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Abstract:
We provide large sample evidence on whether the equity and debt markets impound information about the quality of earnings. We examine eight proxies for earnings quality (four based on the modified Jones approach to estimating abnormal accruals; three based on the Dechow and Dichev [2002] approach which relates working capital accruals to cash flows; and one based on a factor analysis of the other seven). Across all eight metrics, we find that firms with lower quality earnings have higher costs of capital as evidenced by lower debt ratings, larger realized costs of debt, larger industry-adjusted earnings-price ratios, larger equity betas, and positive loadings on an earnings quality factor added to one-factor and three-factor asset pricing regressions. The documented effects are statistically significant and economically meaningful: The results show, for example, that firms with the best earnings quality enjoy discounts of 80-160 basis points in their costs of debt and 150-300 basis points in their costs of equity relative to firms with the poorest earnings quality.

costs of capital, earnings quality

Abstract:
We examine the relation between the cost of equity capital and seven attributes of earnings: quality, persistence, predictability, smoothness, value relevance, timeliness and conservatism. We refer to the first four attributes as accounting-based because measures of these constructs are typically based on accounting information only. We refer to the last three attributes as market-based because proxies for these constructs are typically based on relations between market data and accounting data. Our analysis of the cost of capital effects of these attributes is based on two distinct approaches to measuring the cost of capital: a cross-sectional approach which uses ex ante cost of capital estimates derived from analyst forecast data, and a time-series approach that uses realized returns and asset pricing regressions. Across both sets of tests, we find that firms with the most favorable values of each attribute, viewed individually, enjoy significantly lower costs of capital than firms with the least favorable values. The largest cost of capital effects are found for the accounting-based attributes; within this set, earnings quality has the strongest effects. Among the market-based attributes, value relevance dominates timeliness and conservatism. Considering all attributes together, the results show that investors consistently price earnings quality and earnings persistence, and to a lesser extent, value relevance.

cost of capital, earnings quality, persistence, predictability, smoothness, value relevance, timeliness, conservatism

Abstract:
We examine whether rational investor responses to information uncertainty explain properties of and returns to accounting-based trading anomalies. We proxy for information uncertainty with two measures of earnings quality: the standard deviation of the residuals from a Dechow and Dichev [2002] model relating accruals to cash flows, and the absolute value of performance-adjusted abnormal accruals from a modified Jones [1991] model. Over 1982-2001, we find that accounting-based trading anomalies (post-earnings announcement drift, value-glamour, and accruals strategies) are correlated with earnings quality. Specifically, extreme anomaly portfolios have poorer earnings quality than non-extreme portfolios, and within the extreme anomaly portfolios, poor earnings quality securities are more prevalent and earn larger abnormal returns than good earnings quality securities. Consistent with greater resolution of uncertainty for poor earnings quality securities, the abnormal returns to poor quality securities converge to the abnormal returns to good quality securities as the post-portfolio formation period lengthens. Taken as a whole, these results indicate that information uncertainty plays an important role in explaining accounting anomalies.

anomalies, information uncertainty, earnings quality

Abstract:
We examine whether pricing effects associated with three earnings patterns (increasing annual earnings, quarterly earnings that consistently meet or exceed analyst forecasts, and smooth earnings) are related to each other and, separately, to the quality of the underlying earnings. We identify distinctly-priced incremental elements of increasing earnings and earnings quality. While the statistical significance of the incremental pricing effects of earnings smoothness and of patterns of earnings that meet or exceed analyst forecasts are mixed, in all cases, their economic importance is modest. Our main finding concerns the relation between the pricing effects of earnings patterns and earnings quality: holding constant the level of the pattern, the largest (smallest) pricing effects are associated with earnings patterns supported by high (low) quality earnings. Moreover, for all three earnings patterns, we document that the market either attaches no reward to, or imposes a penalty on, patterns achieved with low quality earnings.

earnings patterns, earnings quality

Abstract:
We investigate whether greater use of call options in compensation and financing arrangements is associated with financial reporting choices that affect accruals quality, which previous research has shown to be a priced measure of information risk. Consistent with prior research documenting an association between the use of call options in compensation arrangements (in the form of employee stock options or ESOs) and increased returns and/or income volatility, we find that ESOs are also associated with poorer accruals quality, which has been shown to be related to increased returns volatility. However, call options used in financing arrangements (in the form of convertible debt and convertible preferred stock) provide no post-issuance incentives to worsen accruals quality, and may encourage the opposite behavior. We predict and find that the use of these instruments is associated with better accruals quality.

Employee stock options, accruals quality, risk incentives

Abstract:
We examine whether rational investor responses to information uncertainty (IU) explain properties of and returns to the post-earnings-announcement-drift (PEAD) trading anomaly. Consistent with a rational learning explanation, we find that: (1) unexpected earnings (UE) signals that are characterized as having greater IU have more muted initial market reactions; (2) extreme UE portfolios are characterized by securities with higher IU than non-extreme UE portfolios; and (3) within the extreme UE portfolios, high IU securities are more prevalent and earn larger abnormal returns than low IU securities. Further tests show that prior evidence of greater PEAD profitability for higher idiosyncratic volatility securities is explained by the greater information uncertainty associated with these securities.

Abstract:
At a joint meeting in September 2002, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) agreed to work together to develop high quality, fully compatible financial reporting standards that could be used for domestic and cross-border reporting; this co-operative effort is sometimes described as international convergence of US GAAP and IFRS financial reporting standards. The IASB-FASB convergence effort involves two kinds of projects. The first type includes short-term projects that are intended to remove many of the numerous individual differences between International Financial Reporting Standards (IFRS, which include International Accounting Standards (IAS) issued by the predecessor body to the IASB) and US GAAP. Examples of current and proposed short-term convergence efforts involve the accounting treatments of nonmonetary exchanges, discontinued operations, income taxes and interim reporting. The second type of convergence project involves longer term joint IASB-FASB projects and co-ordinated projects that are intended to provide major pieces of improved accounting guidance. Examples of the latter include the joint projects on revenue recognition and purchase method procedures and the co-ordinated project on share-based payments. The goal of the IASB-FASB convergence efforts is to make US GAAP and IFRS financial reporting standards as nearly as possible the same across jurisdictions while also improving the overall quality of those standards.

The convergence activities of the IASB and the FASB will of necessity be directly and indirectly affected by regulatory changes and shifts in economic conditions throughout the world. The purpose of this paper is to identify some possible implications for international convergence of a particularly significant regulatory change, namely, the mandated adoption of IFRS by listed enterprises in the European Union beginning in 2005. This change will increase the number of enterprises that apply IFRS to prepare their consolidated reports from several hundred to several thousand, and will require the use of IFRS by enterprises that vary considerably in size, ownership structure, capital structure, political jurisdiction and financial reporting sophistication. The purpose of this discussion paper is to explore several implications of this major shift in financial reporting requirements for the overall international convergence of financial reporting standards and practices.

IAS, Europe, International Convergence

Abstract:
We investigate whether competing information, primarily analyst reports, reduces the usefulness of earnings announcements. Our examination of this issue has two parts. First, we examine whether investors' use of analyst reports, as measured by the absolute abnormal returns to these reports, substitutes for their use of earnings announcements. We find that market reactions to earnings announcements and analyst reports are positively related. This positive relation also characterizes subsequent period analyst reports relative to current period earnings announcements. Second, we test for changes in the absolute reactions to each type of disclosure over 1986-1995, and find that market reactions to both earnings announcements and analyst reports increased, in aggregate, over the sample period. As a whole, these results provide little or no empirical support for the view that the informativeness of earnings announcements is eroded by competing information in the form of analyst reports.

capital market, earnings announcement, analyst report