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Abstract:
I review empirical research on the relation between capital markets and financial statements. The principal sources of demand for capital markets research in accounting are fundamental analysis and valuation, tests of market efficiency, and the role of accounting numbers in contracts and the political process. The capital markets research topics of current interest to researchers include tests of market efficiency with respect to accounting information, fundamental analysis, and value relevance of financial reporting. Evidence from research on these topics is likely to be helpful in capital market investment decisions, accounting standard setting, and corporate financial disclosure decisions.

Capital markets; Financial reporting; Fundamental analysis; Valuation; Market efficiency

Abstract:
I review empirical research on the relation between capital markets and financial statements. The principal sources of demand for capital markets research in accounting are fundamental analysis and valuation, tests of market efficiency, and the role of accounting numbers in contracts and the political process. The capital markets research topics of current interest to researchers include tests of market efficiency with respect to accounting information, fundamental analysis, and value relevance of financial reporting. Evidence from research on these topics is likely to be helpful in capital market investment decisions, accounting standard setting, and corporate financial disclosure decisions.

Capital markets; Financial reporting; Fundamental analysis; Valuation; Market efficiency

Abstract:
We study the stock market reaction to aggregate earnings news. Previous research shows that, for individual firms, stock prices react positively to earnings news but require several quarters to fully reflect the information in earnings. We find that the relation between returns and earnings is substantially different in aggregate data. First, returns are unrelated to past earnings, suggesting that prices neither underreact nor overreact to aggregate earnings news. Second, aggregate returns are negatively correlated with concurrent earnings; over the last 30 years, stock prices increased 6.5% in quarters with negative earnings growth and only 1.9% otherwise. This finding suggests that earnings and discount rates move together over time, and provides new evidence that discount-rate shocks explain a significant fraction of aggregate stock returns.

Abstract:
Assessing the predictive ability of behavioral finance theories using out-of-sample data is important. Without predictive tests, the risk of overfitting theory to data is large considering the potentially boundless set of psychological biases underlying the behavioral explanations for observed security price behavior. We test pricing effects attributed to a central psychological bias, representativeness, which underlies many behavioral-finance theories. This bias influences individuals beliefs about future outcomes based on how closely past outcomes represent certain categories. To produce out-of-sample tests, we use accounting performance to identify these categories and test the idea that investors misclassify firms and thus systematically misprice them. Evidence fails to suggest that trends and sequences of accounting performance, as a proxy for representativeness bias, influence investor expectations to generate return predictability.

Abstract:
The number of published event studies exceeds 500, and the literature continues to grow. We provide an overview of event study methods. Short-horizon methods are quite reliable. While long-horizon methods have improved, serious limitations remain. A challenge is to continue to refine long-horizon methods. We present new evidence that properties of event study methods can vary by calendar time period and can depend on event sample firm characteristics such as volatility. This reinforces the importance of examining event study statistical properties for non-randomly selected samples.

Event studies, econometrics, surveys, accounting, corporate finance, market efficiency

Abstract:
We study standard mutual fund performance measures, using simulation procedures combined with random and random-stratified samples of NYSE and AMEX securities. We track simulated fund portfolios over time. These portfolios? performance is ordinary, and well-specified performance measures should not indicate abnormal performance. Our main result, however, is that the performance measures are badly misspecified. Regardless of the performance measure, there are indications of abnormal fund performance, including market-timing ability, when none exists.

Abstract:
Previous research offers little large-sample evidence on the magnitude of non-financial firms' risk exposure hedged by financial derivatives. Among 234 large non-financial derivatives users, if the median firm simultaneously experiences a three standard deviation change in interest rates, currency exchange rates, and commodity prices, its entire derivatives portfolio will generate, at most, $15 million in current cash flow and will rise in value by $31 million. These amounts are modest relative to firm size, operating cash flows, investing cash flows and other firm benchmarks. The findings indicate corporate derivatives use is a small piece of non-financial firms' overall risk profile, and suggest the need to rethink some empirical research documenting the economic importance of firms' derivative use.

risk management, derivatives instruments, hedging

Abstract:
Previous research offers little large-sample evidence on the magnitude of non-financial firms' risk exposure hedged by financial derivatives. Among 234 large non-financial derivatives users, if the median firm simultaneously experiences a three standard deviation change in interest rates, currency exchange rates, and commodity prices, its entire derivatives portfolio will generate, at most, $15 million in current cash flow and will rise in value by $31 million. These amounts are modest relative to firm size, operating cash flows, investing cash flows and other firm benchmarks. The findings indicate corporate derivatives use is a small piece of non-financial firms' overall risk profile, and suggest the need to rethink some empirical research documenting the economic importance of firms' derivative use.

derivatives, hedging, risk management, risk exposure

Abstract:
If a firm's derivative positions generate positive cash flows or value in periods of economic adversity, then those derivatives are deemed to hedge the firm's risk. Previous research offers little large-sample evidence on the magnitude of non-financial firms' risk exposure hedged by the financial derivatives. In a sample of 234 large corporations that use derivatives, we find that if the median firm simultaneously experiences a three standard deviation change in interest rates, currency exchange rates, and commodity prices, it will collect $15 million of cash from its entire derivatives portfolio and that the entire derivatives portfolio will rise in value by $31 million. These dollar amounts are modest relative to firm size, operating cash flows, investing cash flows and other firm benchmarks. The findings raise questions about the role of derivatives securities held by non-financial firms.

Derivatives; Hedging; Risk management; Exposure

Abstract:
Prior research shows extant discretionary accrual models are misspecified when applied to firms with unusual performance. Nonetheless, research on earnings management and market efficiency frequently uses these models. We examine the specification and power of tests based on performance-matched discretionary accruals, and make comparisons with tests using traditional discretionary accrual measures (e.g., Jones and modified-Jones models). Performance matching on return on assets controls for the effect of performance on measured discretionary accruals. The results suggest that performance-matched discretionary accrual measures enhance the reliability of inferences from earnings management research.

Discretionary accruals, earnings management, performance matching, discretionary-accruals models

Abstract:
Prior research shows that extant discretionary accrual models are misspecified when applied to firms with extreme performance. Nonetheless, use of such models in tests of earnings management and market efficiency is commonplace in the literature. We examine the specification and power of the test based on a performance-matched discretionary accrual measure and compare it with traditional discretionary accrual measures (e.g., Jones and Modified-Jones Models). Performance matching is on return on assets and industry and is designed to control for the effect of performance on measured discretionary accruals. The results suggest that our performance-matched discretionary accrual measure is a viable alternative to existing discretionary accrual models for use in earnings management research.

Earnings Management, Discretionary Accruals, Performance Matching

Abstract:
International differences in the demand for accounting income predictably affect the way it incorporates economic income (dividend-adjusted change in market value) over time. We characterize the "shareholder" and "stakeholder" corporate governance models of common and code law countries respectively as resolving information asymmetry by public disclosure and private communication. Also, code law directly links accounting income to current payouts (to employees, managers, shareholders and governments). Consequently, code law accounting income is less timely, particularly in incorporating economic losses. Regulation, taxation and litigation cause variation among common law countries. The results have implications for security analysts, standard-setters, regulators, and corporate governance.

Abstract:
We evaluate the influence of measurement error in analysts' forecasts on the accuracy of implied cost of capital estimates from various implementations of the 'implied cost of capital' approach, and develop corrections for the measurement error. The implied cost of capital approach relies on analysts' short- and long-term earnings forecasts as proxies for the market's expectation of future earnings, and solves for the implied discount rate that equates the present value of the expected future payoffs to the current stock price. We document predictable error in the implied cost of capital estimates resulting from analysts' forecasts that are sluggish with respect to information in past stock returns. We propose two methods to mitigate the influence of sluggish forecasts on the implied cost of capital estimates. These methods substantially improve the ability of the implied cost of capital estimates to explain cross-sectional variation in future stock returns, which is consistent with the corrections being effective in mitigating the error in the estimates due to analysts' sluggishness.

Cost of Capital, Implied Cost of Capital, Analysts' Forecasts, Discount Rate

Abstract:
In this paper, we derive a measure of diluted EPS that incorporates the economic implications of the dilutive effects of employee stock options. We show that the existing FASB treasury-stock method of accounting for the dilutive effects of outstanding options systematically understates the options' dilutive effect, and thus overstates reported EPS. Using firm-wide data on 731 employee stock option plans, our proposed measure suggests that economic dilution from options is, on average, 100 percent greater than dilution in reported diluted EPS using the FASB treasury-stock method.

We examine the implications of our analysis for stock price valuation, the price-earnings relation, and the return-earnings relation. We demonstrate analytically that when firms have options outstanding, empirical applications of equity valuation models that use reported per-share earnings as an input (e.g., Ohlson 1995) yield upwardly-biased estimates of the market value of common stock. We predict that when the difference between our measure of economic dilution from options and the FASB treasury-stock method dilution from options is greater, the observed return-earnings and price-earnings coefficients will be smaller, and we provide some (albeit weak) empirical support for this prediction.

Employee stock options, Dilution, Diluted earnings per share, Earnings response coefficients, Equity valuation

Abstract:
We derive a measure of diluted EPS that incorporates economic implications of the dilutive effects of employee stock options. We show that the existing FASB treasury-stock method of accounting for the dilutive effects of outstanding options systematically understates the dilutive effect of stock options, and thereby overstates reported EPS. Using firm-wide data on 731 employee stock option plans, we find that economic dilution from options in our proposed measure of options-diluted EPS is, on average, 100% greater than dilution in reported diluted EPS using the FASB treasury-stock method.

We examine the implications of our analysis for stock price valuation, the price-earnings relation, and the return-earnings relation. We demonstrate analytically that when firms have options outstanding, empirical applications of equity valuation models that use reported per share earnings as an input (e.g., Ohlson, 1995), yield upwardly biased estimates of the market value of common stock. We predict that observed return-earnings and price-earnings coefficients are expected to be smaller the greater the difference between our measure of economic dilution from options and FASB treasury-stock method dilution from options, and provide weak empirical support for this prediction.

Abstract:
Despite its popularity, the asymmetric timeliness coefficient has been challenged as a valid measure of conditional conservatism. We propose a model in which accounting income contemporaneously incorporates one component of price revision, incorporates another with a lag unless below a threshold (e.g., losses), invariably incorporates another with a lag, and adds uncorrelated “noise.” We demonstrate validity in this framework. We derive a negative relation between asymmetric timeliness coefficients and the proportion of price changes associated with growth option expectation revisions (proxied by market-to-book), due to lagged recognition. We conclude much criticism of the coefficient misconstrues research objectives.

conditional conservatism, asymmetric timeliness, earnings

Abstract:
Accounting standards reflect a trade-off between relevance and reliability. This trade-off is intensely debated in the context of the accounting standard for R&D costs. However, almost all of the empirical research focuses only on the relevance of accounting disclosures about R&D costs. Little systematic evidence exists on the reliability of future benefits from R&D outlays. We propose and implement a new method to estimate the relation between investments in R&D and the uncertainty of future benefits from those investments. The empirical analysis compares the relative contributions of current investments in R&D and PP&E to future earnings variability using a sample of more than 50,000 firm-year observations. Evidence is strongly consistent with the hypothesis that R&D investments generate future benefits that are far more uncertain than benefits from investments in PP&E. Our results, together with the evidence on value relevance of R&D from previous research, should be helpful in the current discussion on accounting for R&D.

Abstract:
Analyst research helps prices reflect information about a security's fundamentals. However, analysts' private incentives potentially contribute to misleading research and it is possible that the market fixates on such misleading and/or optimistic reports. We examine cross-sectional determinants of the informativeness of analyst reports, i.e., their effect on security prices, controlling for endogeneity among the factors affecting informativeness. Analysts are more informative when the potential brokerage profits are higher (e.g., high trading volume and high volatility) and when they reveal "bad news." Analyst informativeness is reduced in circumstances of increased information processing costs. We fail to find evidence that informativeness of analyst reports is due to market's fixation or over- or under-reaction to analyst reports.

Analyst, Forecast, Analyst Forecast, Earnings Forecast, Informativeness, Market Efficiency

Abstract:
In this study, we examine whether managers delay disclosure of bad news relative to good news. If managers accumulate and withhold bad news up to a certain threshold, but leak and immediately reveal good news to investors, then we expect the magnitude of the negative stock price reaction to bad news disclosures to be greater than the magnitude of the positive stock price reaction to good news disclosures. We present evidence consistent with this prediction. Our analysis suggests that management, on average, delays the release of bad news to investors.

Bad News, Conservatism, Disclosure

Abstract:
We review recent empirical work on the determinants of the cross-section of expected returns. This literature, which includes the influential work by Fama and French (1992, 1993), tends to ignore the positive evidence on beta and to overemphasize the importance of book-to-market. Kothari, Shanken, and Sloan (1995) show that beta significantly explains the cross-sectional variation in average returns, but that size also has incremental explanatory power. We find that, while statistically significant, the incremental benefit of size given beta is surprisingly small economically. Book-to-market is a weak determinant of the cross-sectional variation in average returns among large firms and it fails to account for returns from momentum strategies. This raises doubts about the forecasting power of book-to-market.

Abstract:
We show that the agency theory of overvalued equity (see Jensen, 2005) rather than investors' fixation on accruals explains the accrual anomaly, i.e., abnormal returns to an accrual trading strategy (see Sloan, 1996).Under the agency theory of overvalued equity, managers of overvalued firms are likely to manage their firms' accruals upwards to prolong the overvaluation.Thus, high-accrual portfolios are likely to be over-represented with over-valued firms.Overvaluation, however, cannot be sustained indefinitely and we expect price reversals for high accrual firms.In contrast, undervalued firms do not face incentives to report low accruals, so undervalued firms are not concentrated in low accrual decile portfolios.Therefore, across the accrual decile portfolios, we predict and find an asymmetric relation between accruals and both prior and subsequent returns.In addition, consistent with the predictions of the agency theory of overvalued equity, we find high, but not low, accrual firms' investment-financing decisions and insider trading activity are distorted, and analyst forecast optimism is concentrated among the high-accrual decile portfolios.Overall, return behavior, analyst optimism, investment-financing decisions, and insider trading activity are all consistent with the agency theory of overvalued equity, but do not support investor fixation on accruals.

accrual anomaly; earnings management; agency theory of overvalued equity

Abstract:
Investors, regulators, academics, and researchers all emphasize the importance of comparability. However, an empirical construct of financial statement comparability is typically not specified. In addition, little evidence exists on the benefits of comparability to users. This study attempts to fill these gaps. We develop two measures of financial statement comparability. Empirically, these measures are positively related to analyst following and forecast accuracy, and negatively related to analysts’ optimism and dispersion in earnings forecasts. These results suggest that financial statement comparability lowers the cost of acquiring information, and increases the overall quantity and quality of information available to analysts about the firm.

Abstract:
Based on extant literature, we articulate a positive theory of GAAP under the assumption that the objective is to facilitate the efficient allocation of capital within an economy. The theory predicts that GAAP’s principal focus, as shaped by the demand for and supply of financial information, is on the use of the income statement and balance sheet for performance measurement and control (stewardship). This is consistent with efficient contracting considerations guiding financial reporting. Financial reports produced under this model also generate information useful for equity valuation but this is not the primary objective. Thus, artificially imposing equity valuation as the primary objective of financial reporting standards will result in GAAP rules that are unlikely to serve stakeholders’ needs. The theory allows us to compare and contrast extant GAAP, as observed in a regulated setting, with GAAP that might arise endogenously as a result of market forces. Building on previous research, we argue that verifiability and conservatism, while detracting from accounting’s role in equity valuation, are critical features of GAAP under efficient contracting. We recognize the advantage of using fair values in circumstances where these are based on observable prices in liquid secondary markets but caution against expanding fair values to financial reporting more generally. We conclude that rather than converging U.S. GAAP with IFRS, competition between the FASB and the IASB would allow GAAP to better respond to market forces.

Abstract:
We show that the greater the extent to which a performance measure matches delivered performance, the simpler and more robust are the compensation plans based on it. In some settings stock price changes match delivered performance poorly because they anticipate it. This introduces three problems with price-based plans relative to an earnings-based plan. First, the price-based plans become complex because they require knowing the extent to which prices anticipate the future. Second, price-based plans are less robust to unforeseen events. Third, price-based plans require period-by-period changes in pay-for-performance relationship even when the underlying production function remains unchanged. Earnings-based plans are used in these settings if earnings better match delivered performance.

Abstract:
We argue that the previously documented association between ex ante information (e.g. earnings forecasts) and the subsequent, apparently predictable security price performance is exaggerated. The exaggeration stems from non-random deletion of data, especially in highly right-skewed distributions of long-horizon security returns. Our simulations demonstrate that both forecast optimism and negative abnormal returns are induced when "extreme" observations of ex post long-horizon performance are truncated from samples of rationally priced, unbiased earnings forecasts. Our results suggest caution in interpreting the results of the accounting and finance research that examines the predictability of long-horizon performance based on ex ante information.

Abstract:
We document systematic evidence of risk effects of disclosures culled from a virtually exhaustive set of sources from the print medium. We content analyze more than 100,000 disclosure reports by management, analysts, and news reporters (i.e., financial press) in constructing firm-specific disclosure measures that are quantitative and amenable to replication in future. We expect credibility and timeliness differences in the disclosures by source, which would translate into differential cost of capital effects. We find that when content analysis indicates favorable disclosures, the firm's risk as proxied for by the cost of capital, stock return volatility, and analyst forecast dispersion decline significantly. In contrast, unfavorable disclosures are accompanied by significant increases in risk measures. Analysis of disclosures by source - corporations, analysts, and the financial press - reveals that negative disclosures from financial press sources result in increased cost of capital and return volatility, and favorable reports from financial press reduce the cost of capital and return volatility.

Content Analysis of Disclosure, Cost of Capital

Abstract:
We document frequent and large selling of equity by CEOs. Such selling is designed not simply to offset the current year grant of options and stock. We find that the tax burden associated with the sale and (various measures of CEO) overconfidence both decrease CEOs' propensity to sell their vested equity. However, the effect of taxes on a CEO's decision to sell equity is far more pronounced than overconfidence. We also find that taxable institutional investors and CEOs both respond to taxes, although the CEOs appear to be less tax-sensitive. Other determinants affect the selling decisions largely as predicted in the existing literature.

Executive compensation, taxation, overconfidence, behavioral finance, institutional investors

Abstract:
We examine how personal taxes affect CEOs' decision to sell their vested equity and compare it against diversification, managerial overconfidence and other determinants of CEOs' sale of equity. While CEOs frequently sell large amounts of their unrestricted firm equity, we find that the tax burden associated with the sale deters CEOs from selling their equity. The effect of taxes remains significant even after controlling for other determinants of CEOs' sale of equity. We also find that taxable institutional investors and CEOs both respond to taxes in their selling of equity, although the CEOs appear to be less tax-sensitive. Other determinants affect CEOs' selling decisions largely as predicted in the existing literature.

Executive Compensation, Taxation, Overconfidence, Behavioral Finance, Institutional investors

Abstract:
We show that the greater the extent to which a performance measure matches delivered performance, the simpler and more robust are the compensation plans based on it. In some settings stock price changes match delivered performance poorly because they anticipate it. This introduces three problems with price-based plans relative to an earnings-based plan. First, the price-based plans become complex because they require knowing the extent to which prices anticipate the future. Second, price-based plans are less robust to unforeseen events. Third, price-based plans require period-by-period changes in pay-for-performance relationship even when the underlying production function remains unchanged. Earnings-based plans are used in these settings if earnings better match delivered performance.

Abstract:
A model of earnings, cash flows and accruals is developed assuming a random walk sales process, variable and fixed costs, and that the only accruals are accounts receivable and payable, and inventory. The model implies earnings better predict future operating cash flows than current operating cash flows and the difference varies with the operating cash cycle. Also, the model is used to predict serial and cross-correlations of each firm's series. The implications and predictions are tested on a 1337 firm sample over 1963-1992. Both earnings and cash flow forecast implications and correlation predictions are generally consistent with the data.

Accruals, cash flows, earnings, correlations

Abstract:
Predictability of future returns using ex ante information (e.g., analyst forecasts) violates market efficiency. We show that predictability can be due to non-random data deletion, especially in skewed distributions of long-horizon security returns. Passive deletion arises because some firms do not survive the post-event long horizon. Active deletion arises when extreme observations are truncated by the researcher. Simulations demonstrate that data deletion induces a negative relation between future returns and ex ante information variables. Analysis of actual data suggests a 30-50% bias in the estimated relations. We recommend specific robustness checks when testing return predictability using ex ante information.

Capital markets, Market efficiency

Abstract:
In the study reported here, we set out to examine whether and how the availability of indexed bonds might affect investors' asset allocation decisions. We used historical yields on conventional U.S. T-bonds and an inflation-forecasting model to create a series of hypothetical indexed bond returns. We found that the real (inflation-adjusted) returns on indexed bonds are less volatile than the returns on otherwise similar conventional bonds. Moreover, the correlation with stock returns is much lower for the indexed bonds. An examination of asset allocation among stocks, indexed bonds, conventional Treasuries, and a riskless asset suggests that substantial weight should be given to indexed bonds in an efficient portfolio. These conclusions are generally supported by analysis of the history of actual returns on U.S. Treasury Inflation-Indexed Securities (commonly known as TIPS) for February 1997 through July 2003.

Portfolio Management, asset allocation, Debt Investments, return or yield measures, Economics

Abstract:
We find evidence that conflicts of interest arising from M&A relations influence analysts' recommendations, corroborating regulators' and practitioners' suspicions in a setting, i.e. M&A relations, not previously examined in research on analyst conflicts. In addition, the M&A context allows us to disentangle the conflict of interest effect from selection bias. We find that analysts affiliated with acquirer advisors upgrade acquirer stocks around M&A deals, even around all-cash deals, wherein selection bias is unlikely. Also consistent with conflict of interest, but not selection bias, target-affiliated analysts publish optimistic reports about acquirers after, but not before, the exchange ratio of an all-stock deal is set.

Corporate Finance, Investment Banking, Analysts, Conflict of Interest

Abstract:
Accounting for employee stock options (ESOs) is controversial, with many arguing that it has substantial economic consequences. Such arguments rely on the assumption that one or more interested parties fixate on accounting numbers and fail to understand the real costs and benefits of ESOs. We review the various accounting issues and economic consequence arguments created by ESOs. We conclude that the accounting should facilitate a clear and consistent understanding of the costs of doing business, and that expensing ESOs best achieves this objective.

Accounting for Employee Stock Options, Stock Option Expense, Diluted Earnings Per Share

Abstract:
Many claim that GAAP financial information has become largely irrelevant to explaining valuations. Core et al. compare financial information's value relevance for the New Economy stocks with other stocks. We supplement their analysis with new evidence on the economic determinants of the time-series variation in the coefficients mapping financial information into prices. We document significant variation in the coefficients related to proxies for changing market growth expectations and discount rates and additional variation consistent with time-varying correlated omitted variables. Such findings make it difficult to draw unambiguous inferences about the relevance and reliability of financial information from value-relevance regressions.

Value Relevance, Correlated Omitted Variable Bias, Growth Expectations and Discount Rates

Abstract:
In this study, we propose and implement a new method to estimate the relation between investments in R&D and the uncertainty of future benefits from those investments. The empirical analysis compares the relative contributions of current investments in R&D and PP&E to future earnings variability using a sample of roughly 50,000 firm-year observations from 1972-1997. Evidence is strongly consistent with the hypothesis that R&D investments generate future benefits that are far more uncertain than benefits from investments in PP&E. Our results, together with existing evidence on value relevance of R&D, should help the current discussion on accounting for R&D.

R&D; Capitalization

Abstract:
Public discussion about corporate use of derivatives focuses on whether firms use derivatives to reduce or increase firm risk. In contrast, empirical, academic studies of corporate derivatives-use take it for granted that firms hedge with derivatives. Using data from financial statements of 425 large U.S. corporations, we investigate whether firms systematically reduce or increase their riskiness with derivatives. We find that many firms manage their exposures with large derivatives positions. Nonetheless, compared to firms that do not use financial derivatives, firms that use derivatives display few, if any, measurable differences in risk that are associated with the use of derivatives.

Abstract:
Research on trading rule profitability usually simulates trading on historical data. These data usually are obtained from files such as CRSP, which estimate closing prices as the last trade (at the closing bid or the closing ask, or neither), or the bid-ask average (in the absence of a last trade). A trading rule could not normally be implemented at these prices, for even a smaller number of shares. A simulated contrarian strategy transforms noise in closing price estimates into return biases, by buying at predominantly bid prices and shorting at ask, which is not implementable for most investors. The bias in estimated contrarian portfolio returns is severe. For example, when returns are calculated from successive bid prices of NASDAQ stocks, short-term contrarian profits largely disappear

Abstract:
The nature of corporate hedging behavior is largely unexplored in the existing empirical literature. We attempt to fill this gap by analyzing data from annual financial statements of 425 large US corporations. The sample reveals that many firms actively manage their exposures with sizable derivative positions. Non-financial firms are active in both currency and interest rate derivatives. Contrary to current reports of large derivative losses at a few corporations, such losses are atypical. Compared to corporations that do not use financial derivatives, corporations that do use derivatives display few if any measurable differences in their risk characteristics that can be attributed to derivatives. These results are consistent with the notion that firms use financial derivatives to hedge their inherent exposures to underlying price risks rather than as a tool for speculation.

Abstract:
What does it mean to assert that the CAPM is "dead?" Like Fama and French (1995), we focus on the practical issue of whether betas defined with respect to commonly-employed market proxies provide useful information about expected returns. The possibility that a more comprehensive market index might yield different results is recognized, but not pursued here. We present evidence on the ability of beta and size to explain cross-sectional variation in average returns for 100 portfolios ranked on size and then beta. In particular, the extent to which size is incrementally helpful in explaining average portfolio returns is assessed. We find that, the incremental benefit of size, given beta, while statistically significant, is economically small in estimating expected portfolio returns. We review the evidence indicating that the book-to-market (B/M) effect documented in previous research is exaggerated due to selection biases. Survivor biases are unlikely in large firm samples. Among these firms, the B/M effect is considerably smaller than that observed by Fama and French (1992), consistent with survivor/selection biases leading to an overstated B/M effect. The B/M effect is correlated with past returns, firm size, bid-ask spreads and, possibly, shifts in the investment opportunity set. Therefore, B/M might proxy for rationally priced factors not modeled in the basic CAPM, and average returns will likely continue to be related to B/M in future, although less strongly than in the historical relation.

Abstract:
GAAP provides management with discretion over accounting accruals. Management might use the discretion to improve earnings as a measure of firm performance, or engage in opportunistic management of discretionary accruals. Empirical research on accrual management requires a model to identify discretionary accruals. We assess the effectiveness of alternative discretionary-accrual models using expected relations between stock returns and earnings components under the performance-measure and opportunistic-management-of-accruals hypotheses. None of the five models examined in the paper is effective in isolating discretionary accruals. We find that the discretionary-accrual models randomly decompose earnings into discretionary and nondiscretionary components.

Abstract:
This paper studies the specification of tests for long-horizon (i.e., multiyear) abnormal security returns around firm-specific events, using samples of randomly selected securities and simulated event dates. The main result is that typical long-horizon tests are misspecified. The tests have a severe tendency to indicate abnormal performance when none is present, with rejection frequencies sometimes exceeding 5 to 10 times the significance level of the test. The result is not sensitive to the specific model used for estimating abnormal returns. The parametric test statistics do not satisfy their assumed properties. We identify several sources of misspecification.

Abstract:
We assess earnings lack of timeliness and value- irrelevant noise in earnings as explanations for the weak contemporaneous return-earnings association. Earnings lack timeliness because objectivity, verifiability, and conservatism conventions underlie the accounting measurement process. Noise in earnings is uncorrelated with returns in all periods. It likely gets introduced when estimates of future cash flows that differ from the markets estimates are included in earnings determined by accounting rules. Consistent with earnings lacking timeliness, we find current and future return earnings adjusted for expectational errors explain roughly 3-6 times as much of the annual return variation than current earnings alone.

Abstract:
We find reliable evidence that both dividend yield and book-to-market (B/M) track time-series variation in expected real one-year stock returns over the period 1926-91 and the subperiod 1941-91. The B/M relation is stronger over the full period, while the dividend yield relation is stronger in the subperiod. For the equal-weighted index, the full- period slope coefficient on B/M is so large as to imply that expected real returns are sometimes negative, raising doubts about market efficiency. In this case, the hypothesis that expected real returns are never negative is rejected, using bootstrap methods, at the 0.02 level. A Bayesian bootstrap procedure implies that an investor with prior belief 0.5 that expected real returns are never negative comes away from the B/M evidence dramatically revising that belief, with posterior probability only about 0.05 for the hypothesis. The post-40 evidence is consistent with expected returns always being positive, however.

Abstract:
We study standard mutual fund performance measures, using simulation procedures combined with random and random-stratified samples of NYSE and AMEX securities. We track simulated fund portfolios over time. These portfolios' performance is ordinary, and well-specified performance measures should not indicate abnormal performance. Our main result, however, is that the performance measures are badly misspecified. Regardless of the performance measure, there are indications of abnormal fund performance, including market-timing ability, when none exists.

Abstract:
We show that compensation contracts based on measures of Delivered performance are less costly to shareholders. We compare stock-price changes, earnings, and cash flows as performance measures, and predict that each measure's use in contracts will increase in its contemporaneous correlation with delivered performance. We discuss settings in which each measure has higher contemporaneous correlation with delivered performance than the others. Earnings-based compensation plans are sometimes superior to price-based plans because prices confound delivered performance with expected future performance, and they are sometimes inferior to price-based plans because earnings can lag delivered performance. If mark-to-market accounting causes these expectations to be incorporated in book values, then accounting numbers will be less useful for contracting purposes.

Abstract:
Accounting earnings are often criticized for being manipulable by managers. However, earnings-based compensation plans are ubiquitous. Our theoretical model evaluates net cash flows, accounting earnings, and stock prices as potential performance measures and shows that earnings are often better matched with delivered performance than the other two. Thus it provides an explanation for the popularity of earnings-based compensation plans.

Abstract:
This paper develops a simple integrated model of firm's earnings cash flows and accruals that generates serial and cross-correlation predictions for those series. The model assumes sales follow Erandom walk costs are either variable or fixed and traditional accounting working capital accruals. We use estimates of each firm's contribution margin trade cycle and variance of fixed cost relative to sales variance to predict serial correlations and cross- correlations for each firm's series. The predictions are tested on a 1036 firm sample over the 1963-1992 period. The average actual correlation has the same sign as and similar magnitude to the average predicted correlation for all correlations. The evidence suggests the model is a significant first step towards explaining time series properties of earnings cash flows and accruals.