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Abstract:
Standard formulas for valuing the equity of going concerns require prediction of payoffs "to infinity" but practical analysis requires that they be predicted over finite horizons. This truncation inevitably involves (often troublesome) "terminal value" calculations. This paper contrasts dividend discount techniques, discounted cash flow analysis, and techniques based on accrual earnings when applied to a finite-horizon valuation. Valuations based on average ex-post payoffs over various horizons, with and without terminal value calculations, are compared with (ex-ante) market prices to give an indication of the error introduced by each technique in truncating the horizon. Comparisons of these errors show that accrual earnings techniques dominate free cash flow and dividend discounting approaches. Further, the relevant accounting features of techniques that make them less than ideal for finite horizon analysis are discovered. Conditions where a given technique requires particularly long forecasting horizons are identified and the performance of the alternative techniques under those conditions is examined.

Abstract:
We examine whether stock prices fully reflect the value of firms' intangible assets, focusing on research and development (R&D). Since intangible assets are not reported on financial statements under current U.S. accounting standards and R&D spending is expensed, the valuation problem may be especially challenging. Nonetheless we find that historically the stock returns of firms doing R&D on average matches the returns on firms with no R&D. For companies engaged in R&D, high R&D intensity has a distinctive effect on returns for two groups of stocks. Within the set of growth stocks, R&D-intensive stocks tend to out-perform stocks with little or no R&D. Companies with high R&D relative to equity market value (who tend to have poor past returns) show strong signs of mis-pricing. In both cases the market apparently fails to give sufficient credit for firms' R&D investments. Our exploratory investigation of the effects of advertising on returns yields similar results. We also provide evidence that R&D intensity is positively associated with return volatility, everything else equal. Insofar as the association reflects investors' lack of information about firms' R&D activity, increased accounting disclosure may be beneficial.

Abstract:
We examine whether stock prices fully reflect the value of firms? intangible assets, focusing on research and development (R&D). Since intangible assets are not reported on financial statements under current U.S. accounting standards and R&D spending is expensed, the valuation problem may be especially challenging. Nonetheless we find that historically the stock returns of firms doing R&D on average matches the returns on firms with no R&D. For companies engaged in R&D, high R&D intensity has a distinctive effect on returns for two groups of stocks. Within the set of growth stocks, R&D-intensive stocks tend to out-perform stocks with little or no R&D. Companies with high R&D relative to equity market value (who tend to have poor past returns) show strong signs of mis-pricing. In both cases the market apparently fails to give sufficient credit for firms? R&D investments. Our exploratory investigation of the effects of advertising on returns yields similar results. We also provide evidence that R&D intensity is positively associated with return volatility, everything else equal. Insofar as the association reflects investors? lack of information about firms? R&D activity, increased accounting disclosure may be beneficial.

Abstract:
We evaluate the contribution of analysts' earnings forecasts to investors' decisions by comparing the association between annual excess returns and a broad set of information items derived from financial statements with the association between excess returns and that information set plus the present value of five-year ahead analysts' earnings forecasts. We thus bring to a sharp focus the incremental contribution (over financial statement information) of the major product of analysts - near and medium-term earnings forecasts - to investors' decisions as reflected by annual excess returns. Large differences in explanatory power between the regressions with and without analysts' forecasts are evidence in favor of analysts' contribution to investors' decisions.

However, in assessing analysts' contribution from associations with stock returns care should be taken to account for the inherent simultaneity - analysts not only contribute (possibly) to investors, they also observe stock price behavior and learn from investors' decisions. We are therefore using a system of simultaneous equations to control for the endogeneity of both excess returns and analysts' forecasts, allowing us to isolate the net contribution of analysts' forecasts to capital markets.

Our findings, based on cross-sectional regressions covering the period 1982-1997, indicate that over the sample period, analysts add a hefty 40 percent (in Adj-R2 terms) to the explanatory power of financial information with respect to stock returns. However, when simultaneity (i.e., analysts' learning from returns) is accounted for, their contribution is estimated as a modest 12 percent. This result suggests that analysts' mostly react to changes in market values rather than cause them.

Additional findings are: (1) The explanatory power of the broad-based financial statement information set decreased significantly over the examined period, while the explanatory power of the model including analysts' forecasts decreased at a lower rate. Analysts, therefore, mitigate to some extent the decrease in the informativeness of financial statements. (2) The incremental contribution of analysts in firms that report losses is substantially larger than in profitable companies. (3) The incremental contribution of financial analysts is largest in high-tech industries followed by low-tech industries, and regulated firms, suggesting that the contribution of analysts is larger in sectors where the informativeness of financial reports is low. (4) Analysts' contribution to valuation in firms with substantial research and development (R&D) capital is relatively larger than in firms without such R&D capital. (5) The incremental contribution of analysts during economic boom periods is higher than during recessions (e.g., the early 1990s). (6) Based on a firm-specific measure of analysts' incremental contribution, we find that this contribution decreases with firm size, systematic risk, and earnings persistence, and increases with the firm's R&D capital. All in all, we find the direct contribution of analysts' forecasts of earnings to investors' decision to be quite modest. However, this contribution is substantial in firms, sectors and circumstances where the informativeness of financial statements is relatively low.

Abstract:
We invert the residual income valuation model (using current stock prices, current book value of equity and short-term forecasts of accounting earnings) to obtain an estimate of the expected rate of return for a portfolio of stocks. Our approach is analogous to the estimation of the internal rate of return on a bond using market values and coupon payments.

Estimation of the cost of equity capital by inverting the residual income valuation model requires an estimate of growth in residual income beyond the forecast horizon. The contribution of our method is that we use the stock price and accounting data to simultaneously estimate the unique implied growth rate and the internal rate of return. This growth rate provides an adjustment for the fact that our estimate of the internal rate of return is based on current book value of equity and short-term earnings forecasts.

Our analysis of DJIA firms yields estimates of expected growth that are considerably higher than those assumed by earlier studies. Our estimated market premium over the risk-free rate is closer to the historical premium than that obtained by other studies using earnings forecast data.

After completing the pro-forma forecasting of earnings (as described in, Penman [2000], for example) and/or after obtaining analysts' forecasts of earnings for a number of firms with comparable operating activities, our method may be used to estimate the market's expectation of the cost of capital and growth for these firms. These estimates for comparable firms may be used to determine the intrinsic value of an unlisted firm, a division of a firm, or a firm that is believed to be relatively over/under-valued.

Rate of return, market premium, residual income model

Abstract:
We evaluate the extent to which unbiased and accurate estimates of equity value can be derived from three multi-period accounting-based valuation models using consensus analysts' earnings forecasts over a four-year horizon. The models are: (a) the earnings capitalization model, (b) the residual income model without a terminal value, and (c) the residual income model with a terminal value that assumes residual income will grow beyond the horizon at a constant rate determined from the expected residual income growth rate over the forecast horizon. Our analysis is based on valuation errors that are calculated by comparing estimated prices to actual prices.

We find that, on average, analysts' earnings forecasts convey information about value beyond that conveyed by current earnings, book values and dividends. Each of the models that we used has valuation errors that decline monotonically as the horizon increases, implying that earnings forecasts at each horizon convey new value relevant information. We cannot find a clear advantage to using firm specific growth rates instead of a constant rate of 4% across all sample firms. In addition, only 17% of the imputed growth rates could be used in terminal value calculations. The residual income model with a terminal value shows the best performance on average, but it values more accurately only 48% of our sample firms. The earnings capitalization model and the residual income model without a terminal calculation value more accurately 18% and 13% of the sample firms, respectively. The remaining 21% of firms are more accurately valued using only reported current earnings and book values of equity. Thus, different models are appropriate for different firms. The conditions under which given models work best relate to ex-ante growth indicators such as the current book-to-market, earnings-to-price, the present value of the expected residual income over the forecast horizon, the growth rate in expected earnings, and firm size, but not to industry membership. In all models estimated prices are, on average, downward biased and inaccurate and they explain at best 70% of the variation in market prices. We examined the quality of the earnings forecasts and the quality of the GAAP earnings as two possible reasons for the biased and inaccurate results. Our tests provide evidence consistent with both of these reasons. Thus, we conclude that the poor model performance is due to information missing from the forecasts and to the practice of conservative accounting.

Residual income; Equity valuation; Earnings forecasts; Conservatism

Abstract:
We evaluate the extent to which unbiased and accurate estimates of equity value can be derived from three multi-period accounting-based valuation models using consensus analysts' earnings forecasts over a four-year horizon. The models are: (a) the earnings capitalization model, (b) the residual income model without a terminal value, and (c) the residual income model with a terminal value that assumes residual income will grow beyond the horizon at a constant rate determined from the expected residual income growth rate over the forecast horizon. Our analysis is based on valuation errors that are calculated by comparing estimated prices to actual prices.

We find that, on average, analysts' earnings forecasts convey information about value beyond that conveyed by current earnings, book values and dividends. Each of the models that we used has valuation errors that decline monotonically as the horizon increases, implying that earnings forecasts at each horizon convey new value relevant information. We cannot find a clear advantage to using firm specific growth rates instead of a constant rate of 4% across all sample firms. In addition, only 17% of the imputed growth rates could be used in terminal value calculations. The residual income model with a terminal value shows the best performance on average, but it values more accurately only 48% of our sample firms. The earnings capitalization model and the residual income model without a terminal calculation value more accurately 18% and 13% of the sample firms, respectively. The remaining 21% of firms are more accurately valued using only reported current earnings and book values of equity. Thus, different models are appropriate for different firms. The conditions under which given models work best relate to ex-ante growth indicators such as the current book-to-market, earnings-to-price, the present value of the expected residual income over the forecast horizon, the growth rate in expected earnings, and firm size, but not to industry membership. In all models estimated prices are, on average, downward biased and inaccurate and they explain at best 70% of the variation in market prices. We examined the quality of the earnings forecasts and the quality of the GAAP earnings as two possible reasons for the biased and inaccurate results. Our tests provide evidence consistent with both of these reasons. Thus, we conclude that the poor model performance is due to information missing from the forecasts and to the practice of conservative accounting.

Residual income, Equity valuation, Earnings forecasts, Conservatism

Abstract:
Estimates and projections are embedded in most financial statement items. These estimates potentially improve the relevance of financial information by providing managers the means to convey to investors forward-looking, inside information (e.g., on future collections from customers via the bad debt provision, or on expected assets' cash flows reflected in impairment charges). On the other hand, the quality of financial information is compromised by: (i) the increasing difficulty of making reliable forecasts in a fast-changing, often turbulent economy, and (ii) the frequent managerial misuse of estimates to manipulate financial data. Given the prevalence of estimates in accounting data, whether these opposing forces result in an improvement in the quality of financial information or not is arguably the most fundamental issue in accounting.We examine in this study the contribution of accounting estimates embedded in accruals to the quality of financial information by focusing on the major use of this information by investors - the prediction of enterprise cash flows and earnings. Our extensive tests, reflecting both the statistical and economic significance of estimates, indicate that, by and large, accounting accruals and the estimates they embed do not improve the quality of financial information in terms of enhancing the prediction of enterprise performance. Accruals do not improve the prediction of cash flows, beyond that achieved by current cash flows, and improve only marginally the prediction of earnings. This latter improvement, however, appears to be economically insignificant. Thus, the objective difficulties of generating reliable estimates and projections in a volatile economy, and their frequent misuse by managers appear to offset the positive role of estimates in conveying forward looking information to investors.

Abstract:
Estimates and projections are embedded in most financial statement items. These estimates potentially improve the relevance of financial information by providing managers the means to convey to investors forward-looking, inside information (e.g., on future collections from customers via the bad debt provision). On the other hand, the quality of financial information is compromised by: (i) the increasing difficulty of making reliable forecasts in a fast-changing, often turbulent economy, and (ii) the frequent managerial misuse of estimates to manipulate financial data. Given the ever-increasing prevalence of estimates in accounting data, whether these opposing forces result in an improvement in the quality of financial information or not is among the most fundamental issues in accounting.

We examine in this study the contribution of accounting estimates embedded in accruals to the quality of financial information, as reflected by their usefulness in the prediction of enterprise cash flows and earnings. Our extensive out-of-sample tests, reflecting both the statistical and economic significance of estimates, indicate that accounting estimates beyond those in working capital items do not improve the prediction of cash flows. Estimates do, however, improve the prediction of next year's earnings, though not of subsequent years' earnings. Our economic significance tests corroborate that accounting estimates do not improve cash flow or earnings prediction. We conclude that the usefulness of accounting estimates to investors is limited, and provide suggestions for improving their usefulness.

Abstract:
In this study, we provide evidence on the pricing of other comprehensive income (OCI) that differs from most evidence in prior research. Prior archival research has largely concluded that OCI is not priced by investors. In contrast, we provide evidence in the post-SFAS 130 period that OCI is priced on a dollar-for-dollar basis as is predicted by economic theory for transitory income items. We attribute this finding to our use of post-SFAS 130 as-reported measures of OCI rather than pre-SFAS 130 as-if estimates of OCI measures. Furthermore, we document that two components of OCI, foreign currency translation adjustment and unrealized gains/losses on available-for-sale securities, are priced by investors. In the post-SFAS 130 period, we also find that the type of financial statement in which firms report OCI and its components affects pricing, consistent with the conclusions of prior experimental research. However, our evidence suggests that investors pay greater attention to OCI information reported in the statement of changes in equity, rather than in a statement of financial performance. This could be attributed to investors becoming more familiar in the post-SFAS 130 period with the predominant reporting of OCI and its components in the statement of changes in equity. These findings may be relevant to both the Financial Accounting Standards Board and the International Accounting Standards Board, which jointly are undertaking a new project that, in part, is addressing financial statement presentation of OCI items.

Comprehensive income, capital markets, SFAS 130, summary measures of performance

Abstract:
Earnings manipulation has become a widespread practice for US corporations. However, most studies in the literature focus on whether certain incentives would facilitate managers to manipulate earnings and there has been little evidence documenting the consequences of earnings manipulation. This paper fills this gap by examining how current accruals affect future earnings (the accrual effect) and measuring the size of this effect. We find that the aggregate future earnings will decrease by $0.046 and $0.096, respectively, in the next one and three years for a $1 increase of current accruals. Over the very long-term (25 years), 20% of current accruals will reverse. This negative accrual effect is more significant for firms with high price-earnings ratios, high market-to-book ratios and high accruals where earnings management is more likely to occur. We show that incorporating the accrual effect is useful in improving the accuracy of earnings forecasts for these firms. Accordingly, the empirical results are consistent with the notion that earnings management causes the negative relationship between current accruals and future earnings. In addition, this paper shows that one recently developed accrual model has better performance than the popularly cited model in identifying manipulated earnings.

Abstract:
Earnings manipulation has become a widespread practice for US corporations. However, most studies in the literature focus on whether certain incentives would facilitate managers to manipulate earnings and there has been little evidence documenting the consequences of earnings manipulation. This paper fills this gap by examining how current accruals affect future earnings (the accrual effect) and measuring the size of this effect. We find that the aggregate future earnings will decrease by $0.046 and $0.096, respectively, in the next one and three years for a $1 increase of current accruals. Over the very long-term (25 years), 20% of current accruals will reverse. This negative accrual effect is more significant for firms with high price-earnings ratios, high market-to-book ratios and high accruals where earnings management is more likely to occur. We show that incorporating the accrual effect is useful in improving the accuracy of earnings forecasts for these firms. Accordingly, the empirical results are consistent with the notion that earnings management causes the negative relationship between current accruals and future earnings. In addition, this paper shows that one recently developed accrual model has better performance than the popularly cited model in identifying manipulated earnings.

Abstract:
The immediate expensing of R&D expenditures is often justified by the conservatism principle. However, no accounting procedure consistently applied can be conservative throughout the firm' life. We ask the following questions: (a) When is the expensing of R&D conservative and when is it aggressive, relative to R&D capitalization? and (b) What are the capital market implications of these reporting biases? To address these questions we construct a model of profitability biases (differences between reported profitability under R&D expensing and capitalization) and show that the key drivers of the reporting biases are the differences between R&D growth and earnings growth (momentum), and between R&D growth and return on equity (ROE). Companies with a high R&D growth rate relative to their profitability (typically early cycle companies) report conservatively, while firms with a low R&D growth rate (mature companies) tend to report aggressively under current GAAP. Our empirical analysis, covering the period 1972-2003, generally supports the analytical predictions.In the valuation analysis we find evidence consistent with investor fixation on the reported profitability measures: we detect undervaluation of conservatively reporting firms and overvaluation of aggressively reporting firms. These misvaluations appear to be corrected when the reporting biases reverse from conservative to aggressive and vice versa.

Abstract:
The immediate expensing of R&D expenditures is often justified by the conservatism principle. However, no accounting procedure consistently applied can be conservative throughout the firm's life. We ask the following questions: (a) When is the expensing of R&D conservative and when is it aggressive, relative to R&D capitalization? and (b) What are the capital market implications of these reporting biases? To address these questions we construct a model of profitability biases (differences between reported profitability under R&D expensing and capitalization) and show that the key drivers of the reporting biases are the differences between R&D growth and earnings growth (momentum), and between R&D growth and return on equity (ROE). Companies with a high R&D growth rate relative to their profitability (typically early cycle companies) report conservatively, while firms with a low R&D growth rate (mature companies) tend to report aggressively under current GAAP. Our empirical analysis, covering the period 1972-2003, generally supports the analytical predictions.

In the valuation analysis we find evidence consistent with investor fixation on the reported profitability measures: we detect undervaluation of conservatively reporting firms and overvaluation of aggressively reporting firms. These misvaluations appear to be corrected when the reporting biases reverse from conservative to aggressive and vice versa. This evidence is consistent with behavioral finance arguments about investor cognitive biases.

R&D Accounting, Reporting Biases, Market Valuation, Mispricing

Abstract:
The immediate expensing of R&D expenditures is often justified by the conservatism principle. However, no accounting procedure consistently applied can be conservative throughout the firm' life. We ask the following questions: (a) When is the expensing of R&D conservative and when is it aggressive, relative to R&D capitalization? and (b) What are the capital market implications of these reporting biases? To address these questions we construct a model of profitability biases (differences between reported profitability under R&D expensing and capitalization) and show that the key drivers of the reporting biases are the differences between R&D growth and earnings growth (momentum), and between R&D growth and return on equity (ROE). Companies with a high R&D growth rate relative to their profitability (typically early cycle companies) report conservatively, while firms with a low R&D growth rate (mature companies) tend to report aggressively under current GAAP. Our empirical analysis, covering the period 1972-2003, generally supports the analytical predictions.

In the valuation analysis we find evidence consistent with investor fixation on the reported profitability measures: we detect undervaluation of conservatively reporting firms and overvaluation of aggressively reporting firms. These misvaluations appear to be corrected when the reporting biases reverse from conservative to aggressive and vice versa.

R&D Accounting, Reporting Biases, Market Valuation, Mispricing

Abstract:
Does bad news about one auditor's conduct affect the credibility of all auditors? We examine auditee abnormal stock returns around twenty-five bad news events involving Arthur Andersen LLP's (Andersen) questionable audits of Waste Management, Sunbeam, and Enron. Of these twenty-five windows, twelve (including eight pre-Enron windows) exhibit significantly negative market-wide mean abnormal returns. Moreover, during these twelve windows, portfolios of low quality auditees are, on average, penalized significantly more than portfolios of high quality auditees. During windows related to SEC actions (probes, sanctions), Andersen, Other Big Five and non-Big Five auditees are strongly penalized. Disclosures about the details of accounting and auditing irregularities, on the other hand, more strongly affect Big Five auditees than non-Big Five auditees. Our study is the first to present systematic evidence that bad news about the conduct of one auditor can generate significant negative externalities (spillovers) to all auditors. Interestingly, all three events that show the strongest evidence of spillovers occur before Enron's financial troubles became public. During Enron-related events, by contrast, evidence for spillovers is mixed for both Andersen and non-Andersen auditees.

Auditor Credibility, Spillovers, Agency Costs, Financial Statement Credibility

Abstract:
Prior studies have documented the asymmetrical behavior of Selling, General and Administrative (SG&A) costs (i.e., SG&A costs increase more when activity rises than they decrease when activity falls), and have explained this phenomenon with economic factors. In this study, we draw on agency theory and argue that SG&A cost asymmetry is driven not only by economic factors but also by managerial empire-building incentives. Using data for the S&P 1500 firms over the period 1996 - 2005, we find that on average strong corporate governance mitigates asymmetric SG&A cost adjustment, and that corporate governance is more effective in mitigating cost asymmetry in firm-years with greater empire-building problem as measured by free cash flows. In addition, we posit cost speediness (SG&A costs increase too rapidly when demand increases) as an alternative explanation to cost stickiness (SG&A costs do not go down fast enough when demand falls) for the observed SG&A cost asymmetry. We find evidence of both cost stickiness and cost speediness. More importantly, we find that corporate governance is more effective in mitigating cost speediness by reducing managers' over-investment in SG&A costs in response to sales increases.

Abstract:
Prior studies have documented the asymmetrical behavior of selling, general and administrative (SG&A) costs (i.e., SG&A costs increase more when activity rises than they decrease when activity falls), and have explained this phenomenon with economic factors. In this study, we draw on agency theory and argue that SG&A cost asymmetry is driven not only by economic factors but also by managerial empire-building incentives. Using data for the S&P 1500 firms over the period 1996-2005, we find that: 1) there is a positive association between managers' empire-building incentives and the degree of cost asymmetry; 2) there is a negative association between the strength of corporate governance and the degree of cost asymmetry, and this negative association is stronger in firm-years with a greater empire-building problem. Our findings suggest that the empire-building problem provides an additional explanation for SG&A cost asymmetry, and that corporate governance reduces cost asymmetry by preventing empire-building managers from over-spending on SG&A costs.

Cost Behavior, Cost asymmetry, Sticky Costs, Managerial Empire Building, Corporate Governance

Abstract:
Valuation theory, investment managers, financial analysts, and textbooks advocating horizontal financial statement analysis suggest that the change in earnings growth (earnings acceleration) conveys value relevant information. We test this assertion using a large sample of U.S. firms. Results from cross-sectional short-window (around earnings announcements) and long-window (annual) returns-earnings regressions reveal a strong association between contemporaneous returns and earnings acceleration after controlling for earnings levels and changes. We also find that earnings acceleration is useful in predicting future earnings, and that financial analysts appear to use the information in earnings acceleration in addition to earnings levels and changes in revising their forecasts. This study extends the empirical returns-earnings model that includes only earnings levels and changes and shows that more useful information can be extracted from reported earnings numbers than has been previously documented.

earnings acceleration, earnings growth, earnings prediction, stock returns

Abstract:
How useful are audit qualifications to financial statement users? Prior studies provide mixed evidence on this fundamental issue. In this study we analyze a sample of 206 firms that went public at the Athens Stock Exchange over the period 1987-2002. This is a unique sample because for 150 firms auditors report quantitative estimates of the amount by which assets are overstated and/or liabilities are understated in reported financial statements. We find evidence that financial analysts and underwriters do not incorporate the negative information provided by these qualifications into earnings forecasts and offer prices. Investors, however, appear to efficiently impound the negative implications of the audit qualifications into stock market prices within the first day of trading. We also detect a strong negative market reaction on and around June 10, 2004, when regulators disallowed IPOs with audit qualifications in compliance with European Union Directives. Sample firms with and without qualifications were equally penalized. This negative market sentiment confirms the wider market skepticism reflected in very low IPO activity in Greece in recent years. Overall, our results suggest that underwriters tend to align their interests with the interests of their clients, the old stockholders, at the expense of the new stockholders. They also suggest that the practice of reporting quantifiable qualifications in audit reports is valuable to investors. Although the management may choose not to recognize qualified amounts, investors price these amounts given that they are disclosed by an expert.

Audit Qualifications, Valuation, IPOs, Underwriters, Earnings Forecasts

Abstract:
In recent years, a substantial percentage of managers voluntarily choose to provide disaggregated earnings forecasts, i.e., earnings forecasts supplemented with additional numerical forecasts for other line items on the income statement. We examine whether such disaggregation yields higher-quality (i.e., more accurate and less biased) management earnings forecasts, and whether market reactions to disaggregated vs. aggregated forecasts are consistent with the quality of these forecasts. We find that: (1) for good news forecasts, earnings forecasts with disaggregated information are no different from aggregated earnings forecasts in either bias or accuracy; (2) for bad news forecasts, earnings forecasts with disaggregated information are significantly less accurate and, on average, more optimistic than aggregated earnings forecasts; 3) stock market reactions to disaggregated good news forecasts are no different from stock market reactions to aggregated good news forecasts, but stock market reactions to disaggregated bad news forecasts are more negative than stock market reactions to aggregated bad news forecasts. Taken together, our results suggest that disaggregated earnings forecasts are no better than and sometimes even worse than aggregated earnings forecasts and that investors anticipate and adjust for the biases associated with disaggregation in management earnings forecast.

Management earnings forecasts

Abstract:
We develop a methodology for detecting the reversal of large abnormal accruals. Using this methodology we examine the fixation hypothesis as an explanation of the negative relationship between current abnormal accruals and future stock returns - the accrual anomaly. The hypothesis states that investors fixate on earnings without considering the reversing nature of accruals and thus misprice the stock. The implication is that the market correction of the mispricing takes place when accruals reverse in the future and there should be no evidence of mispricing beyond the reversal point. We do find that the mispricing ends when the accruals reversal is complete. Further, we find a significant association between the reversal quarter’s return and the reversing accruals but no association between returns after the accruals reversal and the reversing accruals. We also find that analysts’ earnings forecast errors are positively associated with the reversing accruals suggesting that analysts do not completely anticipate the reversal of accruals. Overall, our evidence supports the fixation hypothesis as an explanation for the accrual anomaly.

abnormal accruals, accrual reversal, accrual anomaly, fixation hypothesis

Abstract:
This paper examines the first two decades of Greece's experience as a member of the European Union (EU). In evaluating the Greek experience within the EU, we derive three fundamental policy lessons that apply both to similar small peripheral countries now entering the EU and to the EU itself in terms of facilitating their integration in a large economic area. First, small peripheral countries that enter the EU must address the structural deficiencies of their economies before entry in order to minimize the impact of increased competition after the removal of trade protection, and follow domestic policies that maintain and promote their comparative advantage within the EU. Second, the Convergence Criteria have proven to be a successful mechanism for countries with a poor historical policy record to achieve macroeconomic stability, as shown by the case of Greece. Third, common EU policies can be very helpful in facilitating structural reforms in small peripheral economies. However, these policies must be continuously evaluated and improved so that their effectiveness is maximized.

Greece, European Union, Convergence Criteria, European Monetary Union

Abstract:
It is widely agreed that corporate financial reports provide deficient information about intangible assets. However, investors are exposed to substantial information beyond financial reports, such as managers' direct communications to capital markets and analysts' reports. We ask: To what extent do these nonfinancial report sources compensate for the intangibles-related deficiencies of financial statements?

To address this question we assume that analysts' forecasts of earnings reflect, among other things, the beyond-financial-report information we seek, and we use simultaneous equations to estimate the incremental information contribution of earnings forecasts over the information contained in financial reports, thereby isolating value-relevant information not available in financial report. We focus particularly on intangibles-related information, by comparing analysts' contribution for firms with and without R&D. We find that, to some extent, analysts do compensate for the intangibles-related information deficiencies of financial reports, but definitely not for all the deficiencies. Accordingly, we identify the "weakest links"-industries in which analysts don't get intangibles.

Abstract:
This study examines the usefulness of forward-looking financial disclosures to two major users of financial statements: financial analysts and equity investors. Specifically, we examine how analysts incorporate deferred taxes from losses and credits carried forward in earnings forecasts. Then, conditional on analysts' earnings forecasts, we examine how investors incorporate deferred taxes from carryforwards into share prices. We focus on deferred taxes from carryforwards because in measuring and disclosing this information each period, management must use their private information about the firm's profitability prospects. Thus, accounting valuation and disclosure of tax carryforwards is another way for managers to provide earnings forecasts.

We identify two conflicting effects that influence the relation between share prices (or forecasted earnings) and deferred taxes from carryforwards. First, from a measurement perspective, deferred tax assets from carryforwards represent future tax savings; hence, they should be valued positively as assets by analysts and investors. In contrast, from an information perspective, the existence of tax carryforwards may signal a higher probability of future losses. This higher likelihood of losses would translate into higher perceived earnings volatility, and hence, may have a negative effect on expected earnings and share prices. Thus, our empirical tests are structured in a way that allows for both of these effects to affect analysts' earnings forecasts and equity values.

We estimate a recursive cross-section system of two regression models: an analysts earnings prediction model and an equity valuation model. The analysts prediction model relates the present value of expected abnormal earnings to current values of book value of equity, abnormal earnings, and deferred taxes from carryforwards. The valuation model relates share prices to book value of equity, the present value of expected abnormal earnings, and deferred taxes from carryforwards. We distinguish in our earnings prediction and equity valuation models between the measurement and information effects by allowing the regression coefficients in both models to vary by whether the firm has accumulated tax carryforwards or not. We predict positive coefficients on net asset values and earnings. However, we also predict that net assets and earnings would be valued less in companies that have deferred taxes from carryforwards than in companies without deferred taxes from carryforwards.

Results of estimating the analysts earnings prediction model reveal a positive association between current abnormal earnings and the present value of forecasted abnormal earnings. Interestingly, this association between current and future abnormal earnings is weaker for firms with deferred taxes from carryforwards than for firms without such deferred taxes. This result suggests that analysts consider earnings of firms with carryforwards to be less persistent due to the increased likelihood of future losses.

We also investigate whether analysts' forecast errors exhibit different patterns in firms with and without carryforwards. We find that analysts tend to be less precise and more optimistic (biased) in forecasting earnings of firms with carryforwards. However, the higher optimism and lower precision are most significant in fiscal 1992 and they become less visible in later years. Since fiscal 1992 was the first year companies adopted SFAS No. 109, we believe that the higher optimism and lower precision in analysts' earnings forecasts resulted from the introduction of a new and complex accounting rule for income taxes.

An analysis of investors' valuation indicates a strong positive relation between deferred taxes from carryforwards and share prices, suggesting that these carryforwards are valued as assets. In addition, investors value earnings and book values of equity of firms that have carryforwards less than in firms without carryforwards. Finally, we find that investors value the earnings and book values of firms with valuation allowances less than the earnings and book values of firms without a valuation allowance.

The combined results also suggest that analysts fail to consider at least some of the implications of carryforwards on expected cash flows. It is also possible that the analysts' forecast horizon of five years is too short to capture all the valuation implications of carryforwards.

Abstract:
The paper demonstrates empirically that GAAP earnings have properties to serve as a substitute for dividends in equity valuation analysis. Dividends reduce subsequent GAAP earnings, and "intrinsic" equity prices calculated by forecasting earnings are thus reduced by current dividends. This is in accordance with the Miller and Modigliani principle -- the displacement property -- which states that the payment of dividends reduces prices, dollar for dollar. Further, the paper demonstrates that if this displacement is accommodated in calculating equity prices from forecasted GAAP earnings, those prices exhibit the dividend irrelevance property, that is, calculated prices are insensitive to future dividends. The accommodation involves adding the displacement value of dividends to earnings forecasts. Forecasted GAAP earnings cannot be substituted for dividends, dollar for dollar, but the two are substitutes in the sense that the replacement value of expected dividends reduces forecasted earnings, dollar for dollar.