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.     

Accruals and the naïve out-of-sample prediction of operating cash flow

Recent evidence indicates that a naïve no-change out-of-sample forecast of operating cash flow is as accurate as regression model forecasts. The current study uses this evidence to compare the accuracy of two naïve cash flow forecasts: 1) a pure no-change forecast and 2) a no-change forecast which includes adjustments for changes in accounts receivable, inventory and accounts payable. The size- and accrual-matched results indicate that the naïve cash flow forecast with accruals is notably more accurate than the naïve forecast without accruals. Moreover, the results indicate that large sums of positive accruals are more useful for cash flow prediction than large sums of negative accruals. Overall, the study provides creditors, analysts and other members of the financial community with an efficient and effective protocol for cash flow prediction.     

The role of industry classification in estimating discretionary accruals

This study compares the properties of the Global Industry Classification Standard (GICS) with three alternatives: Standard Industrial Classification, North American Industry Classification System, and Fama–French classification. First, we demonstrate that GICS results in more reliable industry groupings for financial analysis and research; in particular, we find that estimations of performance-adjusted discretionary accruals (PADA) based on GICS significantly outperform estimates derived using each of the three alternative classifications systems in capturing discretionary accruals. Second, we show that the difference between GICS and the other systems can provide significantly different results, and hence different inferences, in empirical studies that rely on industry classification. Specifically, we revisit findings by Teoh et al. (J Financ 53[6]:1935–1970, 1998a) and assess the conclusion that initial public offering (IPO) issuers with high abnormal accruals during the IPO year experience subsequent poorer long-term stock performance than issuers with low discretionary accruals do. We find that this result disappears when PADA estimates are based on GICS. Our results call for serious consideration of using GICS classifications in research, either in the primary analysis or as a necessary corroboration.     

Earnings Management and the Long-Run Market Performance of Initial Public Offerings

Issuers of initial public offerings (IPOs) can report earnings in excess of cash flows by taking positive accruals. This paper provides evidence that issuers with unusually high accruals in the IPO year experience poor stock return performance in the three years thereafter. IPO issuers in the most "aggressive" quartile of earnings managers have a three-year aftermarket stock return of approximately 20 percent less than IPO issuers in the most "conservative" quartile. They also issue about 20 percent fewer seasoned equity offerings. These differences are statistically and economically significant in a variety of specifications.     

Analysts’ accrual-related over-optimism: do analyst characteristics play a role?

Bradshaw et al. (J Acc Res 39:45–74, 2001) find that analyst forecast over-optimism is greater for firms with high accruals. This “accrual-related over-optimism” is generally interpreted as evidence that analyst forecasts do not fully incorporate predictable earnings reversals associated with high accruals. We investigate whether analyst experience, access to resources (brokerage size), and portfolio complexity moderate the relation between over-optimistic forecasts and high accruals. We demonstrate the robustness of accrual-related over-optimism to controls for cash flow and prior forecast errors. We find that accrual-related over-optimism is lower for analysts with greater general experience and for analysts following fewer firms but find only limited evidence of lower accrual-related over-optimism for analysts from larger brokerages and for analysts following fewer industries.     

Asymmetric trading by insiders – comparing abnormal returns and earnings prediction in Spain and Australia

This paper examines whether the ‘external governance’ imposed by comparative financial accounting standards reduces the trading advantage of insiders. We do this by directly comparing insider trading returns and insider’s ability to predict future earnings from accruals in Spain and Australia. Results show higher excess returns and greater prediction of future earnings from conditioned insider trading in Australia that is then utilized by financial analysts to lower forecast errors – particularly in contrarian‐based accruals trading. Possible explanations include: (i) a high asymmetric quality for market‐based accruals, (ii) information transfer from informed insiders to uninformed insiders and financial analysts and (iii) a more timely dissemination of financial information in Spain through different ownership and governance structures.     

Earnings management around employee stock option reissues

We investigate market behavior in a setting where managerial incentives to manipulate earnings and market price should be apparent ex ante to market participants. We find evidence of abnormally low discretionary accruals in the period following announcements of cancellations of executive stock options up to the time the options are reissued. Nevertheless, analysts and investors are not misled. Discretionary accruals have little power in explaining stock price performance during this period. Moreover, discretionary accruals do not explain subsequent analyst forecast errors. Thus, our findings suggest that, in this transparent setting, analysts and investors do not respond to earnings management.     

Analyst Earnings Forecast Revisions and the Pricing of Accruals

We investigate the relation between two market anomalies to provide insights into analysts role as information intermediaries. Prior research finds that accruals and analyst earnings forecast revisions predict future returns. We find that the accrual and forecast revision strategies generate hedge returns of 15.5% and 5.5% when implemented independently. Strikingly, a combined strategy that uses forecast revisions to refine the accrual strategy generates a hedge return of 28.5%. Firms with consistent accrual and forecast revision signals have less persistent accruals and earnings. We also find that accruals can be used to refine the forecast revision strategy—high accruals are associated with overoptimism in analyst forecasts. Our findings indicate that although forecast revisions reflect information about accrual and earnings persistence beyond that reflected in the level of current year accruals, investors do not fully incorporate this information into their valuation assessments.     

Firm diversification and earnings management: evidence from seasoned equity offerings

Popular press suggests that diversified firms are more aggressive in managing earnings than non-diversified firms. We examine this claim in the seasoned equity offering (SEO) setting, where firms have been shown to have the incentive to manage earnings upwards. Using the cross-sectional modified Jones [(1991) J Accounting Res 29:193–228] model to measure discretionary current accruals, we find that discretionary current accruals are higher among diversified firms than in non-diversified ones. Our evidence is consistent with the view that the extent of firm diversification is directly related to the degree of earnings management. We further show that diversified issuers with high discretionary accruals underperformed other SEO firms.

Further evidence on analyst and investor misweighting of prior period cash flows and accruals

We empirically investigate three questions: (i) whether analysts and investors mis-estimate the persistence of operating cash flows, (ii) if so, is the cash flow effect distinct from the accrual effect in the sense that one effect holds after controlling for the other, and (iii) if these are distinct effects, which effect is stronger in magnitude? We find that prior period operating cash flows have a significant positive effect on forecast errors and stock returns consistent with analysts and investors underestimating the persistence of operating cash flows. Further, we find that not only is the operating cash flow effect distinct from the accrual (more specifically the working capital accrual) effect but it is also considerably larger in magnitude. To our knowledge, this is the first study that documents the relative magnitude of prior period cash flow and working capital accrual effects on forecast errors and stock returns. Our findings have several implications for future research and practice. First, the consistency of results across the two sets of users (analysts and investors) suggests that analyst-forecast inefficiencies are less likely to be driven by their incentives to promote stocks and more likely to be a manifestation of a broader phenomenon that has not been thoroughly investigated in prior studies. Second, for practitioners, our results suggest that a trading strategy based on prior period working capital accruals and cash flows would earn higher abnormal returns than a trading strategy based on accruals alone.     

The Information Content of Corporate Pension Funding Status in Japan

This paper tests if a firm's pension funding ratio (pension assets/PBO) reveals the management's private information about the firm's operation when the firm can exercise discretion in pension funding. The lax enforcement of pension funding rules and the prevalence of management forecasts make Japanese firms an ideal testing ground. We show that, among firms with large business uncertainty, large accruals, or high effective tax rates, the pension funding ratio predicts the firm's management forecast errors significantly beyond conventional control variable and the effects of pension accounting management. However, the stock market does not appear to incorporate this information immediately.     

Initial credit ratings and earnings management

Credit rating agencies assert that they rely on financial information provided by issuers and that they value rating stability as well as accuracy. In an environment where rating agencies depend on issuer-reported information and are reluctant to adjust ratings promptly, managers of issuing firms can utilize the discretion afforded by GAAP to obtain the most favorable credit ratings. Consistent with our expectations, we find that current accruals are unusually positive and high around initial credit ratings. The increase in abnormally high accruals leading up to the initial credit rating year is followed by a reversal in the subsequent years. Multivariate regression analyses suggest that accounting accruals, abnormal current accruals in particular, are significantly positively related to initial credit ratings after controlling for several issue- and issuer-related characteristics indicative of default risk. Our results are robust to additional tests that account for endogeneity between credit ratings and earnings management, adjust for performance, and account for firms issuing debt and equity simultaneously.     

SEASONED EQUITY ISSUERS’ R&D INVESTMENTS: SIGNALING OR OVEROPTIMISM

It is well known that investors often react negatively to the announcements of seasoned equity offerings (SEOs). We posit that issuers can use positive discretionary (higher than expected) R&D investments before the SEO to signal their investment prospects to mitigate the negative announcement effect. Alternatively, positive discretionary R&D may be attributed to managerial overoptimism about future returns of R&D investments. We find strong support for the signaling hypothesis among high‐tech issuers: investors respond more favorably to the SEO announcements of high‐tech issuers with positive discretionary R&D; these issuers are more likely to use new capital in future R&D and they produce better post‐SEO operating performance. In contrast, we find some evidence of managerial overoptimism among low‐tech issuers: investors tend to penalize low‐tech firms with positive discretionary R&D at SEO announcements; they are more likely to hold new capital as cash and they fail to produce better post‐SEO operating performance.     

Accrual usage to manage earnings toward financial analysts' forecasts

This study examines whether management uses discretionary accounting accruals to move earnings upward toward analysts' earnings forecasts when it appears that earnings before discretionary accruals will fall short of the forecast. An earnings shortfall relative to analysts' forecasts could lead management to fear lower compensation and an increase in the likelihood of job termination. The article finds that firms whose earnings before discretionary accruals are below analysts' forecasts use income-increasing discretionary accruals and do so to a greater extent than do firms whose earnings before discretionary accruals are above analysts' forecasts.     

Credit Ratings and Earnings Management around IPOs

This study examines the impact of having a credit rating on earnings management (EM) through accruals and real activities manipulation by initial public offering (IPO) firms. We find that firms going public with a credit rating are less likely to engage in income‐enhancing accrual‐based and real EM in the offering year. The monitoring by a credit rating agency (CRA) and the reduced information asymmetry due to the provision of a credit rating disincentivise rated issuers from managing earnings. We also suggest that the participation of a reputable auditing firm is crucial for CRAs to effectively restrain EM. Moreover, we document that for unrated issuers, at‐issue income‐increasing EM is not linked to future earnings and is negatively related to post‐issue long‐run stock performance. However, for rated issuers, at‐issue income‐increasing EM is positively associated with subsequent accounting performance and is unrelated to long‐run stock performance following the offering. The evidence indicates that managers in unrated firms generally manipulate earnings to mislead investors, while managers in rated firms tend to exercise their accounting and operating discretion for informative purposes.     

Accruals and firm life cycle: Improving regulatory earnings management detection

Regulators have invested considerable energy into developing analytical tools to better detect earnings management. We propose that firms in similar life cycle stages (LCSs) face similar strategic concerns, managerial pressures, growth prospects, etc., and that the commonality in these factors contribute to the “normal” accruals generating process. Consistent with this prediction, we simulate various earnings management conditions and find that accruals models are misspecified in detecting manipulation within particular LCSs; in particular, introduction, shakeout, and decline firms are over-identified as manipulators, while growth and mature firms are under-identified as manipulators when LCS is not used to estimate accruals. Weighted average performance across life cycle stages reveals that LCS estimation of discretionary accruals substantially improves successful detection and reduces Type I errors relative to other grouping alternatives. The combined improvement across both Type I and Type II errors is over 70% for both the modified Jones and discretionary revenue models of accruals-based earnings management.     

Share Issuance and Factor Timing

We show that characteristics of stock issuers can be used to forecast important common factors in stocks' returns such as those associated with book‐to‐market, size, and industry. Specifically, we use differences between the attributes of stock issuers and repurchasers to forecast characteristic‐related factor returns. For example, we show that large firms underperform after years when issuing firms are large relative to repurchasing firms. While our strongest results are for portfolios based on book‐to‐market (i.e., HML), size (i.e., SMB), and industry, our approach is also useful for forecasting factor returns associated with distress, payout policy, and profitability.     

Earnings quality,bankruptcy risk and future cash flows

Prior research suggests that the quality of accruals may be compromised where the magnitude of accruals is abnormally high, due to the presence of errors in the accruals‐estimation process (Dechow and Dichev, 2002; Richardson, 2003). A consequence of this is that abnormal accruals may not map into realised future cash flows to the extent that would normally be expected of accruals data. Indeed, the association may be insignificant if abnormal accruals consist primarily of estimation noise. Our study investigates whether abnormal accruals for UK firms provide incremental insight into future cash flows. In particular, our paper may be viewed as a development of Subramanyam (1996). We find a significant positive association between abnormal accruals and one‐year‐ahead operating cash flows. This provides a rationale for the pricing of abnormal accruals by the market (Subramanyam, 1996; Xie, 2001) and suggests that abnormal accruals are not merely the products of noise in the accruals‐estimation process. However, our results are conditional upon the probability of one‐year‐ahead bankruptcy risk (Charitou et al., 2004). We also find that abnormal accruals possess small but significant explanatory power for future cash flows even when controlling for the disaggregation of accruals into individual items (Barth et al., 2001).     

Forecasts in IPO Prospectuses: The Effect of Corporate Governance on Earnings Management

Prior research suggests that managers may use earnings management to meet voluntary earnings forecasts. We document the extent of earnings management undertaken within Canadian Initial Public Offerings (IPOs) and study the extent to which companies with better corporate governance systems are less likely to use earnings management to achieve their earnings forecasts. In addition, we test other factors that differentiate forecasting from non‐forecasting firms, and assess the impact of forecasting and corporate governance on future cash flow prediction. We find that firms with better corporate governance are less likely to include a voluntary earnings forecast in their IPO prospectus. In addition, we find that while IPO firms use accruals management to meet forecasts; the informativeness of the discretionary accruals depends on whether or not the firm would have missed its forecast without the use of discretionary accruals.     

Management earnings forecasts and IPO performance: evidence of a regime change

Companies undertaking initial public offerings (IPOs) in Greece were obliged to include next-year profit forecast in their prospectuses, until the regulation changed in 2001 to voluntary forecasting. Drawing evidence from IPOs issued in the period 1993–2015, this is the first study to investigate the effect of disclosure regime on management earnings forecasts and IPO long-term performance. The findings show mainly positive forecast errors (forecasts are lower than actual earnings) and higher long-term returns during the mandatory period, suggesting that the mandatory disclosure requirement causes issuers to systematically bias profit forecasts downwards as they opt for the safety of accounting conservatism. The mandatory disclosure requirement artificially improves IPO share performance. Overall, our results show that mandatory disclosure of earnings forecasts can impede capital market efficiency once it goes beyond historical financial information to involve compulsory projections of future performance.