Why Are Earnings Kinky? An Examination of the Earnings Management Explanation

Prior research has documented a kink in the earnings distribution: too few firms report small losses, too many firms report small profits. We investigate whether boosting of discretionary accruals to report a small profit is a reasonable explanation for this kink. Overall, we are unable to confirm that boosting of discretionary accruals is the key driver of the kink. We caution the use of the ratio of small profit firms to small loss firms as a measure of earnings management. We investigate and discuss a number of alternative explanations for the kink.     

Expected Accrual Models: The Impact of Operating Cash Flows and Reversals of Accruals

This paper augments the Jones (1991) model with operating cash flows and lagged accruals to evaluate the impact of (1) the negative association between accruals and concurrent cash flows, (2) the positive association between accruals and lagged cash flows, and (3) the reversal of accruals. I find that operating cash flows greatly improve the explanatory and predictive power of the Jones model; but, lagged accruals do not. A market test of the expected and unexpected components of accruals indicates that unexpected accruals are on average informative with respect to concurrent stock returns; however, the market does not fully understand the implications of accruals anticipated at the beginning of the return period.This paper has benefited from helpful comments and suggestions from Tae Hee Choi, In-Kyu Moon, and two anonymous reviewers on earlier versions of this paper. The author gratefully acknowledges the financial support from the Queens School of Business.     

What Determines the Variability of Accounting Accruals?

The variability of accounting accruals provides a measure of the normal level of managers accounting discretion and has important implications for event studies of earnings management. We examine how this measure is related to the economic factors including both firm characteristics and attributes of the disclosure environment. We show that the variability of accruals is related to firm size, leverage, variability of cash flows, operating cycle, growth, and other factors. Significant industry differences and temporal patterns are also found.     

The impact of tax on foreign direct investment: Empirical evidence and the implications for tax integration schemes

We estimate the impact of taxation on foreign direct investment (FDI) flows, using data on flows between seven countries for 1984 through 1989, and a sophisticated measure of the cost of capital. We find that the choice between domestic investment and total outward FDI is not significantly affected by taxation but that taxation does affect the location of outward FDI. These results are used to examine the impact of tax integration systems. Giving a tax credit to foreign shareholders may induce a large increase in inward FDI from exemption countries but not from partial-credit countries. For the United States, the total effect would be small.     

Valuation Implications of Investment Opportunities and Earnings Permanence

This study investigates the value-relevance of accounting earnings in the presence of investment (growth) opportunities after making two theoretical and methodological research design refinements. First, we test for the incremental effect of growth on firms earnings response coefficients after controlling for the extent of transitory earnings under the assumption that the value-relevance of earnings with respect to growth should be stronger when earnings are more permanent. Second, we perform comprehensive factor analysis using market-based and accounting-based measures to construct a composite proxy for investment opportunities. We find that firms investment opportunities and the relative permanence of current earnings affect the value-relevance of those earnings. Additionally, we find that the interaction between permanent earnings and investment opportunities produces an even stronger price response to earnings.     

Explaining intercity home price differences

This paper develops and tests an equilibrium model seeking to explain intercity variation in owner-occupied housing prices. Empirical tests with a reduced form equation using aggregated 1980 data on 94 SMSAs suggest explanation for 84% of this intercity home price variation. Intercity housing demand, based upon homeowner quality of life equilibrium, is successfully represented by the non-monetary income determinant of climate mildness in addition to several monetary income determinants that reflect household residual after-tax real income. Intercity housing supply was found to be influenced by intercity variation in construction costs and limitations upon the available supply of undeveloped urban land.     

When Capital Follows Profitability: Non-linear Residual Income Dynamics

Economic reasoning suggests that capital follows profitability. This study introduces into residual income valuation capital follows profitability investment dynamics whereby capital investments are guided by the profitability of underlying investment opportunities. These investment dynamics predict convex versus linear relations between future and current residual income, with slope and convexity dependent on investment opportunity. We test these predictions against the linear information dynamics (LID) proposed by Ohlson (1995) and Feltham and Ohlson (1996), with supportive results. These findings point the way to further development of links between firm value and the economics of value creation.     

A New Approach to Group Structure, Burden Sharing, and the Equilibrium Provision of Public Goods

In the received model of the voluntary provision of a pure public good, the usual practice is to proceed from assumptions about the group characteristics to inferences about an implied outcome. The approach advocated in this paper reverses the traditional direction. Assuming a Nash equilibrium, we ask how to characterize the diverse set of group characteristics which will support it. Approaching the problem from this angle we define three crucial characteristics of a group-equilibrium: consumer's free rider inducing supply, zero contribution-inducing wealth and voluntary surplus tribute which is the amount by which a person's actual income exceeds his/her zero-contribution inducing wealth. Defining these indicators we show how they form the foundation of a complete mapping between the distribution of individual characteristics of a group, and equilibrium public good supply. Certain questions such as the interaction between size of the group and heterogeneity of incomes and tastes not yet adequately addressed are shown to yield easily to this approach.     

The Impact of Taxing Unemployment Insurance Benefits on Unemployment Duration and Post-unemployment Earnings

In 1979, unemployment insurance benefits became taxableincome for recipients with income above a specified threshold.Further legislation in 1982 lowered the income threshold. Thispaper uses the Continuous Wage and Benefit History (CWBH) database to evaluate the effects of the 1982 change on the compensatedduration of unemployment and post-unemployment earnings. The1982 episode is a particularly useful natural experimentbecause the treatment group (those newly subject to benefittaxation) is the middle income category and the two controlgroups (those whose benefits were already taxed and those whosebenefits still were not taxed) are the high and low income categories.If the two control groups show similar trends in unemploymentduration (or post-unemployment earnings) and the treatment groupshows a strikingly different pattern, this is compelling evidenceof a tax effect. The empirical results suggest that taxing unemploymentbenefits reduced the affected workers' mean compensated durationby more than a week, but did not have a statistically significanteffect on their post-unemployment earnings.     

Economic Effects of the 2003 Partial Integration Proposal in the United States

On January 7, 2003, President George W. Bush proposed a significant change in capital income taxation in the United States. In the context of a jobs and growth package, the President proposed to reduce substantially the double taxation of corporate-source income by eliminating investor-level taxes on dividends paid from earnings on which corporate tax had been paid. In addition, the Presidents proposal would have reduced the tax on retained earnings by allowing a basis adjustment for accumulated previously taxed retained earnings. Taken together, these proposals would have moved the U.S. income tax much closer to an integrated tax system along the lines outlined by the Treasury Department in President George H.W. Bushs administration a decade earlier.Putting together the impacts of the Presidents proposal on economic activity through greater capital accumulation and improved calculation, I estimate that the proposal, if it had been enacted in its original form, would yield a permanent increase of 0.48 percent in the U.S. economys potential output. This estimated gain does not include any gains made possible by improved corporate financial policy.At the time of the integration proposal, the author was Chairman of the Council of Economic Advisers.     

Prior Information and the Market Reaction to Dividend Changes

We investigate two hypotheses regarding the information content of dividend change announcements. The first is that the importance of information signaled by a dividend change depends on the reliability of earnings forecasts existing before the dividend announcement. The second hypothesis is that the stock price reaction to dividend change announcements is related to earnings forecast error as of the time of the dividend announcement. Our results reveal that dividend increases convey more information for firms in which financial analysts least accurately predict earnings. The results also indicate that dividend increase and decrease announcements provide market participants with information which, on average, allows them to differentiate between firms on the basis of future earnings realizations. These differential information effects are shown to be robust to price, size, dividend yield, and overinvestment effects.     

The Pitfalls of International Integration: A Comment on the Bush Proposal and its Aftermath

In January 2003, the Bush Administration proposed a new system for taxing corporate dividends, under which domestic shareholders in U.S. corporations would not be taxed on dividends they received, provided the corporation distributed these dividends out of after-tax earnings (the Bush Proposal). The Bush Proposal was introduced in Congress on February 27, 2003. Ultimately, however, Congress balked at enacting full-fledged dividend exemption. Instead, in the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) as enacted on May 28, 2003, a lower rate of 15% was adopted for dividends paid by domestic and certain foreign corporations,¹ and the capital gains rate was likewise reduced to 15%. Significantly and in stark contrast to the original Bush proposal, under JGTRRA the lower rate for dividends and capital gains does not depend on any tax being paid at the corporate level.This comment will focus primarily on the international aspects of both the Bush Proposal and JGTRRA. I will not lay out the proposal or the law in any detail. Instead, I will ask whether either the Bush Proposal or JGTRRA make sense from an economic efficiency perspective when the international implications are taken into account. I will leave to others the question of whether either the Bush Proposal or JGTRRA are sensible ways to stimulate the economy (for discussion of the effect of the 2001 tax cuts see Shapiro and Slemrod, 2001, 2002). I will also omit any discussion of the distributive effects of either the Bush Proposal or JGTRRA, which have been extensively discussed elsewhere (e.g., Tax Policy Center, 2003; Burman, Gale and Orszag, 2003).     

Real effects of separating investment and operating cash flows

This paper investigates the rationale for the measurement of a firm's periodic performance through the accounting classification of its cash outflows into operating cash flow and investment. We show that when the accounting system does not attempt to measure periodic performance and reports only aggregate cash flow, equilibrium capital market prices are such that there is a perverse informational cost to investment over and above the real cost of investment. This induces distortions in the firms' equilibrium investment. We show that other sources of information, consisting of forecasts of future returns to investment play a vital counterbalancing role when the accounting system is inadequate in this way. An accounting signal that provides noisy information on periodic performance decreases the informational cost to investment and moves the economy closer to first best.The first author wishes to acknowledge financial support from McKnight Foundation and the Accounting Research Center, University of Minnesota. An earlier version of the paper was titled Capitalization vs. Expensing: Effects on Investment.     

The Association Between Operating Cash Flows and Dividend Changes: An Empirical Investigation

The Association between earnings and dividend changes has been established since Lintner's (1956) pioneering work. Subsequent research attempted to establish an association between operating cash flows and dividend changes, given earnings, without success (Simons, 1994). Recently, there has been increased attention in cash flow reporting. Regulatory bodies worldwide have stressed the significance of cash flow information in capital markets. Research on the association between cash flows and dividends has been limited, yielding inconclusive results. The purpose of this study is to re-evaluate and extend prior studies by examining the incremental ability of cash flows to explain dividend changes, given earnings. We argue that a positive relationship between cash flows and dividend changes should exist due to liquidity and accruals management considerations. The empirical evidence of this study supports that the dividend changes-cash flow relationship is significantly positive (a) when operating cash flows are low compared to earnings, and (b) when firm growth is moderate.     

The Information Content of Bank Examinations

We identify three types of information from bank examinations—auditing information from verifying the honesty and accuracy of the bank's books, regulatory discipline information about the treatment of the bank by regulators, and private information about bank condition. We estimate these information effects by comparing the cumulative abnormal market returns associated with examinations in which the CAMEL rating remained unchanged, improved, and worsened. All three information effects are found to be greater for banks entering the examination process with unsatisfactory ratings from prior examinations. The only consistently strong effect found is that examination downgrades appear to reveal unfavorable private information about bank condition. The evidence also suggests that the information may reach the market in part through loan quality data released in quarterly financial statements.     

Analyst Following and Equity Offerings Subsequent to Initial Public Offerings

Analyst forecast information is collected for firms following their IPOs and is used in an examination of subsequent seasoned equity offerings (SEOs). Consistent with information asymmetry arguments, the analysis indicates that a larger percentage of firms conducting SEOs within three years of the IPO are covered by financial analysts than those without SEOs, and that analyst coverage is a significant predictor of subsequent SEOs. In addition, the results indicate that long-term earnings growth forecasts are larger for firms with subsequent SEOs, but growth forecasts decline significantly following the SEOs. Further, SEO abnormal returns exhibit a significant negative relationship with earnings growth forecasts. These results are consistent with windows of opportunity arguments since they suggest that SEOs are timed to coincide with the peak of earnings growth expectations, but that market participants compensate by reacting more negatively to offerings by firms with high growth forecasts.     

On the Rationality of the Post-Announcement Drift

This paper demonstrates that a post-announcement earnings drift, which is often advanced as an example of market irrationality, can arise even if traders act rationally on their information. Specifically, we show that in the presence of share supply variations which are unrelated to information, there is a positive correlation between the unexpected component of current public signals and future price changes. Such a correlation arises from the fact that while prices reveal private information that cannot be found in public signals, non-information based trading distorts the information content of prices relative to the implications of both private and public information. Under these circumstances, markets may appear semi-strong inefficient and slow to respond to earnings announcements even though information is processed in a timely and efficient manner. Our findings correspond well with previously documented empirical evidence and suggest that the robustness of earnings-based anomalies may be rational outcomes of varying uncertain share supply.     

Progression and revenue effects of income tax reform

Usually, only initial revenue effects of personal income tax reforms are considered. However, a tax reform characterized by base broadening in exchange for rate reduction can reduce the income elasticity of tax revenue. In that case, the increase in revenue after income growth will be relatively smaller: the tax reform has a negative effect on revenue in the second period. Using the microtax model of the Central Planning Bureau we simulated the effects of the Dutch Oort reform 1990 on revenue elasticities and, consequently, on tax revenue. The income tax revenue elasticity declined by 17 percent which caused an additional revenue loss of 0.6 percent in 1990, rising to 3.8 percent in 1993.     

Would Switching to Timely Reviews Delay Quarterly and Annual Earnings Releases?

The SEC recently issued a proposal to modernize and clarify the regulatory structure of securities offerings. The proposal would allow companies to access capital markets on an almost continuous basis but would require strengthening of the role of independent accountants and other gatekeepers in the registration process. The Commission is seeking comment on whether it should add to the proposed practices the fact than an independent accountant performed a timely review under SAS 71 of an issuer's quarterly financial information (SEC, 1998, p. 231). This is the most recent of several proposals, made by the SEC and others, that provides incentives for companies to purchase quarter-end (timely) reviews of their quarterly data. Some managers who currently have their quarterly earnings reviewed only at year-end (retrospective reviews) argue that having a timely review would delay interim earnings releases. Proponents of timely reviews deny that this would occur, and assert that shifting certain review procedures into interim periods would decrease the time needed to release annual earnings.We estimate the quarterly and annual reporting lags that would occur if companies currently selecting retrospective reviews switched to timely reviews. Our results indicate that quarterly earnings release lags would increase, as opponents of mandatory timely review have argued. Switching to timely review would reduce annual earnings release lags only when interim earnings contain unusual components.     

Activity-Based Costing for Economic Value Added®

Economic value added, which is the currently popular term for the traditional accounting concept of residual income (RI), subtracts from operating income an interest charge for invested capital. This paper provides an activity-based cost system that supports RI maximization. We construct a model of participative budgeting for a multi-activity firm in which the cost system allocates plant and equipment cost to products using a formula that includes the interest charge. The budget system we design enables decision makers to identify RI-improving opportunities for outsourcing and dropping unprofitable products. The budget system also has the open-architecture property that additional informal communication among activity managers can only serve to increase RI.