Audit committees and earnings quality

This research investigates whether audit committees are associated with improved earnings quality for a sample of Australian listed companies prior to the introduction of mandatory audit committee requirements in 2003. Two measures of earnings quality are used based on models first developed by Jones (1991 ) and Dechow and Dichev (2002 ). Our results indicate that formation of an audit committee reduces intentional earnings management but not accrual estimation errors. We also find differences in the associations between audit committee accounting expertise and the two earnings quality measures. Other audit committee characteristics examined are not significantly related to either earnings quality measure.     

Earnings characteristics and analysts’ differential interpretation of earnings announcements: An empirical analysis

This study provides empirical evidence on factors that drive differential interpretation of earnings announcements. We document that Kandel and Pearson's forecast measures of differential interpretation are decreasing in proxies for earnings quality and pre‐announcement information quality. This evidence yields new and useful insights regarding which earnings announcements are less likely to generate newfound disagreement among analysts and investors. Recent research suggests that investor disagreement can increase investment risk, increase the cost of capital, and cause stock prices to deviate from fundamental value. Therefore, our results support prior intuition that increasing the quality of earnings and pre‐announcement information can improve the efficiency of capital markets.     

The effect of board composition on the informativeness and quality of annual earnings: Empirical evidence from Greece

This study examines how the informational quality of annual accounting earnings, varies according to the size and composition of the board of directors of publicly listed firms within the Greek capital market. Data analysis over a period of five years (2000-2004) revealed that the informativeness of annual accounting earnings is positively related to the fraction of outside directors serving on the board, but it is not related to board size. Additionally, firms with a higher proportion of outside board members proved to be more conservative when reporting bad news but on the contrary they do not display greater timeliness on the recognition of good news. Finally, firms with a higher proportion of outside directors report earnings of higher quality compared to firms with a low proportion of outside directors. Our results are robust to several sensitivity tests controlling for endogeneity, firm's fixed effects and alternative models for the estimation of discretionary accruals.     

News-driven return reversals: Liquidity provision ahead of earnings announcements

This study documents a six-fold increase in short-term return reversals during earnings announcements relative to non-announcement periods. Following prior research, we use reversals as a proxy for expected returns market makers demand for providing liquidity. Our findings highlight significant time-series variation in the magnitude of short-term return reversals and suggest that market makers demand higher expected returns prior to earnings announcements because of increased inventory risks that stem from holding net positions through the release of anticipated earnings news. Collectively, our findings suggest that uncertainty regarding anticipated information events elicits predictable increases in the compensation demanded for providing liquidity and that these increases significantly affect the dynamics and information content of market prices.     

Tunneling as an incentive for earnings management during the IPO process in China

Using a sample of 185 Chinese IPO firms listed on the Shanghai Stock Exchange during the period 1999–2001, we show that related-party (RP) sales of goods and services could be used opportunistically to manage earnings upwards in the pre-IPO period. We also provide evidence that such behavior may be motivated by the prospect of tunneling opportunities in the post-IPO period, i.e., exploiting economic resources from minority shareholders for the benefit of the parent company. We provide evidence of one such opportunistic tunneling tool: non-repayment by Chinese parent companies of net outstanding corporate loans made to them by their newly listed subsidiaries. Furthermore, we provide evidence in support of our assertion of an association between such tunneling behavior in the post-IPO period and earnings management via abnormal RP sales in the pre-IPO period. Finally, we demonstrate the apparent failure of investors in Chinese IPOs to perceive the link between the two phenomena. The results enhance understanding of the motives for and consequences of earnings manipulation during the IPO process. They highlight a potential additional investment risk facing foreign investors in China’s capital markets as well as in Chinese firms cross-listed in non-Chinese stock exchanges, and have policy implications for China and other emerging markets which need to improve the protection of minority shareholders’ rights.     

The impact of product market competition on earnings quality

The objective of this paper is to examine the impact of product market competition on earnings quality. Based on a sample from the US manufacturing sector for the period 1996–2005, we find consistent evidence showing a positive relation between product market competition and earnings quality. Additional tests also confirm a positive relation between product market competition and the precision of public and private information held by investors and analysts. We also provide evidence that firms competing in concentrated and heterogeneous industries are associated with a number of earnings attributes and information quality not shared by those competing in concentrated but homogeneous industries. These findings are consistent with the intuition that firms enjoying a monopolistic advantage tend to avoid the attention of their competitors and politicians by creating a more opaque information environment.     

Value or Glamour? An empirical investigation of the effect of celebrity CEOs on financial reporting practices and firm performance

In this study, I investigate the impact of managerial reputation, as proxied by high‐profile awards to CEOs, on financial reporting practices and firm performance. Using a sample of 269 awards given to 189 celebrity CEOs (CEOs who win awards) from 1987 to 2003, I compare within‐firm changes in financial reporting practices and firm performance before and after each CEO wins their first award. I find that celebrity CEOs engage in more conservative accounting practices and are less likely to engage in opportunistic earnings management to meet short‐term earnings benchmarks. In addition, firm performance improves after celebrity CEOs win awards.     

Underwriter reputation,earnings management and the long‐run performance of initial public offerings

This study contributes to the extant literature on the nature of earnings management surrounding initial public offerings (IPOs) by investigating the role of underwriter reputation. We argue that prestigious underwriters will protect their reputation by carefully monitoring and certifying financial information on IPO firms, thereby limiting any potential earnings manipulation. As a result, those IPO firms that are associated with more prestigious underwriters are likely to exhibit substantially less‐aggressive earnings management. Conversely, we find the existence of a negative relationship between earnings management and the post‐offer performance of an IPO firm’s stocks only for those firms associated with less‐prestigious underwriters.     

An analysis of earnings management by European private firms

This paper addresses the questions of whether private firms in eight European countries engage in earnings management, and if so, whether tax incentives affect such practices. To measure earnings management, we analyze the earnings distributions of private firms and compare these distributions with those of public firms in the same countries. The empirical evidence suggests that in absence of capital market pressures, firms still have incentives to manage earnings, as we find that private firms avoid reporting small losses. We further find that private firms in some countries where tax regulation strongly influences financial accounting do not avoid reporting small losses. We attribute this finding to tax incentives reducing firms’ benefits of (upward) earnings management. Finally, our results suggest that some types of earnings management are due to capital market pressures and are specific to public firms since we do not find evidence that private firms avoid earnings decreases.     

The usefulness of operating cash flow and accrual components in improving the predictive ability of earnings: a re‐examination and extension

We examine whether the components of accruals and operating cash flows improve the predictive ability of earnings for forecasting future cash flows. Unlike most previous studies, we avoid data estimation errors and sample self‐selection bias because we exploit data from Australia where reporting of actual cash flow components had been mandatory since 1992. We show that accrual components and operating cash flow components together are more useful than (i) earnings, (ii) operating cash flows and total accruals and (iii) the combination of operating cash flows with accrual components in forecasting future cash flows. These results are robust to several contextual factors, including the length of the operating cash cycle, industry membership, firm profitability and firm size.     

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.     

Cash flow disaggregation and the prediction of future earnings

We examine the incremental information content of the components of cash flows from operations (CFO). Specifically the research question examined in this paper is whether models incorporating components of CFO to predict future earnings provide lower prediction errors than models incorporating simply net CFO. We use Australian data in this setting as all companies were required to provide information using the direct method during the sample period. We find that the cash flow components model is superior to an aggregate cash flow model in terms of explanatory power and predictive ability for future earnings; and that disclosure of non‐core (core) cash flows components is (not) useful in both respects. Our results are of relevance to investors and analysts in estimating earnings forecasts, managers of firms in regulators’ domains where choice is provided with respect to the disclosure of CFO and also to regulators’ deliberations on disclosure requirements and recommendations.     

An alternative interpretation of the discontinuity in earnings distributions

We show that the asymmetric effects of income taxes and special items for profit and loss firms contribute to a discontinuity at zero in the distribution of earnings. Income taxes draw profit observations towards zero while negative special items pull loss observations away from zero. These earnings components are thus expected to contribute to a discontinuity even in the absence of discretion. We show our results are not an artifact of deflation and that other common components of earnings do not have similar effects on the earnings distribution around zero.

Nonlinear dynamics in discretionary accruals: An analysis of bank loan-loss provisions

Several studies have analyzed discretionary accruals to address earnings-smoothing behaviors in the banking industry. We argue that the characteristic link between accruals and earnings may be nonlinear, since both the incentives to manipulate income and the practical way to do so depend partially on the relative size of earnings. Given a sample of 15,268 US banks over the period 1996–2011, the main results in this paper suggest that, depending on the size of earnings, bank managers tend to engage in earnings-decreasing strategies when earnings are negative (“big-bath”), use earnings-increasing strategies when earnings are positive, and use provisions as a smoothing device when earnings are positive and substantial (“cookie-jar” accounting). This evidence, which cannot be explained by the earnings-smoothing hypothesis, is consistent with the compensation theory. Neglecting nonlinear patterns in the econometric modeling of these accruals may lead to misleading conclusions regarding the characteristic strategies used in earnings management.     

Accounting quality,information risk and the term structure of implied volatility around earnings announcements

We examine the association between accounting quality, which is used as a proxy for firm information risk, and the behavior of the term structure of implied option volatility around earnings announcements. By employing a large sample of US firms having options traded on their equity during 1996–2010, we find that lower (higher) accounting quality is significantly associated with stronger (weaker) changes in the steepness of the term structure of implied volatility curve around quarterly earnings announcements. This finding (which is robust to controls for business-stemming uncertainty regarding future firm performance) is consistent with a stronger differential of short vs. long-term uncertainty for higher information risk firms, indicating greater uncertainty on the future economic performance of poorer vs. stronger accounting quality firms. We also establish the trading implications of these findings by demonstrating a (profitable in-sample) self-financed option trading strategy that is based on the quality of the accounting information released on earnings announcement days.     

The Changing Landscape of Accrual Accounting

A fundamental property of accrual accounting is to smooth temporary timing fluctuations in operating cash flows, indicating an inherent negative correlation between accruals and cash flows. We show that the overall correlation between accruals and cash flows has dramatically declined in magnitude over the past half century and has largely disappeared in more recent years. The adjusted R ² from regressing (changes in) accruals on (changes in) cash flows drops from about 70% (90%) in the 1960s to near zero (under 20%) in more recent years. In exploring potential reasons for the observed attenuation, we find that increases in non‐timing‐related accrual recognition, as proxied by one‐time and nonoperating items and the frequency of loss firm‐years, explain the majority of the overall decline. On the other hand, temporal changes in the matching between revenues and expenses, and the growth of intangible‐intensive industries play only a limited role in explaining the observed attenuation. Finally, the relative decline of the timing role of accruals does not appear to be associated with an increase in the asymmetrically timely loss recognition role.     

An analysis of the effect of mandatory adoption of IAS/IFRS on earnings management

This paper examines whether mandatory adoption of international accounting standards, IAS/IFRS, by French companies is associated with lower earnings management. In addition, the impact of six factors that may be related to earnings management level are also considered: the independence and the efficiency of the board of directors, the separation of roles of CEO and Chairman of the board, the existence of an independent audit committee, the existence of block shareholders, the quality of the external audit and the listing on foreign financial markets.Based on a sample of 353 French listed groups relating to the period 2003–2006, our results show that the mandatory adoption of IAS/IFRS is associated with a reduction in the earnings management level. In addition, the independence and the efficiency of the board of directors, the existence of an independent audit committee, the existence of block shareholders, the quality of the external audit and the listing on foreign financial markets are important factors for enforcement of IAS/IFRS in France. Mandatory adoption of IAS/IFRS has decreased earnings management level for companies with good corporate governance and those that depend on foreign financial markets.     

Are incentives for earnings management reflected in the ERC: Large sample evidence

In this study, I examine the effect of exposure to earnings management (EM) incentives on the earnings response coefficient (ERC). Drawing from several anecdotes and normative arguments about the implications of managers' incentives for investor perception, I predict and test that exposure to EM incentives is negatively associated with the ERC. I find that ERC is reliably lower for firms with elevated exposure to EM incentives, holding constant the effects of actual EM and other factors that affect the returns–earnings relation. Furthermore, the effect of the incentive exposure on cash flows as well as on total accruals is reliably negative. These results are robust across alternative price– and returns–earnings specifications, and are insensitive to the inclusion of other measures of earnings quality. Additional analysis shows that the effect of such incentives on the ERC is more pronounced at higher levels of institutional stock ownership. However, a certain class of institutional owners – transient institutions – are less sensitive to the implications of such incentives for earnings quality.