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Abstract:
We study the effect of the Global Analyst Research Settlement and related regulations on sell-side research. These regulations attempted to mitigate the interdependence between research and investment banking. We document that following the regulations many brokerage houses have migrated from the traditional five-tier rating system to a three-tier system. Optimistic recommendations have become less frequent and more informative, whereas neutral and pessimistic recommendations have become more frequent and less informative. Importantly, the overall informativeness of recommendations has declined. The likelihood of issuing optimistic recommendations no longer depends on affiliation with the covered firm, although affiliated analysts are still reluctant to issue pessimistic recommendations.

G14, G24, G28

Abstract:
This paper studies the effect of regulations on sell-side analysts' research. These regulations - NASD Rule 2711, NYSE Rule 472, and the Global Analyst Research Settlement - attempted to mitigate the interdependence between research and investment bank departments of U.S. brokerage houses. We document that since the regulations have been in place, many brokerage houses have migrated from the traditional five-tier rating system to a coarser three-tier system. In addition, optimistic recommendations have become less frequent and more informative, whereas neutral and pessimistic recommendations have become more frequent and less informative. Importantly, the overall informativeness of recommendations has declined. The likelihood of issuing optimistic recommendations no longer depends on whether analysts are affiliated with the covered firm, although affiliated analysts are still reluctant to issue pessimistic recommendations. An analysis of price reactions to recommendations provides mixed evidence on whether investors discount affiliated recommendations to a lesser extent than they did before the regulations.

Recommendation, Global Settlement, NASD 2711, NYSE 472, Underwriting Business, Broker

Abstract:
Sloan (1996) and a number of subsequent studies present evidence that a trading strategy based on publicly available accounting accruals earns abnormal returns of approximately 10% in the year following its initiation. This empirical regularity has been named the 'accrual anomaly'.

In this paper I investigate the accrual anomaly along two dimensions. First, I evaluate whether the accrual anomaly is related to other anomalies documented in the finance literature. Second, I investigate whether different methods for calculating long-term abnormal returns have an effect on the returns to the accrual strategy.

My results indicate that both mergers and divestitures have an effect on the returns generated by the accrual strategy. After excluding observations associated with either mergers or divestitures, there is a decrease of about 25% in the strategy's returns. Second, different calculation methods for benchmark portfolio returns do not have a material effect on the returns of the accrual strategy. Third, when book-to-market is added to size as a second control for normal returns, returns to the accrual strategy decrease by approximately 20%. Fourth, the accrual strategy's returns are much larger in a sample of Nasdaq firms. Overall, I conclude that the accrual anomaly is sensitive to the series of tests conducted in this study, although a substantial portion of it remains unexplained.

accruals, market efficiency, mispricing

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:
In this paper we offer explanations for why firms began voluntarily adopting the expensing provisions of FAS 123 in the second half of 2002. First, we find that firms with greater publicity exposure are more likely to voluntarily expense stock options, controlling for other factors such as the magnitude of the stock option expense. This publicity incentive also explains the timing of the decisions, the summer of 2002, immediately following the accounting scandals of Enron and WorldCom. Second, we find that valuation benefits from expensing stock options, proxied by market's reaction to the proposition by the FASB to undertake a project requiring firms' to expense stock options, are positively associated with the decision to expense. Third, we do not find evidence that stronger corporate governance is associated with the likelihood to expense options. Finally, we find some evidence suggesting that, compared to control firms, expensing firms reduce the number of options granted in 2002 and have started to make more changes to their compensation plans as reflected in the most recent proxy statements.

stock options expensing, publicity

Abstract:
Sloan (1996)'s result of return predictability based on accrual information has generated a large stream of literature. Sloan's (1996) explanation for the phenomenon is that investors fixate on earnings without taking into account accruals' tendency to reverse. Thus, the returns to an accrual strategy are related to accrual reversals. In this study, I directly examine this explanation. I use two properties of the accrual-fixation hypothesis - reversals and overreaction - to generate testable empirical predictions. First, I find that extreme accrual firms tend to remain in extreme deciles in two consecutive years. Further, I find that these sticky firms are associated with future abnormal returns, suggesting that the returns are not a result of accrual reversals, as implied by the accrual-fixation hypothesis. Second, I do not find any evidence of overreaction to accrual information based on the relation between the returns around earnings announcements in successive quarters. Overall, I conclude that my results are not consistent with the accrual-fixation hypothesis. A more conservative interpretation of my results is that the accrual-fixation hypothesis is not the major explanation for the accrual anomaly.

Abstract:
Using a unique database of monthly advertising spending in media outlets, we examine whether managers engage in real earnings management to meet quarterly financial reporting benchmarks. We extend prior literature by: (1) separately analyzing advertising activities, allowing us to explore novel issues such as the possibility that managers could either reduce or boost advertising to meet an earnings benchmark; (2) analyzing actual activities as opposed to inferring them from reported expenses, which are also subject to accrual choices; (3) investigating the timing, within a fiscal quarter, of altered advertising spending; and (4) examining quarterly as opposed to annual earnings benchmarks. Overall, we find that managers reduce their advertising spending to avoid losses and avoid earnings decreases. However, we also provide evidence that firms in the late stages of their life cycle choose to increase advertising to meet earnings benchmarks. Finally, we find some evidence that firms increase their advertising activities in the third month of a fiscal quarter and in the fourth quarter to meet or beat prior year’s earnings.

Real earnings management, advertising, earnings benchmarks

Abstract:
Utilizing a database that became available due to the requirements of FIN 45, we examine the informational role of accounting disclosures on warranties. First, since firms use warranty policies as a business strategy to promote their products, a warranty reserve may serve two roles: an informational signal regarding product quality as well as a contingent liability. Consistent with this view, we find that the stock market recognizes that: (1) the warranty reserve contains information about firms' future performance, and (2) the reserve is a liability. Second, since warranty accruals require estimation of future claims, they can also be used as a tool of earnings management. Our evidence indicates that managers use warranty accruals to manage earnings opportunistically to meet their earnings targets. Finally, we find that the stock market recognizes that warranty liabilities of firms that managed earnings are underestimated.

Warranty, Contigent Liaiblity, Signaling, Earnings Management

Abstract:
In addition to firm recommendations, brokers also issue recommendations for industries. We study these recommendations using data newly available from IBES. First, we find that brokers are inclined to issue optimistic recommendations to industries that show high levels of R&D intensity, past profitability and past returns, as well as to industries in which they are active in providing underwriting services. Second, industry recommendations have investment value: portfolios long in industries about which analysts are optimistic and short in industries about which analysts are pessimistic generate significant abnormal returns. Finally, we find that industry recommendations contain information that is orthogonal to that included in firm recommendations. This evidence sheds new light on the interpretation and investment value of firm recommendations. It suggests that analysts typically benchmark their firm recommendations to industry peers, even when they proclaim to be using a market benchmark. In line with this view, we show that the investment value of analysts’ recommendations is enhanced when both industry and firm recommendations are used jointly.

Industry recommendation, Analysts, Market Efficiency

Abstract:
We study the role of goodwill in promoting contracting efficiency and the effect of SFAS 141 and 142 on this role. We provide three main results. First, when a lending agreement contains some type of minimum-net-worth covenant, the probability of a tangible-net-worth covenant is decreasing in the borrower's goodwill. Second, the use of tangible-net-worth covenants has increased since the promulgation of SFAS 141 and 142. Finally, covenant slack is not significantly related to the use of tangible-net-worth covenants relative to net-worth covenants. These results suggest that contracting parties realize efficiency gains by permitting borrowers' actions to be restricted by the value of GAAP goodwill. However, the salutary effects of goodwill on contracting efficiency have been reduced due to recent changes in GAAP.

Debt Covenants, Goodwill, Financial Accounting

Abstract:
We study the role of goodwill in promoting contracting efficiency and the effect of SFAS 141 and 142 on this role. We provide three main results. First, when a lending agreement contains some type of minimum-net-worth covenant, the probability of a tangible-net-worth covenant is decreasing in the borrower's goodwill. Second, the use of tangible-net-worth covenants has increased since the promulgation of SFAS 141 and 142. Finally, covenant slack is not significantly related to the use of tangible-net-worth covenants relative to net-worth covenants. These results suggest that contracting parties realize efficiency gains by permitting borrowers' actions to be restricted by the value of GAAP goodwill. However, the salutary effects of goodwill on contracting efficiency have been reduced due to recent changes in GAAP.

Debt Covenants, Goodwill, Financial Accounting

Abstract:
We develop and test hypotheses about the economic determinants of the magnitude of the information externalities supplier firms experience at the time of their major customers' information events. We take the existence of such information externalities as given and proceed to develop and test hypotheses about their economic magnitude. As predicted, we find that the information externality suppliers experience at the time of their major customers' information events is increasing in the: (1) major customer's seasonally-adjusted change cost in of goods sold, (2) magnitude of information disclosed by the customer, (3) strength of the economic bond between the supplier and its major customer and (4) supplier's market power relative to other firms in its industry. We interpret our results as evidence of significant information externalities between suppliers and major customers. More importantly, we identify several determinants of these externalities. Our findings suggest that such effects are not limited to the same industry but also extend across the supply chain to firms belonging to different industries.

Accounting, capital markets, information flow

Abstract:
The past decade has seen increasing activity regarding the peace process between Israel and its Arab neighbors. In this paper I study the return patterns of the Tel Aviv Stock Exchange index and of Israeli firms' stocks traded in the United-States following announcements of news related to the peace process. I find that returns on the Tel Aviv Stock Exchange following political events are more extreme than returns on days that do not follow political events. This pattern is also apparent in returns of dually listed stocks (those traded both in the US and in Israel). The pattern is not present in Israeli stocks that are traded only in the US.

Political event, Stock market, Israel, Middle East, News

Abstract:
The cross-sectional approach that is typically used to estimate accrual models implicitly assumes that firms within the same industry have a homogeneous accrual generating process. In this paper, we examine this implicit assumption along three dimensions. First, we argue that the relation between working capital accruals and changes in sales is more complex than portrayed by existing empirical accrual models. In addition to sales changes, accruals are also affected by accrual determinants such as firms' inventory and credit policies. Second, we provide evidence that the assumption of a uniform accrual-generating process is violated in industries whose firms' accrual determinants are highly dispersed. Third, we document some implications of violating the assumption of a uniform accrual-generating process. Firms in industries with high variations in accrual determinants are likely to have large absolute abnormal accruals. We show that the previously-documented increase in the absolute level of abnormal accruals over time could be attributed, in part, to the increased heterogeneity in industries with respect to their accrual-generating processes.

accrual models, earning management

Abstract:
We examine whether successful research and development (R&D) efforts are associated with higher levels and lower variability of future operating performance. Consistent with the uncertainty of R&D’s future benefits, prior studies hypothesize and find a positive relation between R&D and the variability of future earnings. However, such an approach assumes constant marginal productivity of R&D in the cross-section which is unlikely to be the case. We advance the accounting literature on the informational role of R&D expense by studying the effects of measures of innovation outputs, namely patent counts and patent citations which proxy for the economic value of innovation. We predict and find that future operating performance is positively associated with the quality of patents and that this relation is stronger for more productive and innovative firms. We also predict and find that the volatility of future operating performance is negatively associated with patent quality and that the association is more negative for firms whose patents are highly cited. Thus, firms whose R&D is more productive exhibit higher and less volatile future operating performance. Our study demonstrates that the relation between R&D expense (i.e., inputs) and future operating performance is better understood by incorporating information about the productivity (i.e., outputs) of a firm’s R&D outlays in the form of patent counts and citations.

Abstract:
Using a unique database of monthly advertising spending in media outlets, we examine whether managers engage in real earnings management to meet quarterly financial reporting benchmarks. We extend prior literature by: (1) separately analyzing advertising activities, allowing us to explore novel issues such as the possibility that managers could either reduce or boost advertising to meet an earnings benchmark; (2) analyzing actual activities as opposed to inferring them from reported expenses, which are also subject to accrual choices; (3) investigating the timing, within a fiscal quarter, of altered advertising spending; and (4) examining quarterly as opposed to annual earnings benchmarks. Overall, we find that managers reduce their advertising spending to avoid losses and avoid earnings decreases. However, we also provide evidence that firms in the late stages of their life cycle choose to increase advertising to meet earnings benchmarks. Finally, we find some evidence that firms increase their advertising activities in the third month of a fiscal quarter and in the fourth quarter to meet or beat prior year’s earnings.

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