Voluntary disclosure of accruals in earnings press releases and the pricing of accruals

This study investigates firms’ decisions to disclose accruals information in earnings press releases versus to provide it only in 10-Q filings and the impact of this disclosure on the pricing of accruals. I find that firms disclose accruals in their press releases when earnings alone are a weak indication of cash flow performance and that following these disclosures the accruals information is fully impounded into stock prices. The evidence suggests that when investor demand for accruals is likely to exist and firms disclose the information in earnings press releases, the mispricing typically associated with accruals is mitigated.

Hierarchy of earnings thresholds based on discretionary accruals

Prior studies identify hierarchies of earnings thresholds based on distributions of earnings (e.g., Degeorge et al., 1999) and survey opinions of CFOs (Graham, Harvey, & Rajgopal, 2005). We complement extant literature by investigating a threshold hierarchy in the context of accounting discretion exercised by managers. We examine the relative extent of discretionary accruals used to achieve three earnings thresholds—avoiding losses, avoiding earnings declines, and avoiding negative earnings surprises. Our empirical findings suggest that managers are likely to use the largest amount of discretionary accruals to avoid earnings declines, and the least amount of discretionary accruals to avoid negative earnings surprises. Thus, this study identifies the hierarchy of the earnings thresholds based on accounting discretion used in financial reporting. We also find that the hierarchy remains stable over the last two decades during our sample period. Then, we provide several explanations for why managers are likely to exercise more accounting discretion to avoid earnings declines. These explanations include earnings smoothing, reduction of stock returns volatility, and signaling of future growth potential. Overall, this study provides new insights into accruals management behavior.     

Detecting earnings management using cross-sectional abnormal accruals models

This paper examines specification and power issues in relation to three models used to estimate abnormal accruals. In contrast to the majority of prior work evaluating models estimated in time-series, we examine the performance of cross-sectionally estimated models. In addition to testing the standard-Jones (Jones, 1991) and modified-Jones (Dechow et al., 1995) models, we also develop and test a new specification, labelled the ‘margin model’. Consistent with prior US research employing time-series specifications of the two Jones models, our findings suggest that each of the three cross-sectional models are well specified when applied to a random sample of firm-years. However, the margin model appears to generate relatively better specified estimates of abnormal accruals when cash flow performance is extreme. Analysis of the models' ability to detect artificially induced earnings management indicates that all three procedures are capable of generating relatively powerful tests for economically plausible levels of accruals management (e.g., less than 10% of lagged total assets). Regarding their relative performance, the standard-Jones and modified-Jones models are found to be more powerful for revenue and bad debt manipulations. In contrast, the margin appears to be more powerful at detecting non-bad debt expense manipulations.     

Ownership structure and the pricing of discretionary accruals in Japan

This paper examines the valuation effect of discretionary accruals for Japanese firms, taking into account the book value of equity. Consistent with US evidence, the Japanese market prices discretionary accruals, indicating that discretionary accruals enhance the value relevance of reported earnings. This value relevance is lower for cross-held firms, consistent with the view that cross-business shareholding aggravates tunneling or managerial opportunism through discretionary accounting choices. On the other hand, foreign shareholding and bond financing provide effective monitoring on managerial discretion of profit firms to enhance the valuation of discretionary accruals.     

Analyst cash flow forecasts and pricing of accruals

This paper investigates how analyst cash flow forecasts affect investors' valuation of accounting accruals. We find that the strength of the accrual anomaly documented in Sloan (1996) is weaker for firms with analyst cash flow forecasts, after controlling for idiosyncratic risk, transaction costs and firm characteristics associated with the issuance of cash flow forecasts. We further show that this reduction in mispricing of accounting accruals is at least partially attributed to the improved ability of investors to price earnings manipulations imbedded in accruals. We investigate several non-mutually exclusive alternative explanations for this improvement in investors' ability and demonstrate that the increased investor attention and the improved accuracy of analyst earnings forecasts both contribute to the mitigation of the accrual anomaly.     

The pricing of accruals for profit and loss firms

This paper investigates whether the accrual anomaly reported in prior studies exists across both profit and loss firms. We posit that the extent of accrual mispricing is less severe for loss firms than for profit firms because earnings for loss firms are less value relevant and, therefore, less subject to accrual mispricing. As expected, we find that the accrual overpricing anomaly is restricted to profit-making firms and, thus, is dampened by the inclusion of loss firms in the sample. Furthermore, we report that accrual overpricing for profit firms but not for loss firms is primarily attributable to the overpricing of positive accruals of profit firms compared with those of loss firms. Finally, we find that the phenomenon of accrual overpricing for profit but not for loss firms may persist into the new regulatory environment following the passage of the Sarbanes–Oxley Act of 2002.     

The role of current and non-current accruals in the relation between stock returns and earnings

This study examines the role of accruals in the relation between stock returns and earnings for intervals of one to four years. We argue that the roles of current and non-current accruals differ because the former turn over more frequently while the latter include long term timing differences and permanent differences. Accordingly, the roles of both categories of accruals are examined over intervals within and beyond the cycle of current accruals. The results suggest that accruals strengthen the association between stock returns and earnings and that they are more important for shorter intervals. Further, non-current accruals play a dominant role in the relation between stock returns and earnings while the effect of current accruals is negligible for all intervals examined.     

The efficiency of earnings forecast pricing

Prior research has suggested that the information content associated with analysts’ forecast revisions is not immediately incorporated into a firm’s stock price. We find that the apparent anomaly is concentrated in low-priced firms that receive favorable earnings revisions. Variables (such as analyst coverage and celebrity status) cannot reliably explain variations in price formations. Finally, we find that the magnitude of the post-forecast revision drift has decreased after 2002. Overall, our results suggest that the analysts’ forecast revisions anomaly can be explained by a combination of random statistical variations and transaction costs.     

Environmental uncertainty and the market pricing of earnings smoothness

Environmental uncertainty induces variability in an organization's reported earnings, and accentuates the information asymmetry between its managers and outside stakeholders. Managers operating in an environment of high uncertainty, therefore, have an incentive to reduce such variability by smoothing income numbers. We investigate the stock market response to earnings smoothness for firms operating in an environment of high uncertainty. We measure income smoothing by the negative correlation of a firm's change in discretionary accruals with its change in pre-managed earnings as per Tucker and Zarowin (2006). Using future earnings response coefficient (FERC) methodology to measure the informativeness of smoothed earnings, and two measures of environmental uncertainty, this paper documents that current stock price incorporates more information about future earnings for firms operating in high uncertain environments, thus supporting the informational value view of income smoothing.     

The influence of CEO and CFO power on accruals and real earnings management

In this study, we examine the effect of CEO and CFO power on both accruals and real earnings management (AEM and REM, respectively), and the extent to which CEO and CFO power mitigate the effect of one another on AEM and REM. We further examine whether the passage of the Sarbanes-Oxley Act (SOX) altered these effects. In the pre-SOX period, we find that AEM (REM) is greater when the CEO (CFO) is powerful relative to the CFO (CEO). In the post-SOX period, however, we find that the effect of relative CEO power on AEM subsides, whereas the effect of relative CFO power on REM persists. Additionally, we find evidence to suggest that powerful CFOs inhibit the AEM preferences of powerful CEOs in both the pre- and post-SOX periods. Finally, we find evidence to suggest that powerful CEOs inhibit the REM preferences of powerful CEOs in the pre-SOX period, but not in the post-SOX period. Collectively, our results suggest that the power of the CEO relative to the CFO is an important factor in the both the type and magnitude of earnings management.

     

Sarbanes–Oxley Act and the quality of earnings and accruals: Market-based evidence

In this paper we study the impact of the Sarbanes-Oxley Act (SOX) on the valuation weights of earnings and earnings components. The analysis seeks evidence that SOX is associated with changes in investors’ perception of earnings and accruals quality. Of particular interest in the analysis is the effect of SOX on the valuation weight of discretionary accruals that are perceived to be most vulnerable to manipulation prior to SOX. We find reliable increases in the valuation weights of earnings and earnings components after the passage of SOX. Nonetheless, we also find that the post-SOX shifts in the valuation weights of earnings and earnings components are indistinguishable from zero among firms in which the percentage equity shares held by institutional investors is 15% or greater.     

The pricing of accruals quality in credit default swap spreads

We examine the association between accounting information risk, measured with accruals quality (AQ), and credit spreads, primarily measured with credit default swap (CDS) spreads. Theoretically, AQ measures the precision with which accruals map into cash flows. Better AQ implies a more precise estimate of future cash flows and, we predict, a reduction in credit spreads due to resulting lower uncertainty regarding the ability to meet debt interest and principal payments. In support of this hypothesis, we find a negative relationship between AQ and CDS spreads whereby better AQ is associated with lower CDS spreads. Additionally, we investigate the components of total AQ and find that innate AQ is more strongly associated with CDS spreads than is discretionary AQ. We further show that AQ moderates the market's pricing of earnings: the relationship between earnings and CDS spreads weakens as AQ worsens. Together, our results indicate that accounting information risk is priced in credit spreads and that the CDS market responds not only to the level of earnings, but the quality thereof as well.     

Product market competition and earnings management: Evidence from discretionary accruals and real activity manipulation

We examine the association between product market competition and earnings management activities. We use the Herfindahl-Hirschman Index (HHI), a widely used measure for market concentration, as a proxy for product market competition. We examine two forms of earnings management: accrual-based and real activity-based. Our results are mixed, but generally suggest that both income-increasing accrual manipulation and real activity-based manipulation are more prevalent among firms in low competition industries than those in high competition industries. Our findings are robust to various measures of earnings management, alternative measures of product market competitions, and different subsamples. We further explore the reasons why firms in low competition industries are more inclined to manage earnings and find that the market consequences of missing important earnings targets are more severe among firms in low competition industries than those in high competition industries.     

Interfirm differences in earnings variability: an analysis of fundamentals,cash flows and accruals

Prior research shows that the time‐series variability of corporate earnings affects forecasting accuracy and corporate risk, yet little is known about the determinants of earnings variability. This study analyses interfirm differences in earnings variability. Large‐sample evidence shows how the ratio of accrual variability to cash‐flow variability varies across a cross‐section of firms and how these components and the correlation between contemporaneous cash flows and accruals are related to key economic fundamentals.     

Cross-sectional estimation of abnormal accruals using quarterly and annual data: effectiveness in detecting event-specific earnings management

This paper addresses certain methodological issues that arise in estimating abnormal (or discretionary) accruals for detection of event-specific earnings management. Unlike prior studies (e.g., Dechow, Sloan, and Sweeney, 1995; Guay, Kothari, and Watts, 1996) that rely primarily on time-series models, we focus on the specification of cross-sectional models of expected accruals using quarterly as well as annual data. Perhaps more importantly, we present a variation of the Jones model that is shown to be well specified for all cash flow levels. We show that the cross-sectional Jones model yields systematically positive (negative) estimates of abnormal accruals for firms whose cash flows are below (above) their industry median. Using mean squared prediction errors as well as simulation analysis, we show that our model is more powerful than the cross-sectional Jones model in detecting earnings management. In addition, we examine differences in the power of current accrual models in detecting earnings management across audited and unaudited quarters.     

Information content of credit ratings in pricing of future earnings

This paper examines whether credit ratings convey information about the firm’s future earnings to the capital markets. Using the future earnings response coefficient methodology, we find that the current stock returns of rated firms reflect more future earnings than do the stock returns of non-rated firms. We also find that the market reflect more future earnings in current returns for higher-rated firms. In addition, we present evidence that returns impound future earnings to a greater extent after a ratings initiation or upgrade. We empirically eliminate the possibility that our findings are driven by earnings smoothing, market liquidity or omitted default risk factors associated with ratings. Our results are robust to controlling for potential omitted variables, endogeneity bias, loss versus profit firms, and serial correlation of error terms. Overall, the evidence suggests that credit ratings help disseminate private information to reduce information uncertainty about the firm’s future profitability among market participants.     

Product market pricing power, industry concentration and analysts’ earnings forecasts

This is the first study to establish a link between product market power and analysts’ earnings forecast accuracy and bias. Relating two different dimensions of market power to earnings forecastability, we document that (a) a firm’s relative pricing power and (b) its industry concentration are strong positive determinants of analysts’ earnings forecast accuracy. We find that forecasting earnings of higher market power firms is less complex due to their ability to withstand cost shocks as well as greater informational-efficiency enjoyed by such firms. Further, forecast optimism increases with weakening product market pricing power and with lower industry concentration. The knowledge derived from this study will hopefully improve the accuracy of equity valuation, and thereby engender better buy-side (stock selections) and sell-side recommendations by analysts. Our analysis also suggests that brokerage firms compensating analysts based on forecast accuracy need to adjust for the differential in the information complexity of different industries.     

Voluntary profit forecast disclosures,IPO pricing revisions and after-market earnings drift

Prospectus profit forecasts (PPF) constitute one of the most important discretionary disclosure items in an IPO. I examine such disclosures in the Hong Kong market, where both IPO activity and PPF disclosure rates are at high levels. The median forecast typically ‘underestimates’ future earnings by around 6%. More importantly, PPF disclosure exhibits a strong inverse association with pre-listing owners' retained equity levels (Hughes, 1986; and Li and McConomy, 2004). PPF disclosure is thus more likely in IPOs raising more capital and generating larger floats. I also demonstrate a strong link between PPF disclosure and post-IPO earnings drift.Ensuing forecast errors also bear strong connection with IPO coordinators' initial price determinations as well as with subsequent investor returns. This area usefully extends the related literature (Cheng and Firth, 2000; Chen, Firth and Krishnan, 2001; Jog and McConomy, 2003; Chong and Ho, 2007; and Gounopoulos, 2011), which stresses an association between forecast errors and initial investor returns but ignores the preceding price ‘determination’ process. It also suggests that forecast errors serve as a valuable ex-post proxy for the amount of ex-ante uncertainty surrounding issuer value (Beatty and Ritter, 1986; Falconieri, Murphy and Weaver, 2009). This study also demonstrates a connection between final offer price ‘determinations’ and the information content and “superiority” of PPFs (Brown, Richardson and Schwager, 1987). Finally, and in contrast to final offer price ‘determinations’, initial investor returns strongly anticipate post-IPO earnings drift.