Hierarchy of earnings thresholds based on discretionary accruals

Prior studies identify hierarchies of earnings thresholds based on distributions of earnings (e.g., Degeorge et al., 1999) and survey opinions of CFOs (Graham, Harvey, & Rajgopal, 2005). We complement extant literature by investigating a threshold hierarchy in the context of accounting discretion exercised by managers. We examine the relative extent of discretionary accruals used to achieve three earnings thresholds—avoiding losses, avoiding earnings declines, and avoiding negative earnings surprises. Our empirical findings suggest that managers are likely to use the largest amount of discretionary accruals to avoid earnings declines, and the least amount of discretionary accruals to avoid negative earnings surprises. Thus, this study identifies the hierarchy of the earnings thresholds based on accounting discretion used in financial reporting. We also find that the hierarchy remains stable over the last two decades during our sample period. Then, we provide several explanations for why managers are likely to exercise more accounting discretion to avoid earnings declines. These explanations include earnings smoothing, reduction of stock returns volatility, and signaling of future growth potential. Overall, this study provides new insights into accruals management behavior.     

Earnings management and abnormal returns: Evidence from the 1970–1972 Price Control Regulations

We examine the association between abnormal returns and earnings management in the context of price control regulations to test the construct validity of the earnings management model. Abnormal returns are used as a market–based measure, and discretionary accruals are employed to measure earnings management. Our results support the hypotheses that (1) price control regulations affect firms' security prices negatively, (2) firms make income–decreasing discretionary accruals to increase the likelihood of price increase approval, and (3) firms that are affected most negatively by the regulations manage earnings more aggressively. We conclude that the earnings management model we use in this study is capable of predicting opportunistic discretionary accruals.     

Predictive versus opportunistic earnings management,executive compensation,and firm performance

We examine the association between earnings management and an important component of corporate governance, the incentives provided through compensation. We argue that firms with predictive (opportunistic) earnings management, in which discretionary accruals do (do not) relate to future cash flows, provide a more (less) ideal setting for the use of compensation as incentives. Our empirical tests show that CEO compensation levels (measured by salary, bonus, and other forms of compensation) are positively related to predictive earnings management and negatively related to opportunistic earnings management. We also find that predictive earnings management is positively associated with future returns, whereas opportunistic earnings management is negatively associated with future returns. Overall, our results suggest that firms provide more incentives if their earnings are also more informative because of discretionary accruals.     

Does top executive gender diversity affect earnings quality? A large sample analysis of Chinese listed firms

Using a large sample of Chinese listed firms, this paper examines whether the gender of top executives affects earnings quality. Unlike the findings documented in developed markets such as the U.S., our results show that earnings quality proxies, including earnings persistence, the accuracy of current earnings in forecasting future cash flows, the association between earnings and stock returns, and the absolute magnitude of discretionary accruals do not display significant differences for firms with female and male top executives. This study is the first to examine the relationship between gender and earnings quality in emerging markets such as China that offers managerial and policy implications.     

Market perceptions of discretionary accruals by debt renegotiating firms during economic downturn

This study addresses how a stock market prices earnings components around a sudden and severe economic downturn. In particular, the study examines the market valuation of discretionary accruals for debt renegotiating Malaysian firms during the Asian financial crisis. Our analysis shows that negative discretionary accruals for debt renegotiating firms are associated with higher market values of equity and are not related to the firms' future earnings. These findings are consistent with investors placing a positive value on the probability that negative accruals increase the likelihood that concessions can be extracted from lenders during renegotiation. In contrast, discretionary accruals for a control sample of non-debt renegotiating firms are not significantly associated with stock prices but are positively associated with future earnings.     

Discretionary accruals: signalling or earnings management in Australia?

We investigate the signalling effect of discretionary accruals (DAC). Although we find that discretionary accruals are insignificantly related to contemporaneous stock returns, we uncover that income‐increasing discretionary accruals of GAAP‐complying growth firms are significantly and positively related to contemporaneous stock returns. Furthermore, we find that this positive effect is stronger among firms with better corporate governance mechanisms, such as Board of Directors Independence, Audit Committee Independence and Large Shareholders’ Ownership. In addition to contemporaneous stock returns, we also find similar results with the future increase in dividends. Our findings are consistent with the argument that corporate governance can enhance the signalling effect of reported earnings of GAAP‐complying growth firms.     

Accruals,Investment, and Future Performance

It is well documented that accounting measures of investment, such as working capital and capital expenditures, negatively predict future stock returns. The earnings fixation hypothesis suggests that investors overestimate and overvalue the persistence of the accrual component of earnings. Another stream of the literature argues that since accruals capture growth, the accruals anomaly can be explained by the investment anomaly, which finds that firms that grow their assets tend to have lower future returns. As empirical proxies for accruals and investment are either positively correlated or interchangeably used, it is difficult to distinguish between the competing hypotheses in empirical tests. This study contributes to the debate by identifying two special economic settings in which the two explanations offer diverging predictions. First, investment in research and development (R&D) represents an investment expenditure that reduces earnings but is not subject to accrual accounting. Thus, the earnings fixation hypothesis predicts a positive relation between increases in R&D investments and future returns, whereas the investment anomaly predicts a negative relation. Second, firms operating with negative working capital have working capital accruals that are negatively correlated with other forms of investment and growth. Therefore, while the earnings fixation hypothesis still predicts a negative relation between accruals and future returns in this setting, the investment explanation predicts a positive relation. For both sets of tests, the empirical evidence supports the earnings fixation hypothesis for the accruals anomaly and is inconsistent with the notion that the investment anomaly subsumes earnings fixation in explaining future stock returns.     

机构投资者持股、盈余管理与市场反应

由于会计信息的专业性,个人投资者往往难以从会计数据中识别盈余管理;而作为投资专家的机构投资者能否识别盈余管理,并将其融入到市场价格机制中则成为人们关注的焦点。通过检验机构投资者持股对公司股票累计超额报酬率和盈余管理之间关系的影响,研究发现:机构投资者持股较高的股票的超额报酬率与正向操纵性应计利润显著负相关,说明机构投资者股东能从会计信息中识别公司的盈余管理行为,并将其反映到市场价格机制中去。     

The nature of information in accruals and cash flows in an emerging capital market: The case of China

Our study investigates the relative and incremental information content of earnings, operating cash flows, and accruals in the emerging capital market of China. The issue is tested by regressing stock returns on the levels of earnings and their components. Based on a sample of 1516 firm-years for listed Chinese firms during 1995–1998, our results demonstrate that earnings have relative information content over operating cash flows. The autocorrelations and cross-sectional correlations also imply that earnings have greater persistence and predictability than operating cash flows. We also find that discretionary accruals provide incremental information beyond that contained in nondiscretionary accruals, consistent with the argument that discretionary accruals improve the relevance of earnings in reflecting the fundamental values of the listed Chinese firms. Unlike prior findings in the studies on developed markets, we find no strong evidence that the value attached to discretionary accruals is lower than the value attached to nondiscretionary accruals. This is consistent with the argument that managerial policy choices available for the listed Chinese firms were rather limited during our sample period under relatively uniform People's Republic of China Accounting Standards (PRC-GAAP), thus, producing fewer opportunities for earnings management. An alternative interpretation could be that Chinese investors are functionally fixated on earnings.     

Accruals, Cash Flows and the Post‐Earnings‐Announcement Drift

Abstract:   Several prior studies have shown that cash flows have significantly greater impact on stock prices than accruals. We examine the implications of these findings for the post‐earnings‐announcement‐drift anomaly. We argue that, if investors under‐react to earnings news, then the larger price impact of cash flows causes the cash flow component of earnings news to predict future returns better than the accruals component. Consistent with this argument, we show that unexpected cash flows are more positively related to future returns, than are unexpected accruals. Also, unexpected cash flows are found to predict future returns above and beyond that predicted by earnings surprises. Finally, we show that a strategy that decomposes earnings news into its components significantly outperforms strategies based on earnings news alone. The results support under‐reaction explanations for the drift.     

Earnings management of seasoned equity offering firms in Korea

We investigated 249 Korean seasoned equity offering (SEO) firms during the period 1995-1997 to determine if the SEO firms manage earnings in the year before a planned issue of seasoned equity stocks. Using three test methods (accrual difference, correlation, and sign-change), we found that the Korean firms contemplating SEOs in the following year do manage earnings particularly when their relative performances have been poor. The results are robust irrespective of control samples. Analysis of operating performances around SEOs shows that SEO firms tend to increase reported earnings in the year immediately preceding and the year of SEOs, but no differences were found in operating cash flows between the SEO firms and the control firms. By using a regression analysis for discretionary accruals, we found that SEO firms are more likely to manage earnings if the operating performances are poor and if the offer sizes are relatively large. Association tests between stock returns and discretionary accruals indicate that the market reacts positively to net income but negatively to discretionary accruals. The results indicate that the market correctly analyzes the cash flow implications of the SEO firms' opportunistic use of discretionary accruals.     

Management’s tone change, post earnings announcement drift and accruals

This study explores whether the management discussion and analysis (MD&A) section of Forms 10-Q and 10-K has incremental information content beyond financial measures such as earnings surprises and accruals. It uses a classification scheme of words into positive and negative categories to measure the tone change in the MD&A section relative to prior periodic SEC filings. Our results indicate that short window market reactions around the SEC filing are significantly associated with the tone change of the MD&A section, even after controlling for accruals and earnings surprises. We show that management’s tone change adds significantly to portfolio drift returns in the window of 2 days after the SEC filing date through 1 day after the subsequent quarter’s preliminary earnings announcement, beyond financial information conveyed by accruals and earnings surprises. The drift returns are affected by the ability of the tone change signals to help predict the subsequent quarter’s earnings surprise but cannot be completely attributed to this ability. We also find that the incremental information of management’s tone change depends on the strength of the firm’s information environment.     

Highly Valued Equity and Discretionary Accruals

Abstract:  Overvalued equity provides a strong incentive for managers to report earnings that do not disappoint the market (  Jensen, 2005 ). We find that this can be extended to highly valued equity more generally. In the year following the classification as highly valued and compared to firms with less extreme valuations, highly valued firms have significantly higher discretionary accruals and exhibit a more pronounced positive association between discretionary accruals and proxies for the likelihood of failing to meet earnings targets. These findings are consistent with the use of discretionary accruals to manage earnings in support of extreme valuation. Because highly valued equity will likely result in CEOs with valuable stock and stock option portfolios, we test whether and show that the overvalued equity incentive is incremental to a CEO's equity portfolio incentive. One implication is that directors and audit committees should be especially on guard for possible earnings management when a firm has extremely high valuation multiples and when the CEO has a lot of equity at risk.     

The incidence of earnings management on information asymmetry in an uncertain environment: Some Canadian evidence

In this study, we investigate the association between earnings management and information asymmetry considering environmental uncertainty. Results show that a complex and dynamic environment weakens the relationship between discretionary accruals and information asymmetry measured as share price volatility and bid-ask spread. More specifically, the positive relationship between earnings management and information asymmetry is weakened for diversified firms, those intensively investing in R&D, and those facing high sales volatility. This highlights the difficulty for investors to assess earnings management in an uncertain environment. Finally, in such a context, discretionary accruals are more likely to be detected by investors for firms cross-listed on a U.S. stock exchange, a more liquid and transparent stock market compared with the Canadian stock market.     

Articulation-based accruals

We build an articulating financial statements model in which the beginning and ending balance sheet amounts are explicitly linked to accruals. We distinguish accruals based on the source financial statement of the accruals, either the cash flow statement, balance sheet, or statement of owners’ equity. We then examine how the accrual-generating source affects the relations between accruals and future earnings and stock returns. While prior studies document a negative association between accruals and future earnings and returns, we find accruals relating to the current operating section of the balance sheet are positively associated with future earnings. Further, accruals originating from net financial asset via the statement of owners’ equity are positively associated with future returns. We also show that equity investment and discontinued asset accruals differ from operating asset accruals in their association with future earnings.     

Overvaluation and earnings management

Consistent with Jensen’s [Jensen, M., 2005. Agency costs of overvalued equity. Financial Management 34, 5–19] agency-costs-of-overvalued-equity prediction, we find that overvaluation is statistically and economically related to subsequent income-increasing earnings management. This relation is robust to a series of tests that address potential endogeneity concerns, including omitted variable bias and reverse causality. The agency costs of overvalued equity are substantial. Overvaluation-induced income-increasing earnings management is negatively related to future abnormal stock returns and operating performance, and this negative relation becomes more pronounced as prior overvaluation intensifies. Among the most overvalued firms, those with high discretionary accruals underperform those with low discretionary accruals during the following year by 11.88% as measured by the three-factor alphas, and by 12.87% points as measured by industry-adjusted unmanaged EBITDA-to-assets ratio.     

Risk,Mispricing, and Value Investing

We evaluate the stock return performance of a modified version of the book-to-market strategy and its implications for market efficiency. If the previously documented superior stock return of the book-to-market strategy represents mispricing, its performance should be improved by excluding fairly valued firms with extreme book-to-market ratios. To attain this, we classify stocks as value or glamour on book-to-market ratios and accounting accruals jointly. This joint classification is likely to exclude stocks with extreme book-to-market ratios due to mismeasured accounting book values reflecting limitations underlying the accounting system. Using both 12-month buy-and-hold returns and earnings announcement returns, our results show that this joint classification generates substantially higher portfolio returns in the post-portfolio-formation year than the book-to-market classification alone with no evidence of increased risk. In addition, this superior stock return performance is more pronounced among firms held primarily by small (unsophisticated) investors and followed less closely by market participants (stock price <$10). Finally, and most importantly, financial analysts are overly optimistic (pessimistic) about earnings of glamour (value) stock, and for a subset of firms identified as overvalued by our strategy, the earnings announcement raw return, as well as abnormal return, is negative. These last results are particularly important because it is hard to envision a model consistent with rational investors holding risky stocks with predictable negative raw returns for a long period of time rather than holding fT-bills and with financial analysts systematically overestimating the earnings of these stocks while underestimating earnings of stocks that outperform the stock market.     

The role of current and non-current accruals in the relation between stock returns and earnings

This study examines the role of accruals in the relation between stock returns and earnings for intervals of one to four years. We argue that the roles of current and non-current accruals differ because the former turn over more frequently while the latter include long term timing differences and permanent differences. Accordingly, the roles of both categories of accruals are examined over intervals within and beyond the cycle of current accruals. The results suggest that accruals strengthen the association between stock returns and earnings and that they are more important for shorter intervals. Further, non-current accruals play a dominant role in the relation between stock returns and earnings while the effect of current accruals is negligible for all intervals examined.     

Earnings Management and the Long-Run Underperformance of Firms Following Convertible Bond Offers

Abstract:  This paper examines whether the long-run underperformance of convertible bond issuers can be explained by earnings management, as reflected in discretionary current accruals around the time of the offer. Consistent with the earnings management hypothesis, we find that convertible issuers who adjust their discretionary current accruals to report higher net income in the issue year will generally experience inferior operating and stock return performance over the five-year post-issue period. Our findings indicate that there is some temporary overvaluation of convertible issuers by the stock market, but that the resultant disappointed investors will subsequently correct their valuation errors. The similarity of our results to those reported within the prior literature on initial public offers (IPOs) and seasoned equity offers (SEOs) suggests that the earnings management hypothesis is not unique to stock offers, but that it actually extends to convertible bond offers.     

Hedging and earnings management in the light of IFRS implementation: Evidence from the UK stock market

This study examines the association between IFRS implementation, hedging and earnings management. It identifies the financial attributes of firms that utilise hedging and explores the IFRS transition process for hedgers and non-hedgers. This study also investigates the effects of a firm’s decision to use hedging or earnings management on firm value. The findings show that the transition to IFRSs has affected the equity, earnings, leverage and liquidity of hedgers in a significantly positive manner as opposed to non-hedgers, who presented a generally significant negative change in their respective figures. Hedgers tend to be larger sized and exhibit higher profitability, growth, leverage and liquidity. Hedgers also tend to have foreign revenues, be cross-listed in foreign stock markets and audited by a Big 4 auditor. This study reports that hedging and earnings management display an inverse relation. Firm value is found to be positively related to hedging and negatively related to discretionary accruals and managerial opportunism. Effective corporate governance mechanisms are found to display a negative association with discretionary accruals and a positive relation with firm value.