Stuvia 1217723 Summary Seminar Financial Accounting Research Grade 85

Summary Seminar Financial
Accounting Research (grade: 8,5)
geschreven door
sanneerasmus
www.stuvia.com
Gedownload door: hatimvandervaart | hatimbelahcen@hotmail.com

Dit document is auteursrechtelijk beschermd, het verspreiden van dit document is strafbaar.
Stuvia - Koop en Verkoop de Beste Samenvattingen
Four steps to detect market response:

1. When is new information released?
• Earnings release date.
2. Which part of the released information is new?
Seminar Financial Accounting Research • Investors have certain expectations of earnings.
• Unexpected earnings.
Session 1 3. Which part of the market response can be attributed to th
new information?
An empirical evaluation of accounting income numbers (Ball & Brown,
• Numerous events affect returns.
1968) • Identify reaction to firm-specific (e.g., earnings) news.
Introduction and motivation • Abnormal share return.
4. Compare “abnormal” share return with “unexpected”
Motivation: earnings
- Accounting research was mainly normative, prescriptive or theoretical → shortcoming = it
ignored the extent to which predictions of the model conform to observed behaviour (i.e.
research was focused on “ideal world”, normative). For this reason, the authors
operationalise the usefulness of earnings numbers by looking at the decision-making
process of investors, which is reflected in security prices.
- Moreover, the prevailing view was that earnings numbers were useless; earnings are
historical data and were not considered important for the future. In addition, stock markets
were viewed as chaotic and irrational.
Coincidence in other research area → finance: framing stock price behaviour over time as a
function of information flows to the market. Therefore, there is a predictable pattern
around information events. Giving this pattern, you can use event studies as natural way of
studying price behaviour as a function of information.
RQ = Does net income have an impact on the investment decision, i.e., is it reflected in
security prices?
Idea → assess the usefulness of existing accounting numbers by examining their

information content and timeliness:
* Do earnings numbers capture information that is contained in stock prices? → do earnings
have an effect on the decision-making process of investors?
* Do earnings convey new information to the stock market, i.e., is it a timely medium to
investors?
Methodology
Event study → observe the market reaction around the earnings announcement (EA) date.
Event window → 12 months before and 6 months after the earnings announcement date:
* (-12:0) because of annual earnings (= information content)
* (0:+6) to give plenty of time to react to earnings (= timeliness)
he time expectation for accessibility and availability of information.
Assumptions are made that investors:

- think EPS are relevant for decision making
- are able to forecast EPS through accounting information
- adjust their forecasting errors by changing the share price (i.e. markets are efficient)
Step 1: Unexpected earnings (= independent variable)

Market model → actual income (eps) – expected income (eps) = abnormal income (eps):
∆ I j , t−τ =^α 1 jt + α^ 2 jt ∆ M j , t−τ + u^ j , t−τ
- M is a market index of income
- Use OLS-method to calculate α^ 1 jt & α^ 2 jt
1

- Get the expected income change this year → ∆ I^ jt =α^ 1 jt + α^ 2 jt ∆ M j ,t

- Realized income this year → ∆ I jt actual income change
- Calculate unexpected income (= forecast error) → u^ j ,t −τ (= ∆ I jt – ∆ I^ jt )
* u^ j ,t −τ > 0 → good news (GN) firm
* u^ j ,t −τ < 0 → bad news (BN) firm
Three approaches:
- Change in EPS (uncorrected; naïve model → ∆ I jt is entirely unexpected)
- Abnormal income
- Abnormal EPS
Step 2: Abnormal stock returns (= dependent variable)

1. Monthly stock return → PR jm=( p j ,m+ 1+ d jm)/ p jm
* p j ,m+ 1 = closing price
* d jm= dividend this month
* p jm = opening price
2. Decomposition of returns → expected (market) & unexpected part
[PR¿ ¿ jm−1]=b^ 1 j+ b^ 2 j [ Lm−1]+ v^ jm ¿
* Lm = market index
* PR jm = monthly price relative for firm j in month m
* ^v jm = stock return residual for firm j in month m (= abnormal stock return)
* Use OLS-method to estimate ^v jm separately for each firm-month
Step 3: Abnormal performance index (API)

Calculation steps of API:
1. Start with abnormal stock returns ^v jm (= residual)
2. Calculate cumulative abnormal stock returns for each firm-month (e.g. for month +6 and
firm j: cumulate abnormal stock return of firm j from m = -11 before to +6 months after EA)
3. Calculate average cumulative abnormal stock returns for each month across firms in 1)
GN sample, 2) BN sample and 3) full sample.
Step 4: Study the development of the API in the course of time around the announcement
date of the earnings information, separately for the good news (GN) sample and the bad
news (BN) sample
Methodology summarized, for each firm:

1. Estimate investors’ earnings expectations
* Classify each firm as GN (actual earnings > expected earnings) or BN
2. Estimate abnormal stock return for each firm-month
4. Calculate abnormal performance index (API)
* Start with month of EA (= month 0) and corresponding abnormal stock return for
each firm
* Cumulate abnormal stock return for each firm from -11 to 0
* Calculate average cumulative abnormal stock return for month 0 for each of the
samples
* Repeat for the months -1 to -12 and months +1 to +6
Results
2

Main finding = firms with positive (negative) abnormal/unexpected earnings have positive
(negative) abnormal stock returns → earnings are useful for investors; the stock market
reacts to earnings announcements.
Three key findings:

- Information content of earnings
Of all information about an individual firm which becomes available during a year,
over 50% is captured in that year’s income number
- Prices lead earnings
Market anticipates earnings information, a large fraction (85-90%) is impounded
into prices prior the EA. Therefore, earnings are not timely.
- Prices lag earnings
There is a post-earnings announcement drift (i.e. markets are not completely
efficient) → significant cumulative abnormal returns also occur in the post-
announcement period and indicate that the market underreacts to earnings.
How Do Earnings Numbers Relate to Stock Returns? A Review of Classic

Accounting Research with Updated Evidence (Nichols & Wahlen, 2004)
Introduction and motivation
RQ = How do earnings numbers relate to stock returns?
Bottom-line measures for firm performance: accounting → earnings & capital market →
stock returns. This paper summarizes the theory and evidence on how accounting earnings
information relates to stock returns. In addition, they present new empirical evidence on
the relation between earnings and returns by replicating and extending three studies:
1. the association between earnings and returns
2. the effects of earnings persistence on the earnings-returns association
3. the quickness and completeness of the market’s reaction to earnings news
Theory
The three links/assumptions relating earnings to stock returns:
1. Current earnings numbers provide information that equity shareholders can use to form
expectations for future earnings
Earnings persistence refers to the likelihood that a firm’s earnings level will recur in
future periods (= essential element of link 1). In the case of transitory earnings, the
persistence is low or even zero (e.g. one-time gain/loss). Persistent earnings
contribute much more to share value than do transitory earnings.
2. Current and expected future profitability provides shareholders with information about
the firm’s expected future dividend-paying capacity (created wealth will ultimately be
distributed to shareholders through dividends)
3. Share price reflects the present value of all expected future dividends
These links imply that new accounting earnings information that triggers a change in
investors’ expectations about future dividends should correspond with a change in the
market value of the firm.
Methodology and results


Test 1: Earnings-returns association

Methodology (similar to Ball & Brown (1968)):
- Distinguish good news (GN) and bad news (BN) samples based on change in earnings.
- Cumulative abnormal returns (CAR) for months (-11:+6) for the two samples
- Abnormal return = firm’s return – return CRSP size-decile portfolio return
- Average CAR relative to earnings announcement (t0) and plot results
They performed the same test for changes in cash flows instead of earnings.
Results:
- Similar findings as Ball & Brown (1968)
Firms with positive earnings changes experience positive abnormal returns, and vice
versa.
- Extension of Ball & Brown (1968)
Sign and magnitude of earnings news explain differences in abnormal returns →
stronger results (i.e. higher/lower returns) for most extreme changes in earnings.
Moreover, there are stronger results for earnings than for cash flows: accruals matter. The
results suggests that the abnormal returns that can be earned by investing on the basis of
accurate forecasts of future earnings changes are potentially large → explains why
investors and analysts devote so much time and energy to forecasting earnings.
Test 2: The effects of earnings persistence on the earnings-returns association

Methodology:
1. Sort sample firms each year into two portfolios: firms with earnings increases and
earnings decreases.
2. Sort these two partitions each year into 10 deciles based on the magnitude of earnings
changes scaled by lagged total assets
3. Sort each earnings change decile portfolio into 10 deciles based on firm-specific earnings
persistence parameters (by getting the coefficients from autoregressions).
This triple-sort procedure controls for the magnitude of the change in earnings.
Results:
- Earnings increase sample
Significant difference in returns between high vs. low earnings persistence firms
(25.3% vs. 13.6%).
- Earnings decrease sample
Insignificant difference in returns between high vs. low earnings persistence firms.
This is because firms with earnings decreases tend to have low persistence (e.g.
firms that suffer earnings decreases likely change strategies and improve operations).
Other explanations = earnings quality (higher quality → stronger earnings-stock
association & risk → higher risk, lower earnings-stock association).
Test 3.1
Tests 1 and 2 show that earnings and returns are associated → but do earnings contain new
and value-relevant information?
Methodology:

- Idea → examine stock price reactions during days surrounding EA (-4 to +5 days)
- Use quarterly earnings announcements
- Unexpected earnings = EPS – analyst’s forecasted EPS
- Sort firms by quartile into 10 earnings news deciles
Results:
- The market reacts swiftly and significantly to quarterly earnings surprises
- By the end of day +1 that information has had a chance to appear in financial press
- Between day -4 and end of day +1, cumulative abnormal returns (CAR) amount to:
* 3.1% for the highest decile of surprises
* -2.6% for the lowest decile of surprises
The results suggests that earnings contain new information.
Test 3.2
Tests 1 and 2 show that earnings and returns are associated → but how efficiently does the
market react to earnings news?
Methodology:
- Extend event window → days (-60:+60)
- Does the market anticipate news?
- Does the market respond rapidly and completely to news?
Results:
- Prices lead earnings
* Market anticipates the information in quarterly EAs → beginning 60 days prior to
the announcement and continuing through the day of the EA, abnormal returns
move significantly with the sign and magnitude of quarterly unexpected earnings.
* Still, there is substantial change in the 5 days before the EA
- Prices lag earnings
* Post-earnings announcement drift →beginning on day +1 and continuing through
day +60 after the announcement, abnormal returns continue to drift significantly
with the sign and magnitude of the prior quarter unexpected earnings. This implies
that the market reaction to earnings information is not complete → share prices still
react with some delay to (especially extreme) quarterly unexpected earnings.
Conclusion
Three major points:
- Stock returns are significantly related to the sign of annual earnings changes.
Extensions by Nichols & Wahlen (2004):
* Magnitudes of earnings changes are also related to stock returns
* Changes in cash flows → significant but weaker relation with stock returns
- Earnings persistence helps explain variation in earnings-returns association.
* Returns associated with earnings increases are significantly greater for high
persistence firms than for low persistence firms
* Returns associated with earnings decreases do not differ across high and low
persistence firms

- Share prices react rapidly to new information in quarterly earnings.

* Prices lead earnings → the market anticipates much of the information in earnings
in the weeks before earnings announcements
* Prices lag earnings → when earnings surprises are extreme, market reactions tend
to be incomplete as the earnings news relates to abnormal returns after the EA
The strong association between earnings and returns explains why investors/managers/
analysts place so much weight on accounting earnings. Moreover, understanding what
makes earnings information useful to investors can help accountants prepare more useful
financial statements.
Session 2
General information
Ways to assess both the effect of the sign of unexpected earnings as the magnitude:
- Earnings response coefficient (ERC) → ERC measures the extent of a security’s abnormal
market return in response to the unexpected component of that firm’s reported earnings
(causality). Do markets react to new information in earnings?
Question: “Do earnings convey information?” Do earnings (+ BVE) capture information that is contained in stock prices?
- Value relevance (VR) models → Does accounting provide an accurate summary measure of
a firm’s value/performance? Regressions are typically in the form of a price model or return
model. Use the adjusted R2 to assess the VR of the accounting model.
Question: “Do earnings contain information?”
- Link accounting information with stock prices
- The use of the P/B and P/E ratio for valuation imply that stock price is a function of
book equity (B) and earnings (E)
Accounting earnings and cash flows as measures of firm performance: The

role of accounting accruals (Dechow, 1994)
RQ = (When) do accruals improve earnings’ ability to measure firm performance?
Accruals → earnings – cash flows.
The accrual process is expected to:

- mitigate timing and matching problems inherent in cash flows (revenue recognition and
matching principle)
- help earnings to more closely reflect firm performance
Therefore, the view in this paper is that accruals improve the ability of earnings to measure
firm performance.
However, the alternative view is that management typically has some discretion over
accruals which could be used by management to misrepresent performance. Following this
view, earnings will become a less reliable measure of firm performance and cash flows could
be preferable (managers have less discretion over cash flows).
Hypotheses

Main view → accruals reduce timing and matching problems. When is this effect more/less
pronounced?
- H1 & H2 → the role of short vs. long measurement (reporting) intervals.
Timing/matching problems should be more severe for short reporting windows (one
quarter/year), because over entire life of a firm: CF = EARN. Over longer intervals,
cash flows will suffer from fewer timing/matching problems and so the importance of
accruals diminishes. This implies that:
* H1: There is a stronger association between stock returns and earnings than
between stock returns and realized cash flows over short measurement intervals (=
one quarter/year).
* H2: The association of stock returns with realized cash flows improves relative to
the association of stock returns with earnings as the measurement interval increases.
- H3 & H4 → the role of accrual process varies with type of firm, i.e., high vs. low
magnitude of accruals and high vs. low operating cycle.
Example: Cash Flowt = (1 – α )Salest + α Salest-1 with α = proportion of sales on credit.
- For steady-state firms (i.e. no growth): St = St-1 (→ Ct = St; accruals are unimportant)
- For rapidly changing firms: St ≠ St-1 (→ Ct ≠ St; accruals are important)
The difference between sales and cash (Ct ≠ St), and hence the importance of
accruals, will be greater for firms that i) expand more in terms of sales, or ii) sell
more on credit. This implies that:
* H3: The larger the absolute magnitude of aggregate accruals made by a firm, the
lower the association between stock returns and realized cash flows relative to the
association between stock returns and earnings.
* H4: The longer a firm’s operating cycle (= average time elapsing between the
disbursement of cash to produce a product and the receipt of cash from the sale of
the product), the more variable the firm’s working capital requirements and the
lower the association between stock returns and realized cash flows.
Also some tests on accrual components → some accrual components are less important for
mitigating timing and matching problems in cash flows and hence for improving earnings’
ability to better reflect true performance. In this paper, they focus on short-term vs. long-
term accruals and special items.
Methodology and data

Benchmark = stock price performance (= returns) is used as benchmark.
- Assumption → markets are efficient; stock prices unbiasedly reflect all publicly available
information that are relevant for the price.
- “Horse-race” approach → compare whether earnings or cash flows are more strongly
associated with stock returns
- Value relevance model → return = a + b(X)+e
* X = earnings or cash flow measure (scaled by price)
Results
H1
For each measurement interval (quarterly/annually/4-year), the earnings are a better
predictor of returns than cash flows (significantly higher R2).
H2

As the window is extended from quarter to year to 4-years, the explanatory power of cash
flows increases relative to earnings. This is tested by the following ratios: R2CFO/R2EAR and
R2NCF/R2EAR. These ratios increase as the measurement interval is lengthened.
H3
Hypothesis 3 is tested by determining whether the ability of net cash flows to reflect firm
performance declines as the absolute value of aggregate accruals (abs(AA)) increases:
1. All firm-period observations are ranked on the basis of the abs(AA)
2. Quintiles are formed (quantile 1 = small abs(AA), quantile 5 = large abs(AA)).
3. Separate regressions of stock returns on earnings and stock returns on net cash flows are
performed for each quintile.
The cash flow’s relative predictive ability vis-à-vis earnings declines with an increase in
magnitude of accruals:
- Quintile 1 (lowest magnitude of accruals) → earnings and cash flows have a similar
association with stock returns.
- Quintile 5 (highest magnitude of accruals) → cash flows have a much lower association
with stock returns compared to earnings (large accruals indicate more timing and matching
problems with net cash flows).
Thus, earnings, compared to cash flows, explain more of the variation in stock returns as
accruals increase in magnitude. The results also show that cash flows are not a poor
measure of firm performance per se → in steady-state firms, where the magnitude of
accruals is small, the R2 of cash flows and earnings are almost similar.
H4
There is a negative correlation between the length of the operating/trade cycle and the R2
from the return-CF regression. This suggests that accruals play a relatively more important
role in firms with long operating cycles; earnings better reflects firm performance than cash
from operations for firms in industries with long operating cycles.
Short term vs. long-term accruals

As short term operating accruals increase, CF’s explanatory power decreases. This is not
the case with long-term accruals.
Special items
Explanatory power of earnings increases when excluding special items from earnings
number → special items, such as one-time (transitory) components, reduce the ability of
earnings to measure firm performance.
Conclusion and implications

Collectively, the findings suggest there is a role for accruals in producing a more useful and
meaningful performance measure.
This role is more important:

- Over short intervals
- When matching/timing problems are more severe (higher absolute accruals and longer
operating cycles)

- Yet, not all accruals play an equally important role in mitigating these problems (= long-
term accruals and special items)
Bottom line → accruals “work”, despite the potential for (or claimed presence of) earnings
manipulation.
It also shows that the predictive ability of CF vs. earnings varies with many factors.
Moreover, earnings informativeness can be lower due to other reasons than managers’
intent to mislead → economic/reporting factors play a role.
Session 3
General information
Earnings management (EM) → choice by a manager of accounting policies or real actions,
affecting earnings so as to achieve some specific reported earnings objective.
Good vs. bad discretion:

- Good → discretion in financial reporting to convey managers’ (private) information on
their firms’ performance.
- Bad → opportunism; managers choose reporting methods and estimates that do not
accurately reflect the firms’ underlying economics.
Therefore, EM is not necessarily bad → cost-benefit trade-off of having discretion in
financial reporting.
EM patterns/accounting policies:
1. Big bath accounting → report large losses now to enhance the probability of future
reported profits
2. Income minimization→ less extreme than above, but involves taking losses to lower
earnings (e.g. tax reasons)
3. Income maximization → increase reported earnings for bonuses/contracting reasons
4. Income smoothing → lower variability of earnings over time
Three ways to detect EM:

1. Accounting analysis
* Asset distortions → e.g. overstatement or understatement of assets and earnings
through depreciation, impairment, intangible assets, timing of revenue recognition.
* Liability distortions → e.g. unearned revenue, provisions, pension obligations.
* Equity distortions → e.g. reclassifications of financial instruments, hybrid financial
instruments.
2. Distribution of earnings
Idea → EM if there is a discontinuity in the distribution of earnings (i.e. higher
(lower) than expected frequency of firms with slightly positive (negative) earnings).
However, this idea is disputed in later literature (not recommended).
3. Use of accrual models
* Single accrual models
* Total accrual models (= focus)
* Models to detect real transaction-based EM

A review of the earnings management literature and its implications for

standard setting (Healy & Wahlen, 1999)
If EM is just a matter of managers choosing different accounting policies, why does it
matter?
- Accounting policies are typically disclosed
- Assumption that market is efficient and rational on average
This might not be as trivial → earnings are an input to a variety of decisions (e.g.
investment decisions, regulatory consequences). Therefore, it is costly/difficult to undo all
the effects of accounting policy choices.
This paper is written to provide an overview of academic research that can help standard
setters evaluate the prevalence of and methods used for EM.
The paper focuses on:

1. Why do managers engage in EM?
a) Capital market incentives
b) Contracting incentives
c) Regulatory incentives
2. How often do we see EM and how large is EM? (= unclear)
3. How (i.e. through which accruals) are earnings managed?
4. Does EM have any “real” effects for resource allocation in the economy?
Definition of EM
Definition of EM (negative) = EM occurs when managers use judgement in financial
reporting and in structuring transactions to alter financial reports to either mislead some
stakeholders about the underlying economic performance of the company or to influence
contractual outcomes that depend on reported accounting numbers.
Motives for EM
Capital market incentives
Intuition → use EM in an attempt to influence short-term stock price performance.
Two main research ideas:

- Capital market transactions that create incentives for EM
* Mixed evidence for income-decreasing EM prior to management buyout (MBO)
(i.e. when the management team acquires all/part of the business they manage)
* Some evidence for income-increasing EM prior to stock-based M&A → will make
own shares more valuable; better exchange ratio to acquire the target company
* Some evidence for income-increasing EM prior to IPO
- Capital market expectations that create incentives for EM
* Some evidence for EM to avoid small losses
* Some evidence for EM to meet/beat analysts’ forecasts
Contracting incentives
Accounting information (earnings) is used in many contracts. Examples:
- Compensation contracts → to align incentives of management and stakeholders
10

* Evidence that firms with caps on bonus awards are more likely to report accruals
that defer income when that cap is reached compared to similar firms without
bonus caps
* Subsequent research examines the relation between compensation contracts and
EM with mixed evidence
There is still disagreement on this subject.
- Debt contracts → to limit management’s actions that benefit the firm’s stockholders at
the expense of its creditors (e.g. dividends)
* Little evidence that firms close to a dividend constraint in debt covenants engage
in EM
* Evidence that firms that actually violated debt covenant inflated earnings in year
prior to violation
- Supplier contracts → include balance sheet ratios in the contract so that the supplier stays
financially healthy in order to serve the contractual needs of the customer
Contractual incentives are not so much, for example, about fooling the debt holder, it’s
rather about avoiding violating certain restrictions in the contracts.
Regulatory incentives
EM literature focuses on two forms of regulation:
- Industry-specific regulation
* Some industries face regulatory monitoring that is tied to accounting data (e.g.
bank has to satisfy certain capital requirements based on accounting numbers).
* Strong evidence that banks that are close to minimum capital requirements
manipulate accruals (e.g. by understating loan write-offs)
- Anti-trust regulation
* Firms vulnerable to anti-trust investigation or other adverse political consequences
use EM to appear less profitable. Managers of firms seeking government subsidy or
protection may have similar incentives.
* Strong evidence that firms manage earnings downwards to gain import relief or to
avoid (de)regulation
Magnitude and frequency of EM

In general, there is limited evidence on the magnitude and frequency of EM.
In SEO/IPO/M&A settings:
* Magnitude of unexpected accruals rather high → between 2% and 5% per total assets (=
represents between 25% and 50% of typical asset returns; seems too high to be plausible)
* Incidence of EM in IPO setting presumably low → roughly 12% of the issuing forms seem
to manage earnings
* Generalizability of these findings is limited due to specific setting/sample selection
Accruals used to manage earnings

Literature:
- Most studies focus on aggregate (discretionary) accruals
- Some studies look at specific accruals (e.g. depreciation estimates, bad debt provisions) →
less measurement error but there are complementary/substituting effects between accruals
11

- More recently:
* “real” earnings management
* classification shifting (e.g. shift expenses from core expenses to special items)
Real effects for resource allocation in the economy

Much of the evidence (prior 1999) shows that financial statements provide useful
information to investors:
- Value relevance studies → (i) investors find earnings value-relevant, (ii) current earnings
are better predictors of future cash flow performance than current cash flows, and (iii)
different market reaction to nondiscretionary and discretionary accruals
- Indirect implication → investors might not be “fooled” by EM
Yet, evidence also suggest that investors might not see through the effects of EM:
- Evidence of underperformance after equity offerings (EO) for firms that manage earnings
→ evidence that the market is now learning about earnings inflation prior to the issue
- Negative market reactions to revelation of EM (e.g. restatements or SEC investigation
announcements) → market isn’t able to detect EM
- Direct implication → EM affects resource allocation at least for some firms
There is also little evidence that EM for contracting reasons has any effect on stock prices or
resource allocation.
Earnings Management During Import Relief Investigations (Jones, 1991)

RQ = Do managers manage earnings to obtain import relief?
Intuition:
- Import relief (e.g. tariff increases and quota reductions) by the US International Trade
Commission (ITC) is more likely if a US firm is performing poorly
* Import relief is, for example, based on profitability of the industry
* Increase in import protection results in wealth transfer from domestic consumers
and foreign suppliers to domestic producers of the protected good
Therefore, firms have incentives to manage earnings downwards during the import relief
investigation by ITC.
Sample and hypothesis

The sample only contains 23 firms from five industries.
H1: Managers of domestic producers that would benefit from import protection make
accounting choices that reduce reported earnings during ITC investigation periods as
compared to non-investigation periods.
Methodology
Discretionary accruals are used as a measure of managers’ earnings manipulations during
import relief investigations; the most well-known legacy of the paper is the so-called Jones
model. This was a refinement of DeAngelo (NDAt = TAt-1). Idea:
- Earnings = CF + accruals
12

- Accruals can be driven by economic activity (e.g. credit sales, depreciation), or can be
managed by discretion
- Jones tries to capture this discretionary part of accruals:
* Estimate a regression on economic events that drive (normal or non-
discretionary) accruals
Three basic steps:

1. Calculate total accruals (TA)
- Total accruals = earnings – CF
- The relation between total accruals and its economic drivers is estimated before the
event period using the following regression model:
TAt-j = α1 + α2 * ΔREVt-j + α3 * PPEt-j + et-j
Determinants in the model measure economic activities that drive WC and LT
accruals.
2. Estimate the non-discretionary (i.e. normal) component of total accruals (= NDA)
- The coefficient estimates of step 1 are used with measures of activity during event
period (ΔREVt and PPEt) to estimate non-discretionary accruals during event period:
NDAt = α1 + α2 * ΔREVt + α3 * PPEt
3. Calculate the discretionary component of total accruals (DA) as: DAt = TAt – NDAt
Results
Income decreasing EM (i.e. negative discretionary accruals) in the year of the import relief
investigations by ITC (year = 0). The results are insignificant in year -1 and +1.
Problems with accrual models

Three key accrual model specification problems:
1. Type I errors (false positives)
- H0 is falsely rejected (i.e. accrual model suggests there is EM when it isn’t present)
- Why? Proxy for DA contains measurement errors or when there are omitted
variables in the accrual model (underfitted Jones model understates NDA)
2. Type II errors (false negatives)
- H0 is not rejected when it is false (i.e. accrual model does not detect EM when it is
present)
- Why? When accrual model used to generate DA unintentionally removes some or
all of the discretionary accruals (overfitted Jones model overstates NDA)
3. Low power test
- Only EM of large magnitudes are detected (increases probability of type II errors)
- Why? Measurement approach prone to noise
Attempted solution
Dechow, Sloan, and Sweeney (1995):
- Suggest a modified version of the Jones model (i.e. adjusted step 2):
NDAt = α1(1/At-1) + α2 * (ΔREVt – ΔRECt) + α3 * PPEt with REC = receivables
- Intuition → if revenues are manipulated (via receivables) in the event period, applying the
Jones model will overestimate NDA and underestimate DA (and increases probability of
type II errors)
13

Kothari, Leone, and Wasley (2005):

- Suggest performance-adjusted version of Jones model:
NDAt = α1(1/At-1) + α2 * (ΔREVt – ΔRECt) + α3 * PPEt + α4 * ROAt-1
- Intuition → since performance has a large effect on accruals, applying the Jones model will
underestimate NDA and overestimate DA (and increases probability of type I errors)
Conclusion
Many accruals models aimed at detecting EM → main issue = accruals models lack power in
detecting earnings management:
- Hard to determine unmanaged earnings
- Type I and II errors
- EM has to be economically large (e.g. >5% of total assets) to be accurately picked up by
these models
Session 4
General information
Conservatism = the tendency to require a higher degree of verification to recognize good
news as gains than to recognize bad news as losses (= asymmetric verifiability). The
consequence is the persistent understatement of net asset values (e.g. expensing of
intangibles → overstatement of earnings in future periods by causing an understatement of
future expenses).
Two types of conservatism:

- Unconditional conservatism (i.e. news independent conservatism)
Predetermined application of conservative accounting policies (decided beforehand).
Examples = immediate expensing of internally developed intangibles & accelerated
depreciation.
- Conditional conservatism (i.e. news dependent conservatism)
Book values are written down under adverse circumstances but not written up
under favourable circumstances.
Examples = lower of cost or market accounting for inventory & impairment
accounting for long-lived (in)tangible assets.
Conservatism in accounting part I & II (Watts, 2003a & 2003b)

Explanations of conservatism
There are several explanations:
1. Contracting explanation → conservatism helps address moral hazard problems and is an
efficient contracting mechanism.
2. Shareholder litigation → overstatement of a firm’s net assets is more likely to generate
litigation costs compared to understatement.
3. Taxation →defer tax payments by being conservative.
4. Standard setters preference for conservatism → asymmetry in regulators’ costs; more
criticism for overstatement, higher political costs.
Contracting explanation
General idea → stakeholders have asymmetric information, asymmetric pay-offs, limited
horizons and limited liability. Contracts based on accounting measures can mitigate these
14

issues, but only if these measures are timely and verifiable. Conservatism helps achieve
those purposes. Therefore, it is an efficient contracting mechanism (reduces agency costs)
→ it is optimal to have more stringent verification requirements for gains than losses.
Example = debt contracts:

- The primary concern of a bank that has lent money to a firm is that the money is paid back.
- Alleviate the concern by:
* Preventing the company from paying out cash flows to other parties
* Having information about the firm’s financial health and being able to step in if
things are declining
- Solution → debt covenants:
* Prevent company from paying out dividends under certain conditions
* Maintain minimum verifiable capital/earnings requirements
- Conservatism makes accounting more informative to a bank, because it provides timely
information about when things go south → bank’s demand for information is tied to an
asymmetric payoff; higher need for information about when things go bad.
Other examples:
- Compensation contracts → conservatism reduces the likelihood managers will overstate
earnings and net assets to gain higher performance-based compensation.
- Corporate governance → conservatism provides timely signals for investigating the
existence of negative net present value projects; protects the shareholders' option to
exercise their property rights.
Shareholder litigation
Litigation encourages conservatism because litigation is much more likely when earnings
and net assets are overstated, not understated. Since the expected litigation costs of
overstatement are higher than those of understatement, management and auditors have
incentives to be conservative.
Taxation
Firms are trying to minimize their taxes and therefore there might be the incentive to take
more expenses (= conservative) to minimize the taxable income.
Regulation
There is an asymmetry in regulators’ costs; there is more criticism for overstatements,
which leads to higher political costs compared to understatements. Therefore, regulators
could have incentives to encourage conservative accounting.
Contracting explanation and the information perspective

Conservatism benefits equity investors too:
- Conservatism provides a timelier signal when things go bad, so on average, it actually
increases the value of the firm.
- More verifiable earnings numbers make unverifiable forecasts of earnings more reliable.
- Critics claim conservatism leads to an upward bias in future earnings. But this claim isn’t
complete → future years' earnings are higher because gains are deferred until there is
verifiable evidence that they exist and will be realized.
15

Regulatory implications
Empirical evidence shows that conservatism exists for good reasons. FASB has been pushing
for neutral accounting, straying away from conservatism. According to Watts, this is a
dangerous step because it forgets the importance of the verification necessary to prevent
management from introducing biases in accounting numbers.
Empirical measurement
Measuring conservatism:
- Net asset measures → persistent understatement of asset values
* Valuation models
* Book-to-market measures (i.e. book value of assets < market value of assets)
- Earnings and accrual measures → conservatism’s asymmetrical treatment of gains and
losses produces an asymmetry in accruals
* Basu: reversal of negative vs. positive earnings changes (conservatism: bad news
reverses more quickly compared to good news → effect (b1) should be stronger (i.e.
more negative) for negative earnings changes)
∆ Eit ∆ Eit−1 ∆ Eit−1
= α0 + α1 * D + b 0 * + b1 * D *
P it−1 Pit−2 Pit−2
With ∆ E = change in earnings
P = stock price
D = 1 if ∆ E < 0.
* Sign/magnitude of accumulated accruals (conservatism: accruals tend to be
negative and cumulated accruals to be understated)
- Earnings-stock returns relation measures → since conservatism predicts that accounting
losses are recorded on a timely basis but gains are not, accounting losses are predicted to
be more contemporaneous with stock returns than are accounting gains:
Earnings = α0 + α1 * News + α2 * Dummy_News + α3 * News * Dummy_News
With News = stock market returns
Dummy_News = 1 if returns < 0 (bad news)
α3 captures the differential response of earnings to good news vs. bad news →
conservatism implies α3 > 0 (stronger relation between bad news and earnings)
Issues with empirical literature

Debate in the literature on validity of Basu measure:
- Value relevance regressions: returns = f(earnings) ↔ conservatism: earnings = f(returns)
- Some claim the Basu measure isn’t valid and that many other variables affect its estimation
- However, some show that the Basu regression is econometrically valid. That’s why most
papers will use multiple measures of the same construct (validity check)
Non-conservatism explanations that could account for the evidence:

- Abandonment option
Like conservatism, the exercise of the abandonment option produces losses that are
less persistent than profits.
Argument against → the abandonment option alone cannot explain the systematic
understatement of net assets; with neutral reporting, this shouldn’t persist.
- Earnings management
16

EM can also generate understatement of net assets (e.g. big bath charges, creative
acquisition accounting).
Argument against → both in efficient and inefficient markets, shareholders’
responses to income-decreasing accounting choices aren’t in line with an
opportunistic EM view. Compensation contracts are more likely to incentivize
income-increasing, not decreasing, accounting choices.
Conclusions
The overall conclusion is that conservatism is essential and exists for good reason. Watts
also cautions against FASB’s move away from conservatism and advocating of including
accounting valuations based on managerial estimates.
Session 5
Information asymmetry, corporate disclosure, and the capital markets: A
review of the empirical disclosure literature (Healy & Palepu, 2001)
Managers’ reporting decisions
Six forces that affect managers’ voluntary disclosure decisions:
1. Capital markets transactions hypothesis
Theory = investors’ perceptions of a firm are important to managers expecting to
issue public debt/equity or to acquire another company in a stock transaction.
Incentives = reduce information asymmetry →lower the firm’s cost of external
financing.
2. Corporate control contest hypothesis
Theory = boards of directors and investors hold managers accountable for current
stock performance. Poor stock/earnings price performance is associated with the
probability of hostile takeovers.
Incentives = reduce undervaluation/explain poor stock performance to avoid job loss.
3. Stock compensation hypothesis
Theory = managers are directly rewarded using a variety of stock-based
compensation plans (e.g. stock option grants). Therefore, firms that use stock
compensation extensively are likely to provide additional disclosure to reduce the
risk of misvaluation, since managers are paid based on the value of stock.
Incentives = disclose private information to meet restrictions imposed by insider
trading rules and to increase liquidity of the firm’s stock & to reduce contracting
costs associated with stock compensation for new employees.
4. Litigation cost hypothesis
The threat of shareholder litigation can have two effects:
* Legal actions against managers for inadequate or untimely disclosures can
encourage firms to increase voluntary disclosure.
* Litigation can reduce managers’ incentives to provide disclosure, particularly of
forward-looking information.
5. Management talent signalling hypothesis
Talented managers have an incentive to make voluntary earnings forecasts to reveal
their type.
6. Proprietary cost hypothesis
17

Firms’ decisions to disclose information to investors is influenced by the concern

that such disclosures can damage their competitive position in markets (but they
can also use disclosures to scare off the competitors).
Credibility of voluntary disclosure

Because managers have incentives to make self-serving voluntary disclosures, it is unclear
whether management disclosures are credible. This affects whether disclosures have an
effect on resource allocation. There are two mechanisms to increase the credibility:
- Assurance by third-party intermediaries about the quality of management’s disclosures.
- Validation of prior voluntary disclosures through required financial reporting itself (e.g.
managers’ forecasts of revenues and earnings can be verified using actual realizations).
Limitations of studies on voluntary disclosure

One of the major limitations of the above studies is the difficulty in measuring the extent of
voluntary disclosure. Researchers use several proxies for this variable (e.g. management
forecasts). Problems:
- Noise in different proxies (e.g. disclosure quantity = quality?)
- Endogeneity
For example, it could seem like there is an association between high disclosure
quality and specific capital market consequences. However, you don’t know why
firms disclose (e.g. firms may increase disclosure when they are performing well). As
a result the association between capital market variables and disclosure may be
driven by other variables (e.g. firm performance) rather than disclosure.
Capital market consequences

Consequences of voluntary disclosure:
- Improved stock liquidity
Voluntary disclosure reduces information asymmetries among informed and
uninformed investors. As a result, for firms with high levels of disclosure, investors
can be relatively confident that stock transactions occur at a ‘‘fair price’’, increasing
liquidity in the firm’s stock.
- Reduced cost of capital
Lemons problem → information asymmetry leads to inefficient markets. Sellers of
“good” products are disincentivized to sell their product, leading to only low-quality
products being offered. The lemons problem in capital markets creates an incentive
for managers to provide voluntary disclosure to reduce the cost of capital.
- Increased following by financial analysts
If management’s private information is not fully revealed through required
disclosures, voluntary disclosure lowers the cost of information acquisition for
analysts and hence increases their supply. The effect is ambiguous:
* More disclosure enables financial analysts to make superior forecasts and buy/sell
recommendations, thereby increasing demand for their services
* However, if these disclosures are publicly available, it pre-empts analysts’ ability
to distribute managers’ private information to investors, leading to a decline in
demand for their services
18

The Evolving
Disclosure
Landscape:
How Changes
in Technology,
the
Media, and
Capital
Markets Are
19

Affecting
Disclosure
The Evolving
Disclosure
Landscape:
How Changes
in Technology,
the
20

Media, and
Capital
Markets Are
Affecting
Disclosure
The Evolving
Disclosure
Landscape:
21

How Changes
in Technology,
the
Media, and
Capital
Markets Are
Affecting
Disclosure
The Evolving Disclosure Landscape: How Changes in Technology, the
Media, and Capital Markets Are Affecting Disclosure (Miller & Skinner,
2015)
Introduction
There are many new developments that affect disclosure (e.g. increasing access to internet,
big data, social media). This paper discusses several papers that deal with these topics.
Fundamentally, disclosure research is about:
22

1. The why/what/how of voluntary disclosure?

2. How is information disseminated?
3. Are there strategic considerations behind disclosure?
Intersection of new technology and economic reasoning → new research ideas.
Conference call research

Early research focused on causes and consequences of conference calls (they were a form
of voluntary disclosure):
- Why restrict access to conference calls?
- What affects the effectiveness of calls?
More recent research focuses on how managers use conference calls strategically to
manage perceptions (e.g. tone/speech and manage which question can be asked)
Mobility
There is an increased availability of mobile communication devices such as smart phones:
- Increasing access to information at all times
Enables users to acquire, communicate, and trade on information about firms, and so
has significant effects on firms’ information environments and trading activity.
- Potential research ideas:
* How does internet penetration affect information asymmetry?
* How does restricting access to mobility affect information gathering?
Powerful tests if laws/regulations are imposed exogenously.
Social media
In the case of social media, firms have lost a certain amount of control of their information
environments. The arrival of social media platforms means that many more actors can make
their views about the firm known and disseminate those views widely, potentially creating
adverse consequences for firms (especially if the actors are relatively uninformed).
Media
Role of the media:
- Media monitors management (i.e. watchdog role)
- Disseminating information to a wider audience
Political forces
Political forces/processes give incentives to manage a firm’s information environment (e.g.
Kido et al. (2012) → states manipulate their financial statements to seem healthier during
election years).
Session 6
General information
Positive accounting theory (PAT):
- Variety of costs makes accounting choices/policies matter (e.g. agency, information costs)
- Watts and Zimmerman → costs arise in market transactions, intra-firm transactions,
transactions in the political process.
* E.g. performance-based incentives in compensation contracts to motivate
managers (agency costs):
23

- Accounting choices → accounting numbers → compensation.

- Because accounting choices have wealth/real effects, compensation
contracts provide incentives to allow or restrict certain accounting choices.
Three commonly tested hypotheses of the PAT regarding accounting choices:

- Bonus plan hypothesis (often based on accounting variables)
* Compensation gives rise to restrict accounting choices or for manager to make
certain accounting choices
- Debt covenant hypothesis (often based on accounting variables)
* Make certain accounting choices to avoid debt covenant violation
- Political cost hypothesis
* Make income-decreasing accounting choices because high profits may create
political costs (unwanted scrutiny)
Many papers are about understanding the incentives behind accounting choices.
Why do we care about economic consequences?

- Understand (unintended) outcomes of accounting and accounting policies.
* A regulator’s standpoint → understand (unintended) consequences of accounting
regulation, lobbying behaviour etc.
* A auditor’s standpoint → understand what motivates your client to choose certain
accounting policies, make certain reporting choices and the associated implications.
Economic Consequences of Accounting Standards: The Lease Disclosure

Rule Change (Imhoff & Thomas, 1988)
RQ = Do managers adjust firm capital structure due to new accounting rules?
Rule change:
- Before → capital/finance leases were mostly disclosed in footnotes; no impact on balance
sheet/earnings.
- After → moving capital leases from the footnotes to the balance sheet; unamortized
value of leased asset booked as asset, PV future lease payments booked as debt.
The key difference between capital and operating leases is the extent to which risks and
rewards are transferred to the lessee (if most risk/rewards are transferred to the lessee →
capital lease).
Effect of capitalizing leases instead of footnote disclosure:

- Assets will likely increase, but also increases in debt and depreciation expenses.
- Increasing leverage ratios, lower income.
This matters because changes in accounting ratios may have contractual consequences (e.g.
debt covenant violations, performance-based compensation).
Potential responses of companies:

- Do nothing (e.g. take the pay cut, violate covenants)
- Renegotiate/rewrite earnings-based contracts.
- Mitigate the impact of capitalization by changing the capital structure (this paper):
24

* Substitute capital leases and reduce debt.

* Increase in other off-balance sheet financing or equity.
Results
Changes in capital leases
Only 45% of the “footnoted” capital leases were actually capitalized after the new
regulation. There has been a negative change in the PV of all future capital lease payments
(i.e. 55% decline in the capital leases amount).
Changes in operating leases

There has been a positive change in the amount of operating leases (i.e. 37% increase) after
the new regulation. These results indicate that much of the unexpected decline in capital
leases is offset by increases in operating leases, suggesting that many capital leases were
restructured during the transition period to qualify as operating leases.
IFRS 16: new lease regulation

IFRS 16 → capitalize both the finance and the operating leases.
How will this change financial statements?

- Income could increase because lease expenses disappear, but depreciation expenses
decrease income. Therefore, the net effect is unclear.
- EBITDA will likely increase. Debt will likely increase even more. Therefore, the income to
debt ratios are likely declining.
- Consequences for contracts (e.g., debt covenants).
- The increase in liability is unclear and is industry-dependent.
Economic consequences:
- More capitalization of leases could alter the propensity to lease vs. buy
- Other changes in capital structure
- How will it affect incentives to structure leases?
* Maybe less incentive to distinguish between capital and operating leases.
* But, on-balance sheet reporting is exempted for short leases and small leases.
* Prediction → companies will try to structure their leases to shorter lease terms
Lobbying
Lobbying → an attempt to influence accounting regulation.
Regulation:
- The public interest theory → government intervenes with regulation to correct market
failures. Goal = improve social welfare for public interest.
- The special interest theory → regulation impacts stakeholders, so stakeholders have
incentives to shape regulation to their own benefit.
Any stakeholder that is affected by regulation can lobby (e.g. firms, auditors, investment
groups, analysts). How do firms lobby?
- Direct (e.g. comment letters, public hearings, meetings/calls with standard setters)
25

- Indirect (e.g. media comments, trade organizations, auditors, government officials,

sponsoring research studies)
There is limited research on lobbying (because of the unobservable nature of lobbying,

small sample sizes and lack of data). Most research looks at who writes comment letters,
and whether the people who write comment letters behave in accordance with the
predictions of PAT (e.g. whether stakeholders who benefit/suffer more from certain
standards try to impact standard setting).
Conclusion
Financial reporting reflects (1) economic events and (2) the application of accounting
policies. Information/agency/contracting/political costs make accounting choices matter
(e.g. contracts or regulatory consequences based on financial accounting numbers/ratios).
Accounting does not merely reflect, but also affects financial reporting outcomes through:
1) Changes in behaviour that affect the underlying economic event
2) Preference for certain accounting policies (accounting choice/lobbying)
26

Powered by TCPDF (www.tcpdf.org)

Stuvia 1217723 Summary Seminar Financial Accounting Research Grade 85

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Stuvia 1217723 Summary Seminar Financial Accounting Research Grade 85

Uploaded by

Copyright:

Available Formats

Summary Seminar Financial

Accounting Research (grade: 8,5)

Gedownload door: hatimvandervaart | hatimbelahcen@hotmail.com

Four steps to detect market response:

Idea → assess the usefulness of existing accounting numbers by examining their

Assumptions are made that investors:

Step 1: Unexpected earnings (= independent variable)

Gedownload door: hatimvandervaart | hatimbelahcen@hotmail.com

- Get the expected income change this year → ∆ I^ jt =α^ 1 jt + α^ 2 jt ∆ M j ,t

Step 2: Abnormal stock returns (= dependent variable)

Step 3: Abnormal performance index (API)

Methodology summarized, for each firm:

Gedownload door: hatimvandervaart | hatimbelahcen@hotmail.com

Three key findings:

How Do Earnings Numbers Relate to Stock Returns? A Review of Classic

Methodology and results

Gedownload door: hatimvandervaart | hatimbelahcen@hotmail.com

Gedownload door: hatimvandervaart | hatimbelahcen@hotmail.com

Test 1: Earnings-returns association

Test 2: The effects of earnings persistence on the earnings-returns association

Gedownload door: hatimvandervaart | hatimbelahcen@hotmail.com

Gedownload door: hatimvandervaart | hatimbelahcen@hotmail.com

- Share prices react rapidly to new information in quarterly earnings.

Accounting earnings and cash flows as measures of firm performance: The

The accrual process is expected to:

Gedownload door: hatimvandervaart | hatimbelahcen@hotmail.com

Methodology and data

Gedownload door: hatimvandervaart | hatimbelahcen@hotmail.com

Short term vs. long-term accruals

Conclusion and implications

This role is more important:

Gedownload door: hatimvandervaart | hatimbelahcen@hotmail.com

Good vs. bad discretion:

Three ways to detect EM:

Gedownload door: hatimvandervaart | hatimbelahcen@hotmail.com

A review of the earnings management literature and its implications for

The paper focuses on:

Two main research ideas:

Gedownload door: hatimvandervaart | hatimbelahcen@hotmail.com

Magnitude and frequency of EM

Accruals used to manage earnings

Gedownload door: hatimvandervaart | hatimbelahcen@hotmail.com

Real effects for resource allocation in the economy

Earnings Management During Import Relief Investigations (Jones, 1991)

Sample and hypothesis

Gedownload door: hatimvandervaart | hatimbelahcen@hotmail.com

Three basic steps:

Problems with accrual models

Gedownload door: hatimvandervaart | hatimbelahcen@hotmail.com

Kothari, Leone, and Wasley (2005):

Two types of conservatism:

Conservatism in accounting part I & II (Watts, 2003a & 2003b)

Gedownload door: hatimvandervaart | hatimbelahcen@hotmail.com

Example = debt contracts:

Contracting explanation and the information perspective

Gedownload door: hatimvandervaart | hatimbelahcen@hotmail.com

Issues with empirical literature

Non-conservatism explanations that could account for the evidence:

Gedownload door: hatimvandervaart | hatimbelahcen@hotmail.com

Gedownload door: hatimvandervaart | hatimbelahcen@hotmail.com

Firms’ decisions to disclose information to investors is influenced by the concern

Credibility of voluntary disclosure

Limitations of studies on voluntary disclosure