• Selected
• Entire List

Abstract:
We examine 2,190 SEC Accounting and Auditing Enforcement Releases (AAERs) issued between 1982 and 2005. We obtain 676 firms that are alleged to have misstated their quarterly or annual financial statements. We examine the characteristics of misstating firms along five dimensions: accrual quality; financial performance; non-financial measures; off-balance sheet activities; and market-based measures. We compare misstating firms to themselves during non-misstatement years and misstating firms to the broader population of all publicly listed firms. The results reveal that during misstatement years, accruals and cash and credit sales are unusually high, while return on assets and the number of employees are declining. In addition, misstating firms finance more of their assets through operating leases and have relatively less PP&E. We find that market pressures appear to affect incentives to misstate. Misstating firms are raising new financing, have higher market-to-book ratios, and strong prior stock price performance. We develop a model to predict accounting misstatements. The output of this model is a scaled logistic probability that we term the F-Score, where values greater than one suggest a greater likelihood of a misstatement.

earnings quality, accounting misstatement, fraud prediction, accrual quality, F-Score

Abstract:
We address the fact that accounting academics often have very different perceptions of earnings management than do practitioners and regulators. Practitioners and regulators often see earnings management as pervasive and problematic, and in the need of immediate action to remedy. Academics are more sanguine, unwilling to believe that earnings management is being actively practiced by most firms or that the earnings management that does exist should necessarily concern investors. We explore the reasons for these different perceptions, and argue that each of these groups may benefit from some rethinking of their views about earnings management.

Abstract:
This paper suggests a new measure of one aspect of the quality of accruals and earnings. The major benefit of accruals is to reduce timing and mismatching problems in the underlying cash flows. However, accruals accomplish this benefit at the cost of making assumptions and estimates about future cash flows, which implies that accruals include errors of estimation or noise. Since estimation noise reduces the beneficial role of accruals, this study suggests that the quality of accruals and earnings is decreasing in the magnitude of estimation noise in accruals. More specifically, we develop a simple model of working capital accruals where accruals correct the timing problems in cash flows at the cost of including errors in estimation. Based on the model, we derive an empirical measure of accrual quality as the residual from firm-specific regressions of changes in working capital on past, present, and future operating cash flow realizations. The study concludes with two empirical applications that illustrate the usefulness of our measure of accrual quality. First, we explore the relation of accrual quality to economic fundamentals. We find that accrual quality is negatively related to the magnitude of total accruals, length of the operating cycle, and the standard deviation of sales, cash flows, and earnings, while it is positively related to firm size. Second, we show a strong positive relation between accrual quality and earnings persistence.

Quality; Accruals; Earnings; Persistence; Estimation; Errors

Abstract:
Firms with low ratios of fundamentals (such as earnings and book values) to market values are known to have systematically lower future stock returns. We document that short-sellers position themselves in the stock of such firms, and then cover their positions as the ratios revert to normal levels. We also show that short-sellers avoid firms where the transaction costs of short-selling are high and where the low ratios are due to temporarily low fundamentals, rather than temporarily high prices. Our evidence suggest that short-sellers use information in these ratios about either (i) temporary mispricing, or (ii) unknown risk factors, to boost their investment returns.

Abstract:
We derive a measure of implied equity duration as a natural extension of the traditional measure of bond duration and develop an algorithm for the empirical estimation of implied equity duration. We show that the standard empirical predictions and results for bond duration hold for our measure of implied equity duration and that implied equity duration represents an important common factor in stock returns. We also show that the book-to-market factor advocated by Fama and French (1993) acts as a noisy proxy for an underlying duration factor. Finally, we provide evidence that the long-run equity yield curve is downward sloping for durations up to 20 years. Our results suggest that existing empirical tests of asset pricing models using short holding period equity returns are misspecified.

Duration, risk, factors, premium, valuation, returns

Abstract:
We derive a measure of implied equity duration as a natural extension of the traditional measure of bond duration and develop an algorithm for the empirical estimation of implied equity duration. We show that the standard empirical predictions and results for bond duration hold for our measure of implied equity duration and that implied equity duration represents an important common factor in stock returns. We also show that the book-to-market factor advocated by Fama and French (1993) acts as a noisy proxy for an underlying duration factor. Finally, we provide evidence that the long-run equity yield curve is downward sloping for durations up to 20 years. Our results suggest that existing empirical tests of asset pricing models using short holding period equity returns are misspecified.

Duration, risk, factors, premium, valuation, returns

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 evaluate the role of sell-side analysts' long-term earnings growth forecasts in the pricing of common equity offerings. We find that, in general, sell-side analysts' long-term growth forecasts are systematically overly optimistic around equity offerings and that analysts employed by the lead managers of the offerings make the most optimistic growth forecasts. Additionally, we find a positive relation between the fees paid to the affiliated analysts' employers and the level of the affiliated analysts' growth forecasts. We also document that the post-offering under performance is most pronounced for firms with the highest growth forecasts made by affiliated analysts. Finally, we demonstrate that the post-offering under performance disappears once we control for the over optimism in earnings growth expectations. Thus, the evidence presented in this paper is consistent with the 'equity issue puzzle' arising from overly optimistic earnings growth expectations held at the time of the offerings.

Abstract:
Accounting rules for valuing retained interest from securitizations require management to make assumptions concerning discount rates, default rates, and prepayment rates. These assumptions provide management with discretion to determine the “gain on sale” of the receivables. We investigate whether CEO compensation is less sensitive to securitization gains than to other earnings components in the presence of proxies for how independent (outsiders, females, fewer CEO-selected directors) and informed (financial expertise) directors are. Overall, out results do not suggest that better “monitoring” reduces earnings management or CEO pay-sensitivity to reported securitization gains. Our results suggest that CEOs are rewarded for the gains they report and boards do not intervene.

securitizations, fair value, earnings management, financial expertise, outside directors, gains, asset derecognition

Abstract:
We provide evidence that managers use the discretion afforded by fair-value accounting rules to manage the size of reported securitization gains. We show that the ambiguity allowed in discount rate choice is one way that managers can influence these gains. We investigate whether CEO compensation is less sensitive to securitization gains than to other earnings components in the presence of proxies for how independent (outsiders, females, fewer CEO-selected directors) and informed (financial expertise) directors are. We find weak evidence of less earnings management in firms with more independent boards, but find no evidence that our director characteristics influence CEO pay-sensitivity to the gains. Thus, boards do not appear to intervene and adjust compensation for implementation problems related to fair-value accounting rules for securitizations.

securitizations, earnings management, fair value, financial expert, outside directors, reliability, gain

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:
We argue that high accruals are likely to be the outcome of rules with an income statement perspective, while low accruals are likely to be the outcome of rules with a balance sheet perspective and that this has implications for the properties of earnings. Specifically, earnings persistence is affected both by the magnitude and sign of the accruals. Accruals improve the persistence of earnings relative to cash flows in high accrual firms, but reduce earnings persistence in low accrual firms. We show that the low persistence of earnings in low accrual firms is primarily driven by special items. We then show that special item-low accrual firms have higher future stock returns than other low accrual firms. This is consistent with investors misunderstanding the transitory nature of special items. Further analysis reveals that special item-low accrual firms have poor past performance and declines in investor recognition (analyst coverage and institutional holdings). Special items continue to explain future returns after controlling for these factors.

accrual anomaly, earnings persistence, cash flows, special items, investor recognition

Abstract:
We argue that high accruals are likely to be the outcome of rules with an income statement perspective, while low accruals are likely to be the outcome of rules with a balance sheet perspective and that this has implications for the properties of earnings. Specifically, earnings persistence is affected both by the magnitude and sign of the accruals. Accruals improve the persistence of earnings relative to cash flows in high accrual firms, but reduce earnings persistence in low accrual firms. We show that the low persistence of earnings in low accrual firms is primarily driven by balance sheet adjustments relating to special items. We then show that low accrual firms with special items have higher future stock returns than other low accrual firms. This is consistent with investors misunderstanding the transitory nature of special items. Further analysis reveals that special item-low accrual firms have performed poorly, are financially distressed, and have declines in investor recognition (analysts coverage and institutional holdings). We find that special items continue to explain future returns after controlling for these factors. Our results suggest that investors underestimate the probability that special item-low accrual firms will successfully turn themselves around.

Earnings, cash flows, special items, accruals, anomaly, future returns

Abstract:
Relative to recording securitizations as collateralized borrowings, the "gain on sale" treatment allowable under SFAS 125/140 has several accounting benefits such as reducing leverage, increasing profits, and improving efficiency ratios. We argue that to maximize these accounting benefits managers will want to engage in securitizations at the end of the quarter. We document that securitization transactions occur with greater frequency in the last few days of the third month of the quarter. We also find that the end-of-quarter effect is stronger after the introduction of SFAS 125 that made it easier for firms to meet criteria for "gain on sale" treatment. We provide various robustness tests that suggest that the clustering is not due to the demand for the underlying assets, demand for financing, or a decision on the part of firms to systematically perform securitizations at month-end. Overall the consistent explanation for our findings is that flexibility to window-dress the financial statements is an attractive side benefit of engaging in securitizations.

securitizations, window-dressing, timing, SFAS 125, SFAS 140

Abstract:
Over the years, researchers have devised various measures of “earnings quality” to represent decision usefulness in specific decision contexts. These measures, however, have become proxies for “earnings quality” in a generic sense, absent a decision context. The result is that some papers use a proxy for earnings quality that does not match the hypothesized form of decision usefulness in their study, but they nonetheless find results that are consistent with their hypothesis. Other papers are intentionally agnostic and find robust results across multiple proxies for earnings quality. The fact that researchers find consistent and robust results across proxies suggests that there is common component to the various measures of quality, which is the firm’s fundamental earnings process. Existing research does not clearly distinguish the impact of a firm’s fundamental earnings process on the decision usefulness (“quality”) of its earnings from the impact of the application of accounting measurement to that process. Research attention has focused on earnings management that reduces the reliability of earnings rather than on the ability of specific features of an accrual-based accounting system to provide a more decision-useful measure, conditional on the firm’s fundamental earnings process.

earnings quality, accruals, earnings persistence, earnings response coefficient

Abstract:
Analysts who lack information on a company are likely to round their forecasts to the nearest multiple of five (10, 15, 20, etc). As information flow improves this rounding tendency is likely to dissipate. Information flow improved for analysts after 1995 with the advent of web browsers and the increase use of conference calls. Consistent with a structural change in information flow, we find that the proportion of analysts rounding their short-term EPS forecasts declines monotonically from 60 percent prior to 1995 to 28 percent by 2006 (the expected percentage is 20). We also document an improvement in the relative accuracy of rounded forecasts after 1995. We argue that changes in information flow after 1995 will have less impact on long-term growth forecasts since most information revealed in conference calls is short-term in nature. Consistent with this view, we find that the proportion of long-term growth forecasts rounded to the nearest multiple of five stays at around 40 percent with little improvement in accuracy over time. We document that when analysts round to the nearest multiple of five, they tend to round up (be optimistic). We examine investor response to rounded forecasts and find that investors are not fully aware of this optimism.

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:
Duration is an important and well-established risk characteristic for fixed income securities. We use recent developments in financial statement analysis research to construct a measure of duration for equity securities. We find that the standard empirical predictions and results for fixed income securities extend to equity securities. We show that stock price volatility and stock beta are both positively correlated with equity duration. Moreover, estimates of common shocks to expected equity returns extracted using our measure of equity duration capture a strong common factor in stock returns. Additional analysis shows that the book-to-market ratio provides a crude measure of equity duration and that our more refined measure of equity duration subsumes the Fama and French (1993) book-to-market factor in stock returns. Our research shows how structured financial statement analysis can be used to construct superior measures of equity security risk.

Duration, asset pricing, risk, financial statement analysis

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:
This paper evaluates alternative models for detecting earnings management. The paper restricts itself to models that assume the construct being managed is discretionary accruals, since such models are commonly used in the extant accounting literature. Existing models range from simple models in which discretionary accruals are measured as total accruals, to more sophisticated models that separate total accruals into a discretionary and a non-discretionary component. Prior to this paper, there had been no systematic evidence bearing on the relative performance of these alternative models at detecting earnings management. This paper evaluates the relative performance of the competing models by comparing the specification and power of commonly used test statistics across the measures of discretionary accruals generated by each model. The specification of the test statistics is evaluated by examining the frequency with which they generate type I errors for a random sample of firm-years and for samples of firm-years with extreme financial performance. We focus on samples with extreme financial performance because the stimuli investigated in previous research are frequently correlated with financial performance. The first sample of firms are targeted by the Securities and Exchange Commission for allegedly overstating annual earnings and the second sample is created by artificially introducing earnings management into a random sample of firms.

Abstract:
This paper investigates the motivations for managers' decisions to overstate earnings and examines the consequences of such decisions. We examine firms subject to enforcement actions by the Securities and Exchange Commission for having violated the financial reporting requirements of the securities laws. In addition to considering the traditional bonus and debt hypotheses as motivations for earnings management, we also investigate the hypothesis that earnings management is systematically related to firms' demands for external financing. We argue that by employing aggressive accounting policies, firms temporarily inflate their market values and temporarily reduce their costs of capital. Thus, managers of firms with high current demands for external financing have incentives to increase reported earnings. Further, we argue that aggressive reporting is more likely to occur in firms with poor governance structures. The empirical evidence supports our predictions. Relative to a matched control sample, aggressive reporters are in greater need of external financing and have poor governance structures. They have fewer outsiders on their boards of directors; are more likely to have their chief executive officers be chairmen of their boards; are less likely to have audit committees; and are less likely to have large outside blockholders. We also investigate the consequences of aggressive reporting. When management are identified as aggressive reporters, their firms' stock prices fall and they face less liquid markets for their securities and higher costs of capital.

Abstract:
This study investigates firms subject to accounting enforcement actions by the Securities and Exchange Commission (SEC) for alleged violations of GAAP. We investigate: (i) the extent to which the alleged earnings manipulations can be explained by extant earnings management hypotheses; (ii) the relation between the earnings manipulations and weaknesses in the firms' internal governance structures; and (iii) the capital market consequences experienced by the firms when the alleged earnings manipulations are made public. We find that an important motivation for earnings manipulation is the desire to attract external financing at low cost. We show that this motivation remains significant after controlling for contracting motives proposed in the academic literature. We also find that firms manipulating earnings are: (i) more likely to have boards of directors dominated by management; (ii) more likely to have a CEO who simultaneously serves as Chairman of the Board; (iii) more likely to have a CEO who is also the firm's founder; (iv) less likely to have an audit committee; and (v) less likely to have an outside blockholder. Finally, we document that firms manipulating earnings experience significant increases in their costs of capital when the manipulations are made public.

Abstract:
This paper evaluates the implications of nondiscretionary accruals for earnings management and market-based accounting research. We develop a simple model in which earnings management is absent and nondiscretionary accruals perform their intended function of insulating earnings from non-cash working capital shocks. Our analysis indicates that existing techniques for measuring earnings management are likely to misclassify some nondiscretionary accruals as discretionary accruals. Further, we show that certain 'significant' results in existing earnings management research are consistent with the misclassification of nondiscretionary accruals. Finally, we provide a framework for understanding the pricing of cash flow and nondiscretionary accrual components of earnings.

Abstract:
This paper examines the ability of hypotheses based on naive investor expectations to explain the higher returns to contrarian investment strategies. Inconsistent with Lakonishok, Shleifer and Vishny (1995), we find no systematic evidence that stock prices naively reflect extrapolation of past trends in earnings and sales growth. Consistent with Bauman and Dowen (1988) and La Porta (1994), we find that stock prices appear to naively reflect analysts' biased forecasts of future earnings growth. Further, we show that naive reliance on analysts' forecasts of future earnings growth can explain over half the higher returns to contrarian investment strategies.

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.

Abstract:
This study investigates the economic consequences of the FASB's 1993 Exposure Draft requiring the expensing of employee stock options. We examine (i) a sample of firms in industries that are intensive users of employee stock options; (ii) a sample of firms in an emerging 'high-tech' industry (biotechnology); and (iii) a sample of firms submitting comment letters to the FASB opposing the expensing of employee stock options. Our results indicate that investors do not share corporate America's concerns that expensing employee stock options would have negative economic consequences. Additional tests show that corporate America's opposition to expensing is concentrated in firms that use options extensively for top executives rather than in firms with high overall levels of option usage.