Dynamic risk, accounting-based valuation and firm fundamentals

This study extends the accounting-based valuation framework of Ohlson (Contemp Acc Res 11(2):661–687, 1995) and Feltham and Ohlson (Acc Rev 74(2):165–183, 1999) to incorporate dynamic expectations about the level of systematic risk in the economy. Our model explains recent empirical findings documenting a strong negative association between changes in economy-wide risk and future stock returns. Importantly, the model also generates costs of capital that are solely a linear function of accounting variables and other firm fundamentals, including the book-to-market ratio, the earnings-to-price ratio, the forward earnings-to-price ratio, size and the dividend yield. This result provides a theoretical rationale for the inclusion of these popular variables in cost of capital (expected return) computations by the accounting and finance literatures and obviates the need to estimate costs of capital from unobservable (future) covariances. The model also generates an accounting return decomposition in the spirit of Vuolteenaho (J Finance 57(1):233–264, 2002). Empirically, we find that costs of capital generated by our model are significantly associated with future returns both in and out of sample in contrast to standard benchmark models. We further obtain significantly lower valuation errors in out-of-sample tests than traditional models that ignore dynamic risk expectations.     

Product market power and management’s action to avoid earnings disappointment

We investigate the empirical relationship between a firm’s product market power and its management’s action to use real-activity-based earnings management techniques to avoid earnings disappointment by meeting or beating earnings targets such as analysts’ earnings forecasts, positive earnings, or higher earnings relative to previous years. While there is a general consensus that product market competition in an industry affects management’s operating and financial decisions, and thus is an important intervening factor in a firm’s strategies for many economic situations (Nickell in J Political Econ 104:724–746, 1996; Porter in The competitive advantage of nations. Macmillan, London, 1990), the linkage between product market power, managerial incentives, and financial reporting quality has so far received little academic attention. Our analyses show that while the firms manage both accruals and real activities in varying degrees, the firms having greater product market power with the ability to differentiate their products to earn additional revenue, if necessary, are less inclined to engage in real-activity-based earnings management in certain suspect economic situations compared to the firms with less market power. We, however, do not find any significant relationship between product market power and accrual-based earnings management.     

A fractional cointegration approach to testing the Ohlson accounting based valuation model

We examine the long-run relationship between market value, book value, and residual income in the Ohlson (Contemp Acc Res 11(2):661–687, 1995) model. In particular, we test if market value is cointegrated with book value and residual income in light of their non-stationary behaviors. We find that cointegration applies to only 51 % of the sample firms, casting doubt that book value and residual income alone are adequate in tracking variations in market value, yet we find that market value is fractional cointegrated with book value and residual income for 89 % of the sample firms. This implies that the long-run relationship follows a slow but mean-reverting process. Our results therefore support the Ohlson model.     

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.     

Discussion of “Are earnings forecasts more accurate when accompanied by cash flow forecasts?”

Call et al. (Rev Account Stud 2009, this issue) demonstrate that, relative to analysts who issue earnings but not cash flow forecasts, analysts who issue both forecasts (i) produce relatively more accurate earnings forecasts, (ii) have a better understanding of the persistence of current earnings, and (iii) are less likely to get fired. In my discussion, I highlight some general challenges facing research on analyst cash flow forecasts, demonstrate the diminishing difference in the relative accuracy over time (including its compete elimination by 2004), and examine the sensitivity of some of the evidence in Call et al. (2009) to the age of the forecast and to the presence of extreme bad-news earnings surprises.     

The information content of disaggregated accounting profitability: operating activities versus financing activities

This paper reports three empirical findings on the differential information content of the components of accounting profitability. First, the paper finds that the shareholder profitability driven by operating activities has a stronger association with annual stock returns than the shareholder profitability driven by financing activities. The finding provides empirical support for the FASB Financial Statement Presentation project, and the project suggests disaggregating accounting profitability into operating and financing activities. Second, the paper finds that the sustainable portion of operating profitability has a stronger association with annual stock returns than the unsustainable portion. This finding contributes to the literature by extending the two popular methods of breaking down operating profitability (DuPont analysis and operating liability leverage) into sustainable versus unsustainable operating income. Penman (Financial statement analysis and security valuation. McGraw-Hill, New York, NY, 2010) suggests disaggregating operating income into sustainable versus unsustainable operating income. Finally, the paper identifies the conditional persistence in Amir et al. (Rev Acc Stud 16:302–327, 2011) as one of the empirical attributes that affects the valuation usefulness of disaggregated accounting profitability. The conditional persistence measures the marginal contribution of disaggregated profitability to the persistence of aggregate profitability. This paper reports that the disaggregation is more useful in firms with significant differences in the conditional persistence of disaggregated components than in other firms. Test results are robust to controls for cross-sectional and time-series dependence in error terms.     

Option pricing under non-normality: a comparative analysis

This paper carries out a comparative analysis of the calibration and performance of a variety of options pricing models. These include Black and Scholes (J Polit Econ 81:637–659, 1973), the Gram–Charlier (GC) approach of Backus et al. (1997), the stochastic volatility (HS) model of Heston (Rev Financ Stud 6:327–343, 1993), the closed-form GARCH process of Heston and Nandi (Rev Financ Stud 13:585–625, 2000) and a variety of Lévy processes including the Variance Gamma (VG), Normal Inverse Gaussian (NIG), and, CGMY and Kou (Manag Sci 48:1086–1101, 2002) jump-diffusion models. Unlike most studies of option pricing, we compare these models using a common point-in-time data which reflects the perspective of a new investor who wishes to choose between models using only the most minimal recent data set. For each of these models, we also examine the accuracy of delta and delta-gamma approximations to the valuation of both individual options and an illustrative option portfolio.     

Multi-firm voluntary disclosures for correlated operations

We study the no-arbitrage theory of voluntary disclosure (Dye, J Account Res 23:123–145, 1985, and Ostaszewski and Gietzmann, Rev Quant Financ Account 31: 1–27, 2008), generalized to the setting of $n$ firms, simultaneously and voluntarily, releasing at the interim-report date ‘partial’ information concerning their ‘common operating conditions’. Each of the firms has, as in the Dye model, some (known) probability of observing a signal of their end of period performance, but here this signal includes noise determined by a firm-specific precision parameter. The co-dependency of the firms results entirely from their common operating conditions. Each firm has a disclosure cutoff, which is a best response to the cutoffs employed by the remaining firms. To characterize these equilibrium cutoffs explicitly, we introduce $n$ new hypothetical firms, related to the corresponding actual firms, which are operationally independent, but are assigned refined precision parameters and amended means. This impounds all existing correlations arising from conditioning on the other potentially available sources of information. In the model the actual firms’ equilibrium cutoffs are geometric weighted averages of these hypothetical firms. We uncover two countervailing effects. Firstly, there is a bandwagon effect, whereby the presence of other firms raises each individual cutoff relative to what it would have been in the absence of other firms. Secondly, there is an estimator-quality effect, whereby individual cutoffs are lowered, unless the individual precision is above average.     

Equivalent valuations in cash flow and accounting models

This paper investigates the equivalence of equity valuation between the free cash flow model and the residual income model. Two conditions are found to be jointly sufficient for Residual Income and Free Cash Flow models to produce the same equity valuation: (a) the models’ discount rates jointly satisfy the Modigliani and Miller (Am Econ Rev 48:261–297, 1958) condition which relates discount rates for levered equity, unlevered equity, tax savings and debt, and (b) forecasts of the two models’ variables jointly satisfy the income statement and balance sheet identities. Past discussions fail by ignoring or misusing (a).     

Generalized stochastic target problems for pricing and partial hedging under loss constraints��application in optimal book liquidation

We consider a singular version with state constraints of the stochastic target problems studied in Soner and Touzi (SIAM J. Control Optim. 41:404?C424, 2002; J. Eur. Math. Soc. 4:201?C236, 2002) and more recently Bouchard et al. (SIAM J. Control Optim. 48:3123?C3150, 2009), among others. This provides a general framework for the pricing of contingent claims under risk constraints. Our extended version perfectly fits the market models with proportional transaction costs and the order book liquidation issues. Our main result is a direct PDE characterization of the associated pricing function. As an example application, we discuss the valuation of VWAP-guaranteed-type book liquidation contracts, for a general class of risk functions.     

Discussion of “Using accounting information for consumption planning and equity valuation”

This paper discusses Yee (2007), who investigates the role of accounting information for consumption planning and equity valuation. Higher earnings quality increases investor welfare and ex ante stock prices as well as the weight on earnings in valuation equations based on both cash flows and earnings. The former is due to improved consumption smoothing through more informed production choices, while the latter is due to the impact on the relative information content of current cash flows versus earnings about future cash flows.     

Do defaulting CEOs and directors increase the likelihood of financial distress of the firm?

We hypothesize that the information on a CEO’s and directors’ (board members) past personal payment default entries in public credit data files significantly increases the predictive power of Altman’s (in J Fin 23(4):589–609, 1968) and Ohlson’s (In J Acc Res 18(1):109–131, 1980) distress prediction models. We base our hypothesis on the literature showing that (1) managerial traits such as overconfidence, over-optimism, and the illusion of control affect corporate decisions and that (2) these same personal traits explain personal over-indebtedness and credit defaults. Our results of analyzing the credit data files of more than 100,000 CEOs and directors of the Finnish private limited liability companies support this hypothesis. Our results remain materially unchanged when using the bootstrapping method to assess their significance and when excluding small firms (firm size below the sample median). Collectively, our results imply that creditors should recognize the increased distress risk of firms appointing defaulting CEOs and directors.     

CEO bonus compensation: the effects of missing analysts’ revenue forecasts

We investigate the incremental contract relevance of analysts’ revenue forecasts while controlling for earnings forecasts and find CEOs receive smaller bonuses when missing analysts’ annual and quarterly revenue expectations. Our results support the link between the value relevance of the revenue performance measure and the contract relevance of that measure. Further, we find revenue forecasts to be more contract relevant for CEOs of firms with high growth expectations, consistent with Rees and Sivaramakrishnan’s Contemp Acc Res 24(1):259–290, (2007) findings that growth firms receive a larger market penalty for missing revenue targets. Overall, our findings provide empirical support for the conjecture that compensation committees rely on information consistent with that conveyed in analysts’ revenue forecasts when contracting with management.     

Is the diversification discount caused by the book value bias of debt?

We analyze whether the diversification discount is driven by the book value bias of corporate debt. Book values of debt may be a more downward biased proxy of the market value of debt for diversified firms, relative to undiversified firms, as diversification leads to lower firm risk. Thus, measures of firm value based on book values of debt undervalue diversified firms relative to focused firms. Our paper complements recent literature which uses market values to test the risk reduction hypothesis for a subsample of firms for which debt is traded. Alternatively, we employ market value of debt estimates for the whole firm universe. Consistent with the above hypothesis, we show that the use of book values of debt underestimates the value of diversified firms. There is no discount for mainly equity financed firms and lower distress risk and equity volatility for diversified firms. More concentrated ownership increases firm valuation.     

Dividends,research and development expenditures,and the value relevance of book value for UK loss-making firms

We extend prior research on the value relevance of accounting information for loss-making firms by allowing the coefficient of book value to vary across three distinct set of loss-making firm observations in our valuation model. Our key findings are, first, that book value is a less important determinant of equity value for either high R&D-intensive firms or dividend-paying firms, relative to firms with low R&D-intensity and zero dividends. Prior literature suggests that book value is a strong indicator of firm value for loss-making firms. This reasoning stems from book value's role as: (i) a proxy for the value of the possibility of abandoning or adapting the firms' net assets; and/or (ii) a proxy for expected future normal earnings. Our work suggests that this prior literature does not fully capture the valuation role of book value for loss-making firms. Second, we also find that dividends are value relevant, but generally only when the valuation role of book value is contextualised by allowing its coefficient to vary across high R&D-intensive firms, and dividend-paying, loss-making firms.     

What is behind the magic of O-Score? An alternative interpretation of Dichev’s (1998) bankruptcy risk anomaly

Using Ohlson’s (J Account Res 18(1):109–131, 1980) measure of bankruptcy risk (O-Score), Dichev (J Fin 53(3):1131–1147, 1998) documents a bankruptcy risk anomaly in which firms with high bankruptcy risk earn lower than average returns. This study first demonstrates that the negative association between bankruptcy risk and returns does not generalize to an alternative measure of bankruptcy risk. Then, by examining the nine individual components of O-Score, I find that funds from operations (FFO) is the only component that is associated with returns. Furthermore, I show that the return-predictive power of FFO is due to cash flows from operations. Taken as a whole, this study provides evidence that Dichev’s bankruptcy risk anomaly is a manifestation of investors’ under (over)-pricing of cash flows (accrual) component of earnings, i.e., the accrual anomaly documented by Sloan (Account Rev 71(3):289–316, 1996).     

The impact of accruals and lines of business on analysts’ earnings forecast superiority

In this paper, we examine the linkage between analyst advantage (AA) (compared to the seasonal random walk model) in the prediction of quarterly earnings-per-share (EPS) and a broad set of economic determinants. Specifically, we employ a pooled cross-sectional time-series regression model where AA is linked to a set of firm-specific economic determinants that have been employed in extant work (e.g., Brown et al. in J Account Res 22:49?C67, 1987; Kross et al. in Account Rev 65:461?C476, 1990). We refine this set of independent variables by including a new variable (RATIODEV) based upon Sloan (Account Rev 71(3):289?C315, 1996) who documents that differential levels of accruals impact future earnings performance. This variable is particularly salient in explaining AA since analysts may be in a position to identify the permanent component of accruals via fundamental financial analysis. Additionally, we refine the measurement of lines of business??consistent with the reporting requirements of SFAS No. 131 relative to extant work that operationalized proxies for this variable based upon SFAS No. 14. Parameters for these aforementioned variables are significantly positively related to AA, consistent with theory.     

Optimal versus suboptimal choices of accounting expertise on audit committees and earnings quality

By employing a Heckman two-stage selection model, we identify whether employing a financial expert with or without accounting expertise on the audit committee is optimal and how earnings quality varies across these optimal and suboptimal choices. Using four earnings quality measures (informativeness, timely loss recognition, earnings persistence, and accruals quality), we find no differences in earnings quality between firms optimally choosing an expert with or without accounting expertise, consistent with Demsetz and Lehn (J Polit Econ 93:1155–1177, 1985) and others who argue that when firms optimize their choice (i.e., accounting expertise), there should be no difference across the characteristic (i.e., earnings quality) being examined. We do find, however, earnings quality is significantly higher for firms that optimally choose an accounting expert relative to firms that choose (with/without accounting expertise) suboptimally. Finally, firms suboptimally choosing an accounting expert exhibit no improvement, or even lower earnings quality, than firms that optimally choose no accounting expert. Our results provide important evidence of the impact accounting expertise has on earnings quality when considering the firm’s choice.     

Discussion of “Implications of the integral approach and earnings management for alternative annual reporting periods”

The paper by Gunny, Jacob, and Jorgensen (Rev Account Stud, 2013) provides evidence on whether the earnings volatility induced by year-end adjusting entries results from the integral method of accounting or from purposeful earnings management. The authors find that the variance and negative skewness of annual fiscal-year earnings is greater than the corresponding attributes of alternative annual earnings ending in the first three quarters and interpret these findings as evidence consistent with earnings management rather than settling up annual earnings under the integral method of accounting. While it is difficult to assess the usefulness of their conclusion due to problematic assumptions inherent in the research design, Gunny et al. (2013) reinforce the importance of assessing earnings performance using rolling annual windows. Specifically, they find that the quality of earnings for the alternative annual earnings is greater than that of fiscal-year earnings, highlighting that financial statement users may benefit from using alternative annual earnings to assess current and future performance.