes model and find that the convex relations of equity value with earnings and book value of equity are enhanced when there is an increase in economic freedom. The effect of economic freedom that we document is distinct from the effects of GDP growth, legal origin, law enforcement, investor protection, and differences in financial reporting. Our results suggest that greater economic freedom enhances equity value through more efficient management of investment options.

Prof. Jin got his Ph.D. of Accounting from Hong Kong University of Science and Technology, and Master of Accounting, and Bachelor of Economics in Auditing from Xi’an Jiaotong University. His research interest is regulation and valuation. He has publications in top journals such as The Accounting Review.