Aggregate accounting research and development expenditures and the prediction of real gross domestic product

The role of accounting information for public policy making has received increased attention in recent years. Konchitchki and Patatoukas, 2014a, Konchitchki and Patatoukas, 2014b demonstrate that growth in aggregate accounting earnings can predict future growth in nominal and real Gross Domestic Product (GDP). We extend the micro to macro literature by decomposing earnings into the R&D and pre-R&D components. Using the Almon (1965) finite distributed lag model, we find that both components can predict future real GDP growth with different lead-lag structures. Importantly, this decomposition significantly increases the explanatory power of the predictive model using accounting information. Aggregate accounting R&D can predict real GDP through the personal consumption, business investment, and net export channels of GDP. Our study extends prior research on the forecasting usefulness of accounting information at the aggregate level and has practical implications for macro forecasting and for public policy making regarding innovative activities of publicly listed firms.     

Negative accounting earnings and gross domestic product

Review of Accounting Studies - Konchitchki and Patatoukas Journal of Accounting and Economics 57 (1-2), 76–88, (2014a) show that aggregate accounting earnings growth predicts future nominal...     

Trend inflation, wage and price rigidities, and productivity growth

What are the steady-state implications of inflation in a general-equilibrium model with real per capita output growth and staggered nominal price and wage contracts? Surprisingly, a benchmark calibration implies an optimal inflation rate of -1.9 percent. The analysis also shows that trend inflation has important effects on the economy when combined with nominal contracts and real output growth. Steady-state output and welfare losses are quantitatively important even for low values of trend inflation. Further, nominal wage contracting is found to be quantitatively more important than nominal price contracting in generating the results. This conclusion does not arise from price dispersion per se, but from an effect of nominal output growth on the optimal markup of monopolistically competitive labour suppliers. Finally, accounting for productivity growth is found to be important for calculating the welfare costs of inflation. Indeed, the presence of 2 percent productivity growth increases the welfare costs of inflation in the benchmark specification by a factor of four relative to the no-growth case.     

Voluntary disclosure and the cost of equity capital: Evidence from management earnings forecasts

This paper examines the directional effects of management earnings forecasts on the cost of equity capital. We find that forecasters of bad news experience a significant increase in the cost of equity capital in the month after their disclosure. Conversely, the cost of equity capital for good news forecasters does not change significantly in the same period. We also indicate that the magnitude of changes in the cost of capital for good news forecasters is significantly lower than that for bad news forecasters and non-forecasters, which suggests that investors may view good news forecasts less credible. Finally, we show that the effect of the subsequent earnings announcement on the cost of equity capital is preempted by the management forecasts for bad news firms, and that the combined effects of the management earnings forecasts and the earnings announcement are not significant for both good news and bad news forecasters. Our paper contributes to the literature by adding evidence on directional effects of voluntary disclosures and on long-term economic consequences of management earnings forecasts.     

Keeping Up with the Joneses: A Model and a Test of Collective Accounting Fraud

This paper explains the variations in incidence of accounting fraud across economic settings by putting the behaviour and motivation of managers under the microscope. To safeguard their reputation in the managerial labour market, managers of firms that perform poorly are prone to fraudulently inflate earnings if they expect the economy to be strong, since that raises the likelihood of peers reporting high performance. A realised level of economic activity, on the other hand, counteracts this tendency on the part of managers to overstate earnings, by reducing the number of firms that actually perform poorly. We term these two effects the incentive effect and the need effect, respectively. The two effects yield a distinctive relationship between the incidence of accounting fraud and macroeconomic conditions. Specifically, the fraction of firms fraudulently over-reporting earnings is positively related to expected economic performance and negatively related to realised economic performance.
The incentive and need effects on collective fraud are examined empirically by relating proxies of the aggregate incidence of accounting fraud to expected and realised GDP growth rates. The results unambiguously support the predicted influence of macroeconomic performance.     

The Effect of IFRS Adoption and Investor Protection on Earnings Quality Around the World

This study examines the effects of mandatory IFRS adoption and investor protection on the quality of accounting earnings in forty-six countries around the globe. The results suggest that earnings quality increases for mandatory IFRS adoption when a country's investor protection regime provides stronger protection. This study extends the current literature that shows that accounting practices are influenced by country-level macro settings. The results highlight the importance of investor protection for financial reporting quality and the need for regulators to design mechanisms that limit managers' earnings management practices.     

The "Great Moderation" in the United Kingdom

We use a Bayesian time-varying parameters structural VAR with stochastic volatility for GDP deflator inflation, real GDP growth, a 3-month nominal rate, and the rate of growth of M4 to investigate the underlying causes of the Great Moderation in the United Kingdom. Our evidence points toward a dominant role played by good luck in fostering the more stable macroeconomic environment of the last two decades. Results from counterfactual simulations, in particular, show that (i) "bringing the Monetary Policy Committee back in time" would only have had a limited impact on the Great Inflation episode, at the cost of lower output growth; (ii) imposing the 1970s monetary rule over the entire sample period would have made almost no difference in terms of inflation and output growth outcomes; and (iii) the Great Inflation was due, to a dominant extent, to large demand non-policy shocks, and to a lesser extent—especially in 1973 and 1979—to supply shocks.     

Returns to buying earnings and book value: accounting for growth and risk

Historical cost accounting deals with uncertainty by deferring the recognition of earnings until the uncertainty has largely been resolved. Such accounting affects both earnings and book value and produces expected earnings growth deemed to be at risk. This paper shows that the earnings-to-price and book-to-price ratios that are the product of this accounting forecast both earnings growth and the risk to that growth. The paper also shows that the market pricing of earnings and book values in these ratios aligns with the risk imbedded in the accounting: the returns to buying stocks on the basis of their earnings yield and book-to-price are explained as a rational pricing of the risk of expected earnings growth not being realized. Accordingly, the paper provides a rationalization of the well-documented book-to-price effect in stock returns: book-to-price indicates the risk in buying earnings growth. However, growth identified by a high book-to-price as yielding a higher return in this paper is quite different from “growth” typically attributed to a low book-to-price as yielding a lower return. Accordingly, the notion of “growth” versus “value” requires modification.     

Nominal GDP Targeting and the Taylor Rule on an Even Playing Field

Some economists advocate nominal GDP targeting as an alternative to the Taylor Rule. These arguments are largely based on the idea that nominal GDP targeting would require less knowledge on the part of policymakers than a traditional Taylor Rule. In particular, a nominal GDP targeting rule would not require real-time knowledge of the output gap. We examine the importance of this claim by amending a standard New Keynesian model to assume that the central bank has imperfect information about the output gap and therefore must forecast the output gap based on previous information. Forecast errors by the central bank can then potentially induce unanticipated changes in the short-term nominal interest rate, distinct from a standard monetary policy shock. We show that forecast errors of the output gap by the Federal Reserve can account for up to 13% of the fluctuations in the output gap. In addition, our simulations imply that a nominal GDP targeting rule would produce lower volatility in both inflation and the output gap in comparison with the Taylor Rule under imperfect information.     

Are Some Forecasters Really Better Than Others?

In any data set with individual forecasts of economic variables, some forecasters will perform better than others. However, it is possible that these ex post differences reflect sampling variation and thus overstate the ex ante differences between forecasters. In this paper, we present a simple test of the null hypothesis that all forecasters in the U.S. Survey of Professional Forecasters have equal ability. We construct a test statistic that reflects both the relative and absolute performance of the forecaster and use bootstrap techniques to compare the empirical results with the equivalents obtained under the null hypothesis of equal forecaster ability. Results suggest little support for the idea that the best forecasters are actually innately better than others, though there is evidence that a relatively small group of forecasters perform very poorly.     

Terminal Value,Accounting Numbers,and Inflation

In a 2008 article published in this journal, Michael Bradley and Gregg Jarrell argue that the well‐known Gordon‐Shapiro (henceforth “GS”) model for calculating terminal values does not properly account for the effects of inflation. Bradley and Jarrell suggest modifying the growth factor in the standard GS model by adding an additional term to the nominal growth rate that reflects the positive effect of inflation on the value of existing assets. In this article, the authors support the original Gordon‐Shapiro method for calculating terminal values by showing what they believe to be an oversight of the Bradley‐Jarrell critique. According to the authors, the disagreement stems from the use of fundamentally different assumptions about the effect of inflation on the capital investment required to sustain a business. Although Bradley‐Jarrell agree with the authors that intrinsic value is the discounted value of future free cash flows, their assumptions about capital investment effectively lead them to conclusions similar to those practitioners who attempt to value companies on the basis of discounted future accounting earnings. Despite much common practice, the GS model was meant to be applied to free cash flows, not accounting earnings. And for companies with substantial capital investment, the differences between accounting earnings that involve accruals and free cash flows can be very large.     

The Quantitative Importance of News Shocks in Estimated DSGE Models

We estimate a dynamic stochastic general equilibrium (DSGE) model with several frictions and both unanticipated and news shocks, using quarterly U.S. data from 1954 to 2004 and Bayesian methods. We find that unanticipated shocks dominate news shocks in accounting for the unconditional variance of output, consumption, and investment growth, interest rate, and the relative price of investment. The unanticipated shock to the marginal efficiency of investment is the dominant shock, accounting for over 45% of the variance in output growth. News shocks account for less than 15% of the variance in output growth. Within the set of news shocks, nontechnology sources of news dominate technology news, with wage markup news shocks accounting for about 60% of the variance share of both hours and inflation. We find that in the estimated DSGE model (i) the presence of endogenous countercyclical price and wage markups due to nominal frictions substantially diminishes the importance of news shocks relative to a model without these frictions, and (ii) while there is little change in the estimated contributions of technology news when we restrict wealth effects on labor supply, the contributions of nontechnology news shocks are relatively more sensitive.     

The Gordon-Shapiro Dividend Growth Formula and Inflation

The share valuation model which discounts expected dividends is widely accepted in the finance literature. Beyond some point a constant growth rate in expected ividends is assumed. The accepted specification of this growth rate involves a constant retention rate for earnings, and is valid under no inflation. This paper derives the corresponding nominal formula under inflation using a retention rate defined in terms of inflation accounted earnings, and shows that its real counterpart is the accepted formula. It is also shown under inflation that the nominal formula using a retention rate defined in terms of historic cost earnings is considerably more complicated, and that a major error in share valuation results from mistakenly assuming the accepted formula to be valid in nominal terms with a retention rate defined in terms of inflation accounted earnings.     

Stock returns,aggregate earnings surprises,and behavioral finance

We study the stock market's reaction to aggregate earnings news. Prior research shows that, for individual firms, stock prices react positively to earnings news but require several quarters to fully reflect the information in earnings. We find a substantially different pattern in aggregate data. First, returns are unrelated to past earnings, suggesting that prices neither underreact nor overreact to aggregate earnings news. Second, aggregate returns correlate negatively with concurrent earnings; over the last 30 years, for example, stock prices increased 5.7% in quarters with negative earnings growth and only 2.1% otherwise. This finding suggests that earnings and discount rates move together over time and provides new evidence that discount-rate shocks explain a significant fraction of aggregate stock returns.     

Do Macroforecasters Herd?

We show that typical tests of whether forecasters herd will falsely indicate herding behavior for a variety of types of behavior and forecasting environments that give rise to disagreement among forecasters. We establish that forecasters will appear to herd if differences between them reflect noise as opposed to private information, or if they arise from informational rigidities. Noise can have a behavioral interpretation and if so will depend on the behavioral model under consideration. An application of the herding tests to U.S. quarterly survey forecasts of inflation and output growth data 1981–2013 does not support herding behavior.     

Dissecting and connecting the growth and accounting distortion components of accruals

This study refines the accrual decomposition approach in Richardson et al. (Account Rev 81:713–743, 2006) and introduces a growth measure that is free from accounting distortions. My evidence indicates that the lower persistence of accruals extends to accruals that are unrelated to accounting distortions. I, however, find that the growth and accounting distortion components of accruals are not isolated. Growth may provide a context where firms have more incentives to manipulate earnings. I provide evidence that the persistence of both the growth and accounting distortion components of accruals is affected by firm growth and agency cost factors, such as free cash flows, leverage, and overvalued equity. I also document high accounting distortions for relatively high-growth firms that are close to reporting positive earnings, and negative accounting distortions for relatively low-growth firms that are far from the potential to report positive earnings.     

Business Cycle and Management Earnings Forecasts

This study examines the effects of the economic cycle on the properties of management earnings forecasts. Although a large volume of accounting literature examines the determinants of managerial earnings forecasts, the properties of such forecasts, and the response of market participants to earnings forecasts (Cameron 1986; King et al., 1990; Hirst et al., 2008), research on management earnings forecasting incentivized by macro‐economic factors has received scant empirical investigation. We use the National Bureau of Economic Research economic cycle definition to operationalize economic recession, and consider some commonly used management earnings forecast characteristics, including forecast likelihood, forecast frequency, forecast error, forecast pessimism, and forecast precision. We find that the likelihood of providing management earnings forecasts and frequency of forecasts increases during economic recession. We also find that economic recession is positively associated with forecast error, but negatively associated with forecast precision. Our findings suggest macro‐economic factors as an important determinant of management earnings forecasts properties.     

Understanding the Backus–Smith puzzle: It's the (nominal) exchange rate,stupid

Backus, Kehoe and Kydland (BKK 1992) demonstrated that if international capital markets are complete, consumption growth correlations across countries should be higher than their corresponding output growth correlations. In stark contrast to the theory, however, in actual data the consumption growth correlation is lower than the output growth correlation. By assuming trade imperfections due to non-traded goods, Backus, D.K., Smith, G.W. [1993 Consumption and real exchange rates in dynamic economies with non-traded goods. Journal of International Economics 35(3–4), 297–316] showed that there is an additional impediment at work that can lower the consumption growth correlation. While their argument was successful in partially explaining the puzzlingly low cross country correlation of consumption growth rates, it contributed to generating another puzzle because the data forcefully show that consumption growth is negatively correlated with the real exchange rate, which is also a violation of the theory. Using data for OECD countries, we decompose real exchange rate growth into its nominal exchange rate growth and inflation differential components, and find that nominal exchange rate movements are the main source for the Backus-Smith puzzle. We demonstrate the robustness of this finding by examining sub-samples of the data, by allowing for imperfect risk sharing due to ‘rule of thumb’ consumers, and by examining intranational data across the U.S. states where the nominal exchange rate is fixed.     

Conditional Mandates on Management Earnings Forecasts: The Impact on the Cost of Debt

Exploiting a unique conditional disclosure mandate on management earnings forecasts (MEFs) in China, we examine the differential effects of voluntary and mandatory MEFs on the cost of debt. We find that firms providing voluntary MEFs have lower cost of debt than do mandatory forecasters and nonforecasters. The results of the channel analyses reveal that voluntary forecasters have greater commitment to voluntary MEFs in future periods than do mandatory forecasters and nonforecasters, and the precision, accuracy, and timeliness of MEFs are higher for voluntary forecasters than for mandatory forecasters. Additional analyses show that the differential effects of voluntary and mandatory MEFs on cost of debt are stronger for voluntary forecasters operating in opaque information environments, issuing high-quality and confirming forecasts, controlled by private shareholders, and operating in highly competitive product markets. Overall, our results indicate that, compared with mandatory MEFs, voluntary MEFs are more informative for credit investors, particularly for firms facing greater information risk and operating uncertainty.     

The association between qualitative management earnings forecasts and discretionary accounting in the Netherlands

This paper examines whether there is an association between discretionary accounting and the accuracy of long-run forecasts of annual earnings disclosed voluntarily by Dutch companies in the directors’ report. In particular, investigations were made of the consistency in the sign and direction of discretionary accounting techniques and qualitative earnings forecasts. Long-run forecasts are defined, for the purposes of this paper, as forecasts made at least seven months before the year-end. Although not mandatory, qualitative forecasts are released by well over 60% of the listed companies in the Netherlands. Empirical results indicate that there is consistency in the sign and direction of qualitative earnings forecasts and discretionary accounting. After adopting discretionary accounting, the forecast errors are reduced if the company can reach the management earnings forecast (target). In the event that reserves are insufficient to accomplish this goal, managers choose their next best option and take an earnings bath in order to maximize reserves available for future use. By partitioning the sample in various sub-sets it is shown that earnings management and forecast errors occur most in the extreme ranges of financial performance. Overall, the study shows that management engages in discretionary accounting to present results in line with the disclosed qualitative earnings forecasts in their directors’ reports. Whilst discretionary accounting may clearly improve the consistency of companies’ earnings forecasts released via the directors’ reports and the actual earnings, managers’ earnings forecasts are sometimes disclosed in anticipation of planned discretionary accounting actions.