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Abstract:
We extend the analysis in Sloan (1996) to identify the source of information in accruals about earnings quality. Our results indicate that information in accruals about earnings quality is not limited to the current accruals analyzed by Sloan, but extends to non-current accruals. We also show that while information in accruals originates almost exclusively from asset accruals, liability accruals play a useful role in helping to isolate information in asset accruals about earnings quality. Finally, we show that information in accruals about earnings quality originates from both growth in the scale of operations and deterioration in the efficiency of asset usage. Overall, our results indicate that total accruals, defined as the difference between earnings and free cash flows, provide an intuitive, robust and parsimonious measure of earnings quality. Contrary to existing studies, our results also indicate that the information in accruals about earnings quality is not attributable to a single factor, such as 'discretionary' accruals or firm growth.

Accruals; Growth; Efficiency; Abnormal returns

Abstract:
We examine the relation between a broad set of corporate governance indicators and various measures of managerial decision making and organizational performance. Using a sample of 2,106 firms, we distill 39 structural measures of corporate governance (e.g., board characteristics, stock ownership, institutional ownership, activist stock ownership, existence of debt-holders, mix of executive compensation, and anti-takeover variables) into 14 governance constructs using principal components analysis. We find that these 14 constructs are related to operating performance, have a somewhat mixed association with abnormal accruals, Tobin's Q, and excess stock returns, and little relation to class action lawsuits and accounting restatements.

Corporate governance

Abstract:
This paper extends the work of Sloan (1996) by linking accrual reliability to earnings persistence. We construct a model showing that less reliable accruals lead to lower earnings persistence. We then develop a comprehensive balance sheet categorization of accruals and rate each category according to the reliability of the underlying accruals. Empirical tests generally confirm that less reliable categories of accruals lead to lower earnings persistence and that investors do not fully anticipate the lower earnings persistence, leading to significant security mispricing. We conclude that there are significant costs associated with the recognition of unreliable information in financial statements.

Accruals, reliability, earnings persistence, capital markets, market efficiency

Abstract:
Existing research indicates that firms with high accruals are more likely to experience future earnings reversals and SEC enforcement actions for GAAP violations, but that investors do not appear to anticipate these consequences. In this paper, we directly examine the published opinions of two types of professional investor intermediaries to see if they anticipate the consequences of high accruals. First, we examine the earnings forecasts of sell-side analysts. We show that analysts' earnings forecasts do not anticipate the future earnings reversals associated with high accruals. Second, we examine the audit opinions of independent auditors. We find no evidence that auditors signal the higher likelihood of GAAP violations through their audit opinions. Overall, our evidence indicates that even professional investor intermediaries act as if they do not anticipate the consequences of high accruals.

Abstract:
This paper examines the usefulness of accounting information in predicting earnings management. We investigate a comprehensive sample of firms from 1971-2000 that restated annual earnings. We find that firms restating earnings have high market expectations for future earnings growth and have higher levels of outstanding debt. We also find that a primary motivation for the earnings manipulation is the desire to attract external financing at a lower cost. Furthermore, our evidence suggests that restating firms have been attempting to maintain a string of consecutive positive earnings growth and consecutive positive quarterly earnings surprises. Together, our evidence is consistent with capital market pressures acting as a motivating factor for companies to adopt aggressive accounting policies. Finally, we document that information in accruals, specifically, operating and investing accruals, are key indicators of the earnings manipulation that lead to the restatement. Collectively, the evidence suggests that market participants can gain substantial value from a careful consideration of information in financial statements.

voluntary disclosure, capacity competition, price competition, strategic interactions

Abstract:
We develop a comprehensive and parsimonious measure of the extent to which a firm is raising (distributing) capital from (to) capital market participants. We show that the relation between our measure of net external financing and future stock returns is stronger than has been documented in previous research focusing on individual categories of financing transactions. Decompositions of our measure reveal additional insights. First, the weaker results of previous research are attributable to 'refinancing' transactions having no change on net external financing. Second, after controlling for refinancing transactions, there is a consistently strong and negative relation between all major categories of external financing transactions and future stock returns. Third, the negative relation between external financing and future stock returns is most consistent with a combination of over-investment and aggressive accounting.

External financing, Capital structure, Capital markets, Market efficiency

Abstract:
This paper examines the dynamic behavior of analysts' earnings forecasts over the twelve months preceding annual earnings announcements. We investigate the claim that analysts make optimistic forecasts at the start of the year and then 'walk down' their estimates to a level the firm is likely to beat by the end of the year. The sample consists of I/B/E/S individual-analyst forecasts for the period 1983-1997. In the post-1992 period, we find strong evidence of a switch from upward-biased to downward-biased forecasts of annual earnings as the announcement date approaches. Forecast pessimism is strongest for high market-to-book firms, for large firms, and in periods when real GDP is growing. We also find that analysts forecasts are more accurate for firms involved in new equity issuance. Finally, we find that pessimistic forecasts are more frequent in years when firms report positive special items, high cash flows from operations and high working capital accruals.

Abstract:
Following Sloan (1996), numerous studies document that the accrual component of earnings is less persistent than the cash flow component of earnings. Disagreement exists, however, as to the explanation for this result. One stream of literature follows Sloan's lead in arguing that this result is attributable to accounting distortions (Xie, 2001; Dechow and Dichev, 2002; Richardson et al., 2005). A second stream of literature argues that this result is attributable to a more general growth effect and that growth-related factors such as diminishing returns to new investment explain the lower persistence of accruals (e.g., Fairfield, Whisenant and Yohn, 2003a; Cooper, Gulen and Schill, 2005). We provide new evidence indicating that temporary accounting distortions are a significant contributing factor to the lower persistence of the accrual component of earnings. Our evidence indicates that the lower persistence of accruals extends to accruals that are unrelated to sales growth and that extreme accruals are systematically associated with alleged cases of earnings manipulation.

accruals, earnings management, conservative accounting, aggressive accounting

Abstract:
Following Sloan (1996), numerous studies show that the accrual component of earnings is less persistent than the cash flow component of earnings. Disagreement exists, however, as to the explanation for this result. Xie (2001) attributes the result to managerial discretion. Fairfield et al. (2003a) argue that it is a special case of a more general growth anomaly that is attributable to the widespread use of conservative accounting methods and/or diminishing marginal returns to new investment. Finally, Dechow and Dichev (2002) and Richardson et al. (2004) argue that it is attributable to transitory accrual estimation error. In this paper, we provide theory and evidence to discriminate between these alternative explanations. Our analysis suggests that transitory accrual estimation error provides the most consistent explanation for the lower persistence of the accrual component of earnings. Further, our results suggest the accrual estimation error is at least partially attributable to managerial discretion.

Accruals, earnings management, conservative accounting, aggressive accounting

Abstract:
Prior research shows that the cash component of earnings is more persistent than the accrual component of earnings. We investigate whether the persistence of the cash component is influenced by management's decision to retain or distribute cash flows. We find that when firms retain the cash flows, the cash component has low persistence almost identical to that of accruals. Only when the cash flows are distributed to equity holders does the cash component have high persistence. We investigate whether investors understand the differential implications of each use of cash flows for future earnings. Inconsistent with a naïve fixation on earnings, we find that investors correctly price cash flows relating to equity and debt distributions. However, we find that retained cash flows are mispriced in a similar manner to accruals. Our results are consistent with a combination of investors misunderstanding diminishing marginal returns to new investments and/or over-investment. Our results also suggest that discounted free cash flows valuation models should explicitly forecast retained cash flows.

Accruals, free cash flow, capital markets, earnings persistence

Abstract:
We analyze the relation between corporate financing activities and sell-side analysts' investment research. We document pervasive evidence of overoptimism in sell-side analysts' earnings forecasts, stock recommendations and target prices that is systematically related to corporate financing activities. Overoptimism is greatest for firms issuing equity and debt and least for firms repurchasing equity and debt. Our evidence is consistent with allegations that sell-side analysts routinely manipulate their investment advice in response to investment banking pressures in order to temporarily inflate stock prices around securities issuances.

External Financing, Sell-side Analysts, Capital Markets, Market Efficiency

Abstract:
We examine whether managers' trading decisions (both at a firm and personal level) are correlated with trading strategies suggested by the operating accruals and the post-earnings announcement drift (SUE) anomalies. We discuss advantages and disadvantages of the use of managerial trading activity to infer managers' private valuation about their own securities. Our results provide corroborative evidence for the accruals anomaly, i.e., managers' repurchase and insider trading behavior varies consistently with the information underlying the operating accruals trading strategy. On the other hand, we do not find corroborative evidence for the SUE anomaly.

Accruals, SUE, share repurchases, insider trading

Abstract:
We examine whether managers' trading decisions (both at a firm and personal level) are correlated with trading strategies suggested by the operating accruals and the post-earnings announcement drift (SUE) anomalies. We discuss advantages and disadvantages of the use of managerial trading activity to infer managers' private valuation about their own securities. Our results provide corroborative evidence for the accruals anomaly, i.e., managers' repurchase and insider trading behavior varies consistently with the information underlying the operating accruals trading strategy. On the other hand, we do not find corroborative evidence for the SUE anomaly.

Accruals, SUE, share repurchases, insider trading

Abstract:
Prior research has documented the empirical regularity that more firms than expected (i) report small positive earnings and (ii) have zero forecast errors. It appears that management avoid reporting negative earnings or disappointing analysts. We investigate how and why firms beat these benchmarks (benchmark beaters).

We document that benchmark beaters have high accruals and unusual levels of special items relative to other firms. We find that a strong motivation for reporting small profits is to delay reporting bad news. We find that small profit firms show a decline in earnings and exhibit poor stock price performance over the following year. In contrast, we find that firms with zero forecast errors do well in the future. These firms have positive abnormal returns over the following year. We document that zero forecast error firms are high growth, high market capitalization firms. We argue that these firms want to avoid disappointing analysts since they are most likely to suffer from the "torpedo effect": small earnings disappointments lead to large stock price declines.

Earnings management, accruals, benchmark

Abstract:
Security regulators and the business press have alleged that firms play an 'earnings-guidance game' where analysts make optimistic forecasts at the start of the year and then 'walk down' their estimates to a level the firm can beat by the end of the year. In a comprehensive sample of I/B/E/S individual analysts' forecasts of annual earnings from 1983-1998, we find strong support for the claim in the post-1992 period. We examine whether the 'walk down' to beatable targets is associated with managers' incentives to sell stock after earnings announcements on the firm's behalf (via new equity issuance) or from their personal accounts (insider trades). Consistent with these hypotheses, we find that the 'walk down' to beatable targets is most pronounced in firms that are either net issuers of equity or in firms where managers are net sellers of stock after an earnings announcement. These findings provide new insights on how capital market incentives affect communications between managers and analysts.

Analyst forecasts; Benchmark beating; Pessimism; Optimism; Walkdown; Equity issuance; Insider trading; Earnings guidance; Disclosure; Earnings surprise; Forecast error

Abstract:
The empirical research examining the association between typical measures of corporate governance and various accounting and economic outcomes has not produced a consistent set of results. We believe that these mixed results are partially attributable to the difficulty in generating reliable and valid measures for the complex construct that is termed corporate governance. Using a sample of 2,106 firms and 39 structural measures of corporate governance (e.g., board characteristics, stock ownership, institutional ownership, activist stock ownership, existence of debt-holders, mix of executive compensation, and anti-takeover variables), our exploratory principal component analysis suggests that there are 14 dimensions to corporate governance. We find that these indices have a mixed association with abnormal accruals, little relation to accounting restatements, but some ability to explain future operating performance and future excess stock returns.

corporate governance, earnings quality, firm performance, principal component analysis, recursive partitioning

Abstract:
This paper lays out a decomposition of book-to-price (B/P) that derives from the accounting for book value and that articulates precisely how B/P absorbs leverage. The B/P ratio can be decomposed into an enterprise book-to-price (that pertains to operations and potentially reflects operating risk) and a leverage component (that reflects financing risk). The empirical analysis shows that the enterprise book-to-price ratio is positively related to subsequent stock returns but, conditional upon the enterprise book-to-price, the leverage component of B/P is negatively associated with future stock returns. Further, both enterprise book-to-price and leverage explain returns over those associated with Fama and French nominated factors including the book-to-price factor albeit negatively so for leverage. The seemingly perverse finding with respect to the leverage component of B/P survives under controls for size, estimated beta, return volatility, momentum, and default risk.

Abstract:
This paper lays out a decomposition of book-to-price (B/P) that articulates precisely how B/P "absorbs" leverage. The B/P ratio can be decomposed into an enterprise book-to-price (that pertains to operations and potentially reflects operating risk) and a leverage component (that reflects financing risk). The empirical analysis shows that the enterprise book-to-price ratio is positively related to subsequent stock returns but, conditional upon the enterprise book-to-price, the leverage component of B/P is negatively associated with future stock returns. Further, both enterprise book-to-price and leverage explain returns over those associated with Fama and French nominated factors - including the book-to-price factor - albeit negatively so for leverage. The seemingly perverse finding with respect to the leverage component of B/P survives under controls for size, estimated beta, return volatility, momentum, and default risk.

Book-to-price, Leverage, Enterprise book-to-price, Stock Returns

Abstract:
This paper uses pre-offer market valuations to evaluate the misvaluation and Q theories of takeovers. Bidder and target valuations (price-to-book, or price-to-residual-income-model-value) are related to means of payment, mode of acquisition, premia, target hostility, offer success, and bidder and target announcement-period returns. The evidence is broadly consistent with both hypotheses. The evidence for the Q hypothesis is stronger in the pre-1990 period than in the 1990-2000 period, whereas the evidence for the misvaluation hypothesis is stronger in the 1990-2000 period than in the pre-1990 period.

takeovers, misvaluation, market efficiency, behavioral finance

Abstract:
This paper tests the hypothesis that irrational market misvaluation affects firms' takeover behavior. We employ two contemporaneous proxies for market misvaluation, pre-takeover book/price ratios and pre-takeover ratios of residual income model value to price. Misvaluation of bidders and targets influences the means of payment chosen, the mode of acquisition, the premia paid, target hostility to the offer, the likelihood of offer success, and bidder and target announcement period stock returns. The evidence is broadly supportive of the misvaluation hypothesis.

takeovers, misvaluation, market efficiency, behavioral finance

Abstract:
We examine the relation between the relative amount of fees paid to auditors for non-audit services and the behavior of accrual measures. We extend prior research in two important directions. First, using a pooled sample of 2,295 firms for the fiscal year 2000, we find very little evidence of a relation between the provision of non-audit services and measure of accruals. However, there appears to be three distinct clusters of firms where only one cluster (consisting of only about 20 percent of the sample) exhibits a statistically positive association between non-audit fees and accrual behavior. Second, we examine the corporate governance characteristics of firms in the cluster with a positive association between non-audit fees and accrual behavior relative to the remaining firms. We find that this subset of firms have a smaller market capitalization, lower institutional holdings, higher insider holdings, smaller board of directors (and audit committee), and lower percentage of independent board (and audit committee) members. These results suggest that the provision of non-audit services is potentially problematic only for a small subset of firms that appear to be de facto controlled by management.

corporate governance, earnings quality, accruals, audit quality, non-audit services

Abstract:
This paper examines whether links between inside and outside directors have an impact on CEO compensation. Using a comprehensive sample of 22,074 directors for 3,114 firms, we develop a measure of the "back door" distance between each pair of directors on a company's board. Specifically, using the entire network of directors and firms, we compute the minimum number of other company boards that are required to establish a connection between each pair of directors (ignoring the obvious link that occurs when directors are on the same board). The back door distance provides a measure for the existence and strength of a communication channel between board members that can be used to influence decisions by the board of directors. We document that CEOs at firms where there is a relatively short back door distance between inside and outside directors or between the CEO and the members of the compensation committee earn substantially higher levels of total compensation (after controlling for standard economic determinants and other personal characteristics of the CEO and the structure for board of directors). This statistical association is consistent with recent claims that the monitoring ability of the board is hampered by "cozy" and possibly difficult to observe relationships between directors.

Interlocks, executive compensation, network analysis

Abstract:
This paper examines the extent of firm level over-investment of free cash flow. Using an accounting based framework to measure over-investment and free cash flow, I find evidence that, consistent with agency cost explanations, over-investment is concentrated in firms with the highest levels of free cash flow. Further tests examine whether firms' governance structures are associated with over-investment of free cash flow. The evidence suggests that certain governance structures, such as the presence of activist shareholders, appear to mitigate over-investment.

Free cash flow, investment, governance

Abstract:
This paper explores whether firms that share common directors also pursue similar corporate policies. Using a sample of 885 U.S. firms with common directors, we find that director fixed effects strongly explain variation in firms' governance, financial, disclosure, and strategic policy choices. Moreover, the director fixed effects provide incremental explanatory power over traditional economic determinants of firms' policies. consistent with our hypotheses, the director effects are less pronounced in large firms, in firms with more outside board members, and for directors with numerous outside board appointments. Our evidence is more consistent with directors and firms "matching" their policy preferences rather than directors "imposing" their policy preferences on firms.

Board of Directors, Corporate Governance, Corporate Policies, Disclosure

Abstract:
Numerous studies have documented that the most recent annual change in net operating assets is negatively related to future stock returns. In recent work, Hirshleifer, Hou, Teoh and Zhang (2004) show that the level of net operating assets scaled by the previous year's total assets is also negatively related to future returns. They argue that their levels variable is superior to the change variable used in prior research because it picks up cumulative past changes, rather than just the most recent annual change. We point out that deflation of a level by a lagged level produces a change. As such, their level variable is similar to the change variable used in prior research, and their claim that it picks up cumulative past changes in net operating assets is misleading.

accounting information, balance sheet, market efficiency

Abstract:
Existing research indicates that firms with high accruals are more likely to experience earnings reversals and lower returns in the future. It has further been shown that analysts and auditors do not anticipate these consequences. In this paper, I examine a sophisticated set of investors (short sellers) to see whether they anticipate the consequences of high accruals. Unlike analysts and auditors, short sellers have particularly strong incentives to understand the accrual anomaly since they can directly profit from the lower firm performance of high accrual firms. I find that short sellers utilize information contained in fundamental ratios like market-to-book. However, I do not find systematic evidence that short sellers trade on the basis of information contained in accruals.

Accruals, Returns, Short sellers

Abstract:
We develop a comprehensive and parsimonious measure of corporate financing activities and document a negative relation between this measure and both future stock returns and future profitability. The economic and statistical significance of the results using our comprehensive measure of external financing is stronger than in previous research focusing on individual categories of corporate financing activities. To discriminate between risk versus misvaluation as explanations for this relation, we analyze the association between our measure of external financing and sell-side analysts' forecasts. Consistent with the misvaluation explanation, we find that our measure of external financing is positively related to overoptimism in sell-side analysts' forecasts.

Financing, Sell-side analysts, Capital markets, Market efficiency

Abstract:
Do short sale transactions precede bad news events? Not recently. This paper examines short sale transactions around significant news events. Using a novel and comprehensive dataset covering daily short sale transactions for 4,193 securities on the New York Stock Exchange for the period April 1, 2004 through March 31, 2005, we find no evidence that short sale transactions are concentrated prior to bad news events. This challenges prior research that has found short sale transactions have tended to precede stock price declines. Additional analysis reveals that there is no reliable evidence of daily changes in short sales transactions leading daily stock returns, inconsistent with the notion that short sale transactions (at least in the aggregate) are based on private information.

short selling, sophisticated investors, management forecasts, earnings announcements

Abstract:
In this paper we examine whether the utilization of independent valuers provides a credible signal about the underlying reliability of upward asset revaluations. A sample of recognized Australian asset revaluations is used to compare the reliability of independent and director based revaluations of non-current assets. Reliability is defined in terms of ex-post adjustments of recognized value increases, and is determined by an examination of the extent to which upward revaluations are subsequently reversed. Univariate results provide evidence that independent revaluations are more reliable than directors? revaluations. Further, after controlling for opportunistic incentives to revalue, the strength of corporate governance and macroeconomic conditions we find that independent revaluations are more reliable than directors? revaluations over the three years following the revaluations. While the employment of high quality (brand name) valuers may be perceived to add additional credibility to the revaluation, we find that reliability is not related to valuer quality.

Abstract:
We examine the relation between the fees paid to auditors for audit and non-audit services and the choice of accrual measures for a large sample of firms. Using our pooled sample, we find that the ratio of non-audit fees to total fees has a positive relation with the absolute value of accruals similar to Frankel et al. (2002). However, using latent class mixture models to identify clusters of firms with a homogenous regression structure reveals that this positive association only occurs for about 8.5 percent of the sample. In contrast to the fee ratio results, we find consistent evidence of a negative relation between the level of fees (both audit and non-audit) paid to auditors and accruals (i.e., higher fees are associated with smaller accruals). The latent class analysis also indicates that this negative relation is strongest for client firms with weak governance. Overall, our results are most consistent with auditor behavior being constrained by the reputation effects associated with allowing clients to engage in unusual accrual choices.

Audit fees, auditor independence, accruals, corporate governance

Abstract:
It has been alleged that firms and analysts engage in an earnings guidance game where analysts first issue optimistic earnings forecasts and then 'walk down' their estimates to a level firms can beat at the official earnings announcement. We examine whether the walk-down to beatable targets is associated with managerial incentives to sell stock after earnings announcements on the firm's behalf (via new equity issuance) or from their personal accounts (through option exercises and stock sales). Consistent with these hypotheses, we find that the walk-down to beatable targets is most pronounced when firms or insiders are net sellers of stock after an earnings announcement. These findings provide new insights on the impact of capital market incentives on communications between managers and analysts.

Earnings Announcement, Expectations Management, Insider Trading, Stock Options

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

accruals, earnings distribution, discretionary accruals, earnings management

Abstract:
A key measure of earnings quality is the deviation of net income from operating cash flows. Sloan (1996) finds that firms with high accruals (or a large gap between net income and operating cash flow) experience a decline in earnings performance not anticipated by investors, resulting in predictable future returns. In this paper, I examine whether investors short sell securities with high accruals. Such a strategy is able to directly profit from the predictable lower future returns. Using a sample of U.S traded firms from 1990-1998, I do not find evidence that short sellers trade on the basis of information contained in accruals.

accruals, earnings quality, returns short sellers

Abstract:
In this paper we examine whether there are differences in the reliability of asset revaluations made by boards of directors versus independent (external) appraisers. We use a sample of recognized Australian asset revaluations. As a first step we examine the determinants of the choice between director-based revaluations and those undertaken by independent appraisers. We find that independent appraisers are more likely to be used for revaluations of land and buildings and directors are more likely for investments, plant and equipment and identifiable intangibles. We interpret this as evidence of firms harnessing directors' knowledge of asset specificities. We also find that firms with less independent boards are more likely to use independent appraisers. We interpret this as evidence of substitutability between governance mechanisms.

As for differences in reliability, we find that revaluations of plant and equipment that are made by independent appraisers are more reliable than those by directors. However, we are unable to detect a difference for other classes of non-current assets. We define reliability in terms of ex-post adjustments of recognized value increases. Reliability is determined by an examination of the extent to which upward revaluations are subsequently reversed.

asset revaluations, corporate governance, reliability

Abstract:
Existing research indicates that firms with high accruals are more likely to experience future earnings problems, but that investors' expectations, as reflected in stock prices, do not appear to anticipate these problems. In this paper, we directly examine the published opinions of two types of professional investor intermediaries to see if they provide investors with information concerning the future earnings problems experienced by firms with high accruals. First, we examine the earnings forecasts of sell-side analysts. We show that analysts' earnings forecasts do not incorporate the predictable future earnings declines associated with high accruals. Second, we examine the behavior of independent auditors. We find no evidence that auditors signal the higher likelihood of GAAP violations associated with high accruals through either their audit opinions or through auditor changes. Overall, our evidence indicates that analysts and auditors do not alert investors to the future earnings problems associated with high accruals, thus corroborating previous findings that investors do not appear to anticipate these problems.

Accruals, Analysts, Auditors, Capital markets