Showing papers in "Review of Accounting Studies in 2003"
TL;DR: In this paper, the authors investigate whether boosting of discretionary accruals to report a small profit is a reasonable explanation for the kink in the distribution of profits in the earnings distribution.
Abstract: Prior research has documented a “kink” in the earnings distribution: too few firms report small losses, too many firms report small profits. We investigate whether boosting of discretionary accruals to report a small profit is a reasonable explanation for this “kink.” Overall, we are unable to confirm that boosting of discretionary accruals is the key driver of the kink. We caution the use of the ratio of small profit firms to small loss firms as a measure of earnings management. We investigate and discuss a number of alternative explanations for the kink.
861 citations
TL;DR: The authors compare risk premia (RP) inferred using the Ohlson-Juettner (RPOJ) and residual income valuation (RPRIV) models in three ways: correlation with risk factors, correlation with RP estimated by multiplying current realizations of risk factors by coefficients obtained from regressing prior-year RP on prior year risk factors; and correlation with ex post returns.
Abstract: We compare risk premia (RP) inferred using the Ohlson-Juettner (RPOJ) and residual income valuation (RPRIV) models in three ways: (1) correlation with risk factors; (2) correlation with RP estimated by multiplying current realizations of risk factors by coefficients obtained from regressing prior-year RP on prior-year risk factors; and (3) correlation with ex post returns. RPOJ has expected correlations with risk factors, a modest correlation with RP estimated from prior-year regressions, and an economically significant association with ex post returns. RPRIV has generally higher correlations, but regression coefficients are sensitive to whether the industry median ROE is computed with or without loss firms.
791 citations
TL;DR: This paper examined the role of institutional investors in the pricing of accruals and found that firms with a high level of institutional ownership and a minimum threshold level of active institutional traders have stock prices that more accurately reflect the persistence of accrued revenue.
Abstract: This paper examines the role of institutional investors in the pricing of accruals. Using Bushee;s (1998) classification of institutional investors, we show that firms with a high level of institutional ownership and a minimum threshold level of active institutional traders have stock prices that more accurately reflect the persistence of accruals. This result holds after controlling for differences in the persistence of accruals between firms with high and low institutional ownership, and after controlling for other characteristics that are correlated with institutional ownership and future returns. Additionally, firms with low institutional ownership are smaller, less profitable, and have lower share turnover, suggesting that limits to arbitrage impede institutional investors from exploiting the seemingly large abnormal returns for these firms.
414 citations
TL;DR: This article investigated the informational properties of pro forma earnings and found that higher levels of exclusions lead to predictably lower future cash flows and that investors do not fully appreciate the lower cash flow implications at the time of the earnings announcement.
Abstract: We investigate the informational properties of pro forma earnings. This increasingly popular measure of earnings excludes certain expenses that the company deems non-recurring, non-cash, or otherwise unimportant for understanding the future value of the firm. We find, however, that these expenses are far from unimportant. Higher levels of exclusions lead to predictably lower future cash flows. We also find that investors do not fully appreciate the lower cash flow implications at the time of the earnings announcement. A trading strategy based on the excluded expenses yields a large positive abnormal return in the years following the announcement, and persists after controlling for various risk factors and other anomalies.
338 citations
TL;DR: In this paper, the authors investigated investors' reactions to revenue and expense surprises around preliminary earnings announcements and found that investors value more highly a dollar of revenue surprise than a dollars of expense surprise.
Abstract: This study investigates investors' reactions to revenue and expense surprises around preliminary earnings announcements. Results show that investors value more highly a dollar of revenue surprise than a dollar of expense surprise. Results further show that these differential market reactions to revenue and expense surprises vary systematically for growth versus value firms and depend on (a) the proportion of variable to total costs, (b) the relative persistence of sales and expenses, and (c) the proportion of operating to total expenses. Results highlight the importance of interpreting the earnings surprise in the context of its sources—e.g. surprise in revenues or in total expenses.
331 citations
TL;DR: In this article, the authors show that operating earnings reported by managers and analysts are more value relevant than a measure of operating earnings derived from firms' financial statements, as reported by Standard and Poor's.
Abstract: Prior research has shown that pro-forma (recurring operating) earnings reported by managers and analysts are more value relevant than GAAP net income. Since GAAP net income contains many non-operating items that reduce its value relevance compared to operating earnings, comparing the value relevance of GAAP net income with operating earnings unduly favors operating earnings. We show that operating earnings reported by managers and analysts are more value relevant than a measure of operating earnings derived from firms' financial statements, as reported by Standard and Poor's. Our evidence is important because it indicates that operating earnings reported by managers and analysts contain value relevant information beyond that provided by operating earnings obtained by sophisticated users from firms' financial statements.
208 citations
TL;DR: The authors examined the investor response to Form 10-K and 10-Q reports filed between 1996 and 2001 and found that the absolute value of excess return is reliably greater on the day of and on the one or two days immediately following the filing date.
Abstract: This study examines the investor response to Form 10-K and 10-Q reports filed between 1996 and 2001. The samples comprise essentially the entire body of EDGAR filings, including the small business (SB) versions of each filing type. The study documents that the absolute value of excess return is reliably greater on the day of and on the one or two days immediately following the filing date. The response is stronger around a 10-K date than a 10-Q date, more elevated for delayed filers, and increases significantly over the study period for both filing types. A regression analysis indicates that differences in response due to filing delay and year of filing are not subsumed by other attributes of the information environment, such as changes in industry composition, day of week, market capitalization, and shares held by institutions.
171 citations
TL;DR: In this paper, the authors present evidence that prices of firms followed by sell-side analysts and favored by institutional investors incorporate future earnings earlier than prices of other firms, and they conduct two sets of empirical tests: the first examines coefficients from regressions of returns on lead, contemporaneous and lag earnings changes; the second compares the timing of monthly abnormal returns from earnings-based zero-investment portfolios.
Abstract: This paper presents evidence that prices of firms followed by sell-side analysts and favored by institutional investors incorporate future earnings earlier than prices of other firms. We conduct two sets of empirical tests: the first examines coefficients from regressions of returns on lead, contemporaneous, and lag earnings changes; the second compares the timing of monthly abnormal returns from earnings-based zero-investment portfolios. In both sets of tests, the results for analysts and institutions are incremental to each other. In addition, neither the analyst price lead nor the institutional price lead is due to price leads increasing with firm size.
170 citations
TL;DR: In this article, the authors examined post-earnings announcement drift in the context of theories that consider investors' non-Bayesian behaviors and found that investors' overconfidence about their private information and the reliability of the earnings information are two important factors that explain drift.
Abstract: Prior research has been unable to explain the phenomenon known as post-earnings announcement drift, raising questions concerning the semi-strong form efficiency of the market typically assumed in capital market research. This study contributes to our understanding of this anomaly by examining drift in the context of theories that consider investors' non-Bayesian behaviors. The empirical evidence reveals that investors' overconfidence about their private information and the reliability of the earnings information are two important factors that explain drift. Finally, this study also provides insight into the puzzling relationship between dispersion and drift discussed in prior research.
155 citations
TL;DR: The authors found that the stock market overweights the contribution of order backlog in predicting future earnings, and a hedge strategy that exploits such overweighting generates significant future abnormal returns, however, such mispricing is not due to analysts' inability to incorporate order backlog into their earnings forecasts.
Abstract: Although leading indicators are becoming increasingly important for equity valuation, disclosures of such indicators suffer from the absence of GAAP related guidance on content and presentation. We explicitly examine (i) whether one leading indicator—order backlog—predicts future earnings, and (ii) whether market participants correctly incorporate such predictive ability in determining share prices. We find that the stock market overweights the contribution of order backlog in predicting future earnings, and a hedge strategy that exploits such overweighting generates significant future abnormal returns. However, such mispricing is not due to analysts' inability to incorporate order backlog into their earnings forecasts.
140 citations
TL;DR: This paper found that accruals and cash flows have no differential relation to one-year-ahead operating income, and that the lower persistence of accruality versus cash flows may not be due to earnings management but rather due to the effect of growth on future profitability.
Abstract: Prior research provides evidence that a higher proportion of accrued relative to cash earnings is associated with lower earnings performance in the subsequent fiscal year. The result has been widely interpreted as indicative of higher levels of operating accruals relative to cash flows foreshadowing a subsequent “earnings reversal,” and thus signaling earnings management. We note, however, that earnings performance in prior studies is typically defined as one-year-ahead operating income divided by one-year-ahead invested capital, or a measure of profitability. We find that accruals are more highly associated than cash flows with invested capital in the denominator of the profitability measure. In contrast, accruals and cash flows have no differential relation to one-year-ahead operating income. The evidence is not consistent with accruals having a reversal effect on earnings. This suggests that the lower persistence of accruals versus cash flows may not be due to earnings management but may rather be due to the effect of growth on future profitability.
TL;DR: In this article, the authors present a financial statement analysis that distinguishes leverage that arises in financing activities from leverage arising in operations, and conclude that balance sheet line items for operating liabilities are priced differently than those dealing with financing liabilities.
Abstract: This paper presents a financial statement analysis that distinguishes leverage that arises in financing activities from leverage that arises in operations. The analysis yields two leveraging equations, one for borrowing to finance operations and one for borrowing in the course of operations. These leveraging equations describe how the two types of leverage affect book rates of return on equity. An empirical analysis shows that the financial statement analysis explains cross-sectional differences in current and future rates of return as well as price-to-book ratios, which are based on expected rates of return on equity. The paper therefore concludes that balance sheet line items for operating liabilities are priced differently than those dealing with financing liabilities. Accordingly, financial statement analysis that distinguishes the two types of liabilities informs on future profitability and aids in the evaluation of appropriate price-to-book ratios.
TL;DR: In this article, the authors examined the value relevance of two alternative accounting methods for exploration and development (E&D) expenditures for oil and gas firms and concluded that full cost accounting data is more value-relevant than successful efforts (SE) accounting data.
Abstract: This paper examines the value relevance of two alternative accounting methods for exploration and development (E&D) expenditures for oil and gas firms. I find that full cost (FC) accounting data is more value-relevant than successful efforts (SE) accounting data. Further analysis reveals that the smooth earnings provided by the FC method contributes to the higher value relevance of the FC method. This study concludes that a policy of full capitalization of expenditures with uncertain future economic benefits better summarizes information relevant to investors relative to a policy of partial capitalization.
TL;DR: In this article, the authors argue that since there is considerable evidence that IBES earnings differ from pro-forma earnings, it is not clear that the empirical analyzes in this paper may be used to draw any conclusions about pro forma earnings.
Abstract: Doyle et al. (2003, this issue) provide evidence that IBES exclusions have incremental explanatory power (over GAAP earnings) for future cash flows, for market-adjusted returns at the earnings announcement date, and for future market-adjusted returns. They argue that this evidence supports the viewpoint that “the current regulatory concern about the use of pro forma earnings may be warranted.” My contention in this discussion is that one can readily posit alternative explanations for each of the empirical results, in turn suggesting that the results do not provide a basis for regulatory concern. Further, since there is considerable evidence that IBES earnings differ from pro forma earnings, it is not clear that the empirical analyzes in this paper may be used to draw any conclusions about pro forma earnings.
TL;DR: In this paper, the authors derive a new model of the ARR-IRR relation, and describe how the conservatism of GAAP constrains a firm's IRR to fall in a range bounded by its historical growth rate and ARR.
Abstract: Accounting information is used for measuring firm performance in various financial applications—a practice supported by empirical studies demonstrating the value relevance of accounting numbers, but disputed by theoretical papers arguing that a firm's accounting rate of return (ARR) serves poorly as a proxy for its internal rate of return (IRR). We derive a new model of the ARR–IRR relation, and describe how the conservatism of GAAP constrains a firm's IRR to fall in a range bounded by its historical growth rate and ARR. Using cross-sectional data, we demonstrate that economic returns can be estimated from accounting numbers for many firms. We link empirical results to underlying economic theory, and thus contribute to understanding why accounting information is value relevant.
TL;DR: In this paper, the authors investigate the effectiveness of proportionate liability in reducing the probability of fraud and audit risk relative to joint and several liability in two strategic audit settings: one that provides conclusive evidence of fraud, and another that provides inconclusive evidence for fraud.
Abstract: We investigate the effectiveness of proportionate liability in reducing the probability of fraud and audit risk relative to joint and several liability in two strategic audit settings: one that provides conclusive evidence of fraud and one that provides inconclusive evidence of fraud. In both settings the auditor makes an audit effort choice, but in the second setting the auditor also evaluates the audit evidence. Our results show that when the auditor chooses only effort, a proportionate liability rule with large marginal liability relief decreases audit risk. However, when the auditor also evaluates the audit evidence this result no longer holds.
TL;DR: In this article, the authors show that in the presence of share supply variations which are unrelated to information, there is a positive correlation between the unexpected component of current public signals and future price changes.
Abstract: This paper demonstrates that a post-announcement earnings drift, which is often advanced as an example of market irrationality, can arise even if traders act rationally on their information. Specifically, we show that in the presence of share supply variations which are unrelated to information, there is a positive correlation between the unexpected component of current public signals and future price changes. Such a correlation arises from the fact that while prices reveal private information that cannot be found in public signals, non-information based trading distorts the information content of prices relative to the implications of both private and public information. Under these circumstances, markets may appear semi-strong inefficient and slow to respond to earnings announcements even though information is processed in a timely and efficient manner. Our findings correspond well with previously documented empirical evidence and suggest that the robustness of earnings-based "anomalies" may be rational outcomes of varying uncertain share supply.
TL;DR: The Dechow et al. as mentioned in this paper study on the distribution of earnings raises an important question: why are earnings kinky? They conduct a number of tests of the earnings management explanation and do not find supportive evidence.
Abstract: The Dechow et al. paper (2003, this issue) on the distribution of earnings raises an important question: why are earnings kinky? They conduct a number of tests of the earnings management explanation and do not find supportive evidence. They also provide evidence that a number of factors influence the magnitude of the discontinuity in earnings, suggesting that it is a poor proxy for the extent of earnings management. This discussion addresses the contribution of their study, the power of their tests and the implications for future research.
TL;DR: In this article, the authors study a principal-agent model of moral hazard in which the principal has an abandonment option and the option holder cannot always commit to the precise circumstances under which the option will be exercised.
Abstract: We study a principal-agent model of moral hazard in which the principal has an abandonment option. The option to abandon a project midstream limits a firm's downside risk. From a consumption (production) perspective, the option is clearly beneficial. However, from an incentive perspective, the option can be costly. Removing the lower tail of the project's underlying cash flow distribution also eliminates the information it contains about an agent's (unobservable) productive input. In addition, there is also the issue that the option holder cannot always (ex ante) commit to the precise circumstances under which the option will be exercised. These concerns introduce an interaction in the valuation of the abandonment option and information system. In particular, the manner in which information is coarsened and the direction of the flow of information are critical design parameters that affect option value.
TL;DR: In this paper, the authors consider a setting where a firm delegates an investment decision and, subsequently, a sales decision to a privately informed manager, and they show that compensating the manager based on pre-tax residual income can ensure after-tax NPV-maximization.
Abstract: We consider a setting where a firm delegates an investment decision and, subsequently, a sales decision to a privately informed manager. For both decisions corporate income taxes have real effects. We show that compensating the manager based on pre-tax residual income can ensure after-tax NPV-maximization (“goal congruence”) for each decision problem in isolation. However, this metric fails if both decisions are nontrivial, since it requires asset-specific hurdle rates and hence precludes asset aggregation. After-tax residual income metrics (e.g., EVA) allow the firm to consistently apply its after-tax cost of capital as the hurdle rate to its aggregate asset base. We show that existing tax depreciation schedules may explain why firms in practice use more accelerated depreciation schedules than those suggested by previous studies. Our findings also rationalize the widespread use of “dirty surplus” accounting for windfall gains and losses for managerial retention purposes.
TL;DR: In this article, the authors rely on cognitive biases proposed in the behavioral finance literature to predict stock price drifts after earnings earning announcements and conclude that it may be premature to conclude that the cognitive biases discussed here cause drifts.
Abstract: Liang (2003, this issue) hypothesizes that the predictable stock price drifts that occur after earnings earning announcements increase with (a) divergence in analyst beliefs and (b) the reliability of publicly reported quarterly earnings. Whereas the prior literature has generally hypothesized that drifts are caused by the inability of the stock market to fully appreciate predictable autocorrelation in seasonally-differenced quarterly earnings, this paper relies on cognitive biases proposed in the behavioral finance literature. While the results are consistent with these predictions, my discussion raises possible reasons why it may be premature to conclude that the cognitive biases discussed here cause drifts.
TL;DR: In this article, the authors investigate the relation between accruals mispricing and institutional ownership (IO), a proxy for investor sophistication, and find that less IO, more misprices.
Abstract: Collins et al. (2003, this issue) empirically investigate the relation between accruals mispricing and institutional ownership (IO), a proxy for investor sophistication. Their results show that accruals mispricing and IO are negatively correlated; less IO, more accruals mispricing. The authors attribute this differential in accruals mispricing to institutions' superior ability to price accruals either due to superior analytical ability or due to greater access to private information. While the research question is intriguing, a number of methodological limitations may limit the reliability and generality of the findings. In this paper, I discuss these limitations and offer ways of overcoming them, as well as identify a future research avenue in the area of mispricing.
TL;DR: Fairfield et al. as mentioned in this paper showed that the accrual effect is at least partly due to the fact that accruals signify an increase in (less productive) net operating assets.
Abstract: Fairfield et al. (2003a, this issue) suggests that the accrual effect in Sloan (1996) is at least partly due to the fact that accruals signify an increase in (less-productive) net operating assets. Thus, the paper is a useful and thought-provoking reminder that accruals have both earnings and balance sheet effects. However, the impact of the empirical results is diminished by the lack of a convincing story that ties and grounds these results to other knowledge in the area. Sloan (1996) is an influential study, which documents a simple but important relation: the accrual portion of earnings is less persistent than the cash portion of earnings. In addition, Sloan finds that investors do not seem to fully appreciate the implications of accruals for future earnings, so that firms with high current accruals earn lower future stock returns. This study prompted a flurry of subsequent research which investigates the specific causes and explanations for this phenomenon. For example, Xie (2001) finds that the lower persistence of accruals is primarily due to the role of discretionary accruals, while Desai et al. (2002) argue that the accrual effect for stock returns is a variation on the ''value/glamor'' anomaly. Fairfield et al. (2003a, this issue), hereafter FWY, is another follow-up on Sloan (1996), which observes that the documented effects in accruals and cash flows concern variables scaled by some measure of investment (e.g., total assets). Thus, the documented lower persistence of scaled accruals could be due to one of two effects. First, it could be due to the lower persistence of unscaled accruals (a numerator effect), which is the commonly accepted explanation. Alternatively, FWY suggests that the lower persistence of scaled accruals could be due to the relation between accruals and growth in the investment base (a denominator effect). As the author points out, this alternative explanation seems promising because the concept of accruals is closely related to the concept of growth in assets. In fact, the commonly used balance sheet-based derivation of accruals reveals that the two concepts are at least somewhat mechanically related.
TL;DR: Ertimur et al. as discussed by the authors study the difference in the market reaction to revenue versus expense surprises and propose alternative explanations for the base-line result that the market reacts more to revenue surprises than to expense surprises.
Abstract: Ertimur et al. (2003, this issue) study the difference in the market;s reaction to revenue versus expense surprises. The discussion first reviews their main findings and assesses the paper's potential contributions. Alternative explanations are then considered for the base-line result that the market reacts more to revenue surprises than to expense surprises. The hypothesized reasons for revenue surprises to matter more are critiqued, as are the tests of the hypotheses, and potential extensions that would link these test to financial statement analysis are suggested. Finally, two aspects of the assessment of how the reaction to revenue and expense surprises differs across value and growth firms are discussed: The definitions of value and growth firms and the potential benefits of assessing why analyst revenue forecasts are (not) observed for many value (growth) firms.
TL;DR: Baldenius and Ziv as mentioned in this paper employ a parametric example to illustrate the intuition behind their findings, as well as to delineate their incremental contribution and to speculate on the robustness of the results.
Abstract: Baldenius and Ziv (2003), emphasize the role played by corporate taxes in the context of a multi-period setting that features project selection and incentive issues In this discussion, I employ a parametric example to illustrate the intuition behind their findings, as well as to delineate their incremental contribution and to speculate on the robustness of the results I also highlight the differences between the residual income framework employed in their paper and traditional models of agency