Firm valuation, abnormal earnings, and mutual funds flow

We examine the valuation effects of overall demand for corporate equities combined with the influence of abnormal earnings and unexpected funds flow. Our results indicate that the expected and unexpected net new total flow of funds into all stock mutual funds do not by themselves have a meaningful effect on firm equity valuation. However, we find the combination of unexpected funds flow and realized abnormal earnings have significant and important valuation effects. Importantly, the valuation impact is greatest for those firms with high earnings growth potential that also operate in an environment characterized by high information asymmetry.

Value relevance of value-at-risk disclosure

The SEC issued FRR No. 48 in 1997 to enhance public disclosure of firms’ exposures to market risk. We examine whether the quantitative value-at-risk (VAR) estimates disclosed by 81 non-financial firms during the period 1997–2002 are value-relevant using the earnings-returns relation. The empirical results indicate that high VAR is associated with weaker earnings-returns relation. Further analysis shows that VAR is positively and significantly associated with future stock return volatility. Our evidence suggests that investors perceive the earnings of firms with substantial market risk exposure to be less persistent, and adjust the future abnormal earnings for the higher risk exposure. Thus, this results in a lower expected rate of return.

Disclosure of fees paid to auditors and the market valuation of earnings surprises

We investigate if the SEC’s recently mandated disclosure of fees for audit and nonaudit services paid by firms to their incumbent auditors affected the market’s perception of auditor independence and earnings quality. Following the initial fee disclosures in 2001, we find that the market valuation of quarterly earnings surprises (earnings response coefficient) was significantly lower for firms with high levels of nonaudit fees than for firms with low levels of such fees. In contrast, in the year prior to the new fee disclosures, there was no reduction in earnings response coefficients for firms that subsequently reported high nonaudit fees. Our evidence suggests that mandated fee disclosures provided new information that was viewed by the market as relevant to appraising auditor independence and earnings quality.

Underwriter choice and earnings management: evidence from seasoned equity offerings

Using a sample of seasoned equity offerings (SEOs), this paper examines the association between the choice of financial intermediary and earnings management. We contend that with more stringent standards for certification and intense monitoring, highly prestigious underwriters restrict firms’ incentives for earnings management to protect their reputation and to avoid potential litigation risks, while firms with greater incentives for earnings management avoid strict monitoring by choosing low-quality underwriters. Consistent with our predictions, we find an inverse association between underwriter quality and issuers’ earnings management. In addition, we find that underwriter quality is positively related to SEOs’ post-issue performance, even after controlling for the effect of earnings management. We also find that firms with low-underwriter prestige and high levels of earnings management under-perform the most. However, the effect of underwriter choice on post-issue performance does not last long.

The valuation consequences of voluntary accounting changes

Firm management typically claims that voluntary accounting method changes (VACs) are made to enhance the informativeness of earnings by better matching accounting practices with economic reality. In contrast, skeptics argue that managers adopt new accounting procedures to opportunistically manage earnings and influence their firm’s stock price. In this paper, we investigate these alternative motives for VACs. Specifically, we investigate whether VACs cause equity prices to deviate from their fundamental values in the short-term by studying the long-run stock-price performance for a sample of firms that voluntarily change accounting methods. In addition, we investigate changes in earnings informativeness by examining the behavior of earning response coefficients and the relationship between earnings and future cash flows in years surrounding the VAC event. In contrast to prior research, we find little evidence that a strategy based solely on the earnings effect of a VAC can generate abnormal returns. While we find weak evidence of post-VAC abnormal returns for extreme VACs, this result appears to be driven by the accruals anomaly documented in Sloan [Sloan, R. G. (1996). The Accounting Review, 71, 289–315]. Our evidence further suggests that earnings informativeness is not significantly altered by voluntary changes in accounting methods. Taken together, our evidence suggests the market recognizes the financial statement effects of alternative acceptable accounting methods and efficiently processes the valuation implications of VACs.

An integrated analysis of the association between accrual disclosure and the abnormal accrual anomaly

We find no evidence of accrual mispricing for firms that disclose accrual information at earnings announcements. For these firms, the market differentiates the discretionary from the nondiscretionary components of the earnings surprise. In contrast, the market fails to distinguish between the discretionary and the nondiscretionary components of the earnings surprise for firms that do not disclose accrual information at earnings announcements. These firms experience some stock price correction around the filing date. However, the correction is only partial, resulting in a post-filing drift.

A re-evaluation of auditors’ opinions versus statistical models in bankruptcy prediction

Existent empirical evidence on the relative performance of auditors’ going concern opinions versus statistical models in predicting bankruptcy is mixed. This study attempts to add new reliable evidence on this important issue by conducting the comparison based upon an improved statistical model. The improved statistical model incorporates some new developments advocated by recent bankruptcy prediction research (e.g., Shumway, 2001). First, the following non-traditional variables are added: a composite measure of financial distress, industry failure rate, abnormal stock returns, and market capitalization. Secondly, a hazard model is employed. The prediction ability of the hazard model with incorporation of non-financial-ratio variables is superior to that of auditors’ going concern opinions in the holdout sample. This suggests that a well-developed statistical model could serve as a decision aid for auditors to better make going-concern judgments. Further analyses reveal some evidence that industry failure rate does not have a significant impact upon auditors’ going concern judgments as it should be; auditors could improve their going concern judgments by considering industry-level information in addition to firm-specific information. Finally, we find that auditors’ opinions do have incremental contribution beyond stock-market information and industry failure rate in predicting bankruptcy.

Never judge a book by its cover: what security analysts have to say beyond recommendations

Our study analyzes market reaction to the entire content of a large sample of analysts’ reports from the period 2002 to 2004 for the German market. In particular, we explore whether the three summary measures in the reports, i.e., recommendation revisions, earnings forecast revisions, and target price forecast revisions are acknowledged by the market. Additionally, we investigate if stated justifications in the written text of analysts’ reports contain information value beyond the three summary measures. We find that earnings forecast revisions and target price forecast revisions contain valuable information, both unconditionally and conditional on the rest of the information in the report. Our findings also reveal that justifications made by analysts are of high salience to market participants. These justifications provide valuable information, both unconditionally and conditional on all other types of information in a report. Our findings also suggest that business ties between banks and the analyzed companies do not affect market reaction to dissemination of an analysts’ report.

Asymmetric timeliness tests of accounting conservatism

Recent accounting research employs an asymmetric timeliness measure to test the hypothesis that reported accounting earnings are “conservative.” This research design regresses earnings on stock returns to examine whether “bad” news is incorporated into earnings on a more timely basis than “good” news. We identify properties of the asymmetric timeliness estimation procedure that will result in biases in the test statistics except under very restrictive conditions that are rarely met in typical empirical settings. Using data series that are devoid of asymmetric timeliness in reported earnings, we show how these biases result in evidence consistent with conservatism. We conclude that the biased test statistics inherent in the asymmetric timeliness research design preclude using this method to measure conservatism; that these biases are irresolvable as they originate in the test’s specification; and that studies employing asymmetric timeliness tests cannot be interpreted as providing evidence of conservatism.

The Impact of Dual Agency

In 1984, the State of Hawaii’s legislature enacted a law making it mandatory for real estate agents engaged in dual agency relationships (i.e., when the seller’s and the buyer’s agents are employed by the same real estate firm) to disclose this fact to both parties in writing. The assumption was that the dual agency relation was damaging to the seller. This study analyzes the effect of disclosed and undisclosed dual agency, and the impact of the legislation, using data prior to and after the legislation (approximately 2,000 residential sales in each period). To account for property characteristics, hedonic models for the log of sale price and for the log of days on market are estimated in each period. Our empirical analysis suggests that dual agency significantly reduced the sales price, but the influence was much smaller after the legislation (8.0 versus 1.4%). In addition, dual agency significantly decreased the time on market by approximately 8.5% pre-legislation and 8.1% post-legislation, although the influence was much stronger for lower priced residences. These results are confirmed using a seemingly unrelated regression model.

Macro information environment change and the quality of management earnings forecasts

The 1990s were characterized by substantial increases in the performance of and investor reliance on financial analysts. Because managers possess superior private information and issue forecasts to align investors’ expectations with their own, we predict that managers increased the quality of their earnings forecasts during the 1990s in order to keep pace with the improved forward-looking information provided by financial analysts, upon which investors increasingly relied. Using a sample of 2,437 management earnings forecasts, we document an increase in management earnings forecast precision, management earnings forecast accuracy, and managers’ tendency to explain earnings forecasts in 1993–1996 relative to 1983–1986. Given that these forecast characteristics are linked to greater informativeness and credibility, we also document that the information content of management earnings forecasts, as measured by the strength of share price responses to forecast news, increased in 1993–1996 relative to 1983–1986. As expected, the increased information content of management forecasts primarily occurred for firms covered by financial analysts.

Who hedges more when leverage is endogenous? A testable theory of corporate risk management under general distributional conditions

This paper develops a theory of a firm’s hedging decision with endogenous leverage. In contrast to previous models in the literature, our framework is based on less restrictive distributional assumptions and allows a closed-form analytical solution to the joint optimization problem. Using anecdotal evidence of greater benefits of risk management for firms selling “credence goods” or products that involve long-term relationships, we prove that those optimally leveraged firms, which face more convex indirect bankruptcy cost functions, will choose higher hedge ratios. Moreover, we suggest a new approach to test this relationship empirically.

Do analysts overreact to extreme good news in earnings?

We provide an alternative explanation for the previous finding of analysts’ overreaction to extreme good news in earnings. We show that such finding could be a result of analysts’ rational behavior in the face of high earnings uncertainty rather than their cognitive bias. Extreme earnings performance tends to be associated with higher earnings uncertainty that generally leads to more forecast optimism. Once this effect is accounted for, the univariate result of analysts’ overreaction to extreme good news in earnings is subsumed, leaving only their underreaction in general.

Voluntary disclosure of accruals in earnings press releases and the pricing of accruals

This study investigates firms’ decisions to disclose accruals information in earnings press releases versus to provide it only in 10-Q filings and the impact of this disclosure on the pricing of accruals. I find that firms disclose accruals in their press releases when earnings alone are a weak indication of cash flow performance and that following these disclosures the accruals information is fully impounded into stock prices. The evidence suggests that when investor demand for accruals is likely to exist and firms disclose the information in earnings press releases, the mispricing typically associated with accruals is mitigated.

Financial Leverage,CEO Compensation,and Corporate Hedging: Evidence from Real Estate Investment Trusts

This paper studies the determinants of corporate hedging practices in the REIT industry between 1999 and 2001. We find a positive significant relation between hedging and financial leverage, indicating the financial distress costs motive for using derivatives in the REIT industry. Using estimates of the Black–Scholes sensitivity of CEO’s stock option portfolios to stock return volatility and the sensitivity of CEO’s stock and stock option portfolios to stock price, we find evidence to support managerial risk aversion motive for corporate hedging in the REIT industry. Our results indicate that CEO’s cash compensation and the CEO’s wealth sensitivity to stock return volatility are significant determinants of derivative use in REITs. We also document a significant positive relation between institutional ownership and hedging activity. Further, we find that probability of hedging is related to economies of scale in hedging costs.

Rewriting earnings history

Research on the usefulness of financial information generally focuses on the innovation in the information examined, such as an earnings surprise or cash flow growth. Consequently, prior research sheds little light on the role of the rich historical record of financial information in users’ decision-making. Using a sample of published restatements of earnings, we show that the revision of the historical pattern of earnings, distinct from the magnitude of the restatement and its impact on current earnings, significantly affects investors’ decisions and predicts class action lawsuits. Specifically, we find that restatements that eliminate or shorten histories of earnings growth or positive earnings have significantly more adverse effects for investor valuations and the likelihood of lawsuits than other restatements. This evidence about the value-relevance of refreshing the historical record of earnings is pertinent to the FASB’s recent cautious expansion of the scope of circumstances that require a restatement of financial information in FAS 154.

Measuring the impact of sales on earnings and equity price

In this paper we examine how sales affect earnings and in turn the stock price using a model in which sales contribute to earnings by a fixed sales margin rate and the stock price responds more sensitively to sales-induced earnings than to non-sales-induced earnings. We report that the regression coefficient of the sales margin (2.54) is about three times the earnings response coefficient (0.85) for the full sample and can be as high as 19 times the earnings response coefficient for an industry (i.e., 11.95 vs. 0.62 for restaurants). We contribute to the literature by identifying and documenting factors that make separating out the sources of earnings more important in equity pricing.

Analysts’ forecast revisions and firms’ research and development expenses

This study examines whether reported values for firms’ research and development (R&D) affect analysts’ annual earnings forecast revisions following quarterly earnings announcements. Because R&D introduces uncertainty into earnings forecasts, analysts may benefit from additional information searches in an effort to increase forecast accuracy. Also, accounting standards mandate an immediate expensing of R&D, in essence projecting a zero value for the R&D. To the extent that R&D will produce future payoffs, the expense treatment reduces the informativeness of reported earnings for forecasting future earnings. Thus, the marginal benefit of analysts’ efforts to produce more information may increase with the magnitude of the R&D component of earnings announcements and trigger additional forecast revisions. Alternatively, if the cost of information searches exceeds the benefit, analysts’ forecast revisions may decrease. Our results show a positive relation between R&D expenses and analysts’ forecast revision activity. We also find a positive and significant association between the level of R&D expenses and the magnitude of analysts’ forecast revisions following quarterly announcements. These results point to a greater amount of analyst scrutiny when reported earnings are accompanied by high levels of R&D expenses.

Can corporate governance save distressed firms from bankruptcy? An empirical analysis

We examine financially distressed firms and document how governance characteristics affect (1) a firm’s ability to avoid bankruptcy and (2) the power of financial/accounting information to predict bankruptcy. Overall, our findings indicate that a distressed firm’s governance characteristics significantly affect its probability of bankruptcy. We find that smaller and more independent boards with a higher ratio of non-inside directors and with larger ownership stakes of inside directors are more effective at avoiding bankruptcy once distress is indicated. These results are consistent with the belief that these types of governance structures induce more effective monitoring. The results are also consistent with the view that the inclusion of governance characteristics enhances the power of financial accounting models in predicting bankruptcy.

The Effect of Reputation and Competition on the Advice of Real Estate Agents

We study a two-period bargaining game where buyers and sellers employ real estate agents to help them determine the sales price of a house. We find that agents are less likely to provide aggressive bargaining advice to their client when they receive percentage commissions and when they work for the buyer. In addition, we find that agents are less likely to suggest aggressive bargaining strategies when there is little market competition, the gains to trade are large, in markets where housing values appreciate slowly, and when dual agency is permitted. More importantly, we show that an agent is more likely to bargain aggressively and capture a portion of the gains to trade for a client when the house’s sales price is closely related to the agent’s reputation and future business (referrals).