Earnings attributes and investor-protection: International evidence

This study explores the effects of investor-protection on reported earnings quality assessed on the basis of four accounting-based earnings attributes (accruals quality, earnings persistence, earnings predictability, and earnings smoothness). We test the hypothesis that favorable values of each earnings attribute (considered individually) occur in countries whose institutional characteristics provide relatively strong investor-protection. The results based on K-means cluster analysis of institutional characteristics are mixed. Earnings smoothness is less prevalent in strong investor-protection countries, as hypothesized. However both accruals quality and earnings predictability are better in countries whose institutional characteristics are relatively weak. No association is found between investor-protection and earnings persistence, except that countries with low ownership concentration appear to have high earnings persistence. The results based on regression analysis are consistent with those based on the cluster analysis. These results imply that conclusions about the impact of institutional characteristics on earnings quality depend on how earnings quality is measured.     

On the nonlinear relation between product market competition and earnings quality

The literature documents conflicting results regarding the influence of product market competition on earnings quality. We extend this stream of literature by incorporating competition’s effect on both the opportunities and the incentives to manage earnings. The combination of both effects results in a nonlinear relation between product market competition and earnings quality. At low competition levels, additional information associated with one more rival helps reveal earnings irregularity and deter earnings management to a larger extent than its effect on the incentives to manage earnings, suggesting a positive relation between competition and earnings quality. At high competition levels, the latter effect dominates the former. We thus predict a positive (negative) relation between competition and earnings quality at low (high) competition levels. Consistent with our hypothesis, we document an inverted U-shaped relation between earnings quality and product market competition.     

Earnings response coefficients of OECD banks: Tests extended to include bank risk factors

We investigate two issues: Do share prices of banks in European markets respond to unexpected accounting earnings disclosures? Are share prices as well as unexpected earnings changes correlated with bank-relevant risk factors? Results reveal that bank share prices respond to unexpected earnings changes at the time of accounting reports in the same manner as the shares of the more widely-researched non-bank firms. Apart from finding significant earnings response coefficients in eight countries, we find that credit risk, price risk, exchange rate risk, and solvency risk are significantly correlated with share price changes. Third, three bank risk factors are significantly correlated with unexpected earnings changes. These results are obtained after corrections for several statistical and econometric problems so our reported parameters are robust, certainly more so than in earlier studies using ordinary least square regressions. These new findings extend earnings response literature to several banking sectors, and also identify bank's key risk factors.     

Use of benchmarks in predicting earnings management?

This study conducts multiple approaches to identify whether earnings benchmarks are an indicator for earnings management within the Australian market. We investigate firms reporting small positive earnings and small positive earnings changes, referred to as benchmark beaters. Accrual quality models, earnings distributions and earnings persistence measures are applied to identify whether benchmark beating firms are manipulating earnings. Our findings suggest that the small positive earnings benchmark attracts earnings managers. However, we do not identify any evidence to indicate that the positive earnings change benchmark is a signal for earnings management.     

Do Short Sellers Target Firms with Poor Earnings Quality? Evidence from Earnings Restatements

We study the behavior of short sellers around earnings restatements. We find that short sellers accumulate positions in restating firms several months in advance of the restatement and subsequently unwind these positions after the drop in share price induced by the restatement. The increase in short interest is larger for firms with high levels of accruals prior to restatement. We document that heavily shorted firms experience poor subsequent performance and a higher rate of delisting. Overall, these results suggest that the motive for short selling is, at least in part, related to suspect financial reporting and that short sellers pay attention to information being conveyed by accruals.

Corporate citizenship and earnings attributes

This study examines the association between corporate citizenship and earnings attributes. We examine four accounting-based earnings attributes, including persistence, predictability, smoothness, and accrual quality. Our sample consists of 652 public companies used to select the 100 Best Corporate Citizens (BCC) published by Business Ethics Magazine in 2001 and 2002. We find that BCC's earnings are more predictable, more persistent, and smoother than non-BCC's. Consistent with prior research findings, our results also indicate that BCC report higher subsequent accounting returns than non-BCC in the three-year period following the publication of the 2001 and 2002 BCC lists. We attribute these findings to the effort of good corporate citizens to preserve their reputation and the public's trust.     

Earnings management and earnings quality

Viewing the detection of earnings management from the perspective of a crime scene investigator sheds new light on prior research on earnings management and its close relative, earnings quality. The works of Ball and Shivakumar [2008. Earnings quality at initial public offerings. Journal of Accounting and Economics, in press.] and Teoh et al. [1998. Earnings management and the subsequent market performance of initial public offerings. Journal of Finance 53, 1935–1974.] are used to illustrate the application of seven components of a crime scene investigation to earnings management research.     

Earnings quality at initial public offerings

We show that, contrary to popular belief, initial public offering (IPO) firms report more conservatively. We attribute this to the higher quality reporting demanded of public firms by financial statement users and consequentially higher monitoring by auditors, boards, analysts, rating agencies, press, and litigants, and to greater regulatory scrutiny [Ball, R., Shivakumar, L., 2005. Earnings quality in UK private firms: comparative loss recognition timeliness. Journal of Accounting and Economics 39, 83–128]. We also question the evidence of Teoh et al. [1998b. Earnings management and the subsequent market performance of initial public offerings. Journal of Finance 53, 1935–1974] supporting the alternative hypothesis that managers opportunistically inflate earnings to influence IPO pricing. We conjecture that upward-biased estimates of “discretionary” accruals occur in a broad genre of studies on earnings management around similar large transactions and events.     

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.

Earnings persistence, accruals and managerial share ownership

We investigate the relationship between earnings persistence and a broad measure of total accruals (TACC). We propose and find that in Australia, TACC is less persistent than cash flows. We further propose that the persistence of accrual components is positively associated with the reliability of those components. However, we find that the least reliable accrual component has the greatest persistence and suggest possible reasons for this. We then investigate the relationship between earnings persistence and managerial share ownership, but find no evidence of a consistent, strong relationship. Rather, for the non-current operating accruals we find evidence consistent with incentive alignment for large firms with high operating cash flows, whereas for small firms we find evidence consistent with efficient contracting.     

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.

Does auditor tenure influence the reporting of conservative earnings?

In this study, we examine the relation between auditor tenure and the reporting of conservative earnings. Using several measures of conservatism, we document a positive association between the conservatism in reported earnings and the length of the auditor–client relationship. We further document an increase in conservatism between short and medium tenure that does not deteriorate over long tenure. Collectively, the results imply lower conservatism for short auditor tenure, which suggests that mandating auditor rotation may have an adverse affect on the conservatism in reported earnings.     

Disagreement over the persistence of earnings components: evidence on the properties of management-specific adjustments to GAAP earnings

We examine disagreement between management and Thomson Datastream over the persistence of earnings components. Using income statement and footnote disclosures, we identify the source and properties of disputed items. Disagreements typically reflect opaque reporting practices (for example, in the case of transitory operating items) and restrictive classification rules (for example, in the case of discontinued operations). Incremental and relative value relevance tests suggest that the majority of management-specific adjustments reflect appropriate classification of earnings components by insiders. Nevertheless, evidence consistent with strategic disclosure does emerge for a subset of management adjustments.

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.