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Abstract:
This paper examines the link between managers' equity incentives - arising from stock-based compensation and stock ownership - and earnings management. We hypothesize that managers with high equity incentives are more likely to sell shares in the future and this motivates these managers to engage in earnings management to increase the value of the shares to be sold. Using stock-based compensation and stock ownership data over the 1993-2000 time period, we document that managers with high equity incentives sell more shares in subsequent periods. As expected, we find that managers with high equity incentives are more likely to report earnings that meet or just beat analysts' forecasts. We also find that managers with consistently high equity incentives are less likely to report large positive earnings surprises. This finding is consistent with the wealth of these managers being more sensitive to future stock performance, which leads to increased reserving of current earnings to avoid future earnings disappointments. Collectively, our results indicate that equity incentives lead to incentives for earnings management.

Equity incentives, stock-based compensation, stock ownership, insider trading, earnings management, meeting or beating analysts' forecasts, abnormal accruals

Abstract:
This paper examines the link between managers' equity incentives - arising from stock-based compensation and stock ownership - and earnings management. We hypothesize that managers with high equity incentives are more likely to sell shares in the future and this motivates these managers to engage in earnings management to increase the value of the shares to be sold. Using stock-based compensation and stock ownership data over the 1993-2000 time period, we document that managers with high equity incentives sell more shares in subsequent periods. As expected, we find that managers with high equity incentives are more likely to report earnings that meet or just beat analysts' forecasts. We also find that managers with consistently high equity incentives are less likely to report large positive earnings surprises. This finding is consistent with the wealth of these managers being more sensitive to future stock performance, which leads to increased reserving of current earnings to avoid future earnings disappointments. Collectively, our results indicate that equity incentives lead to incentives for earnings management.

Equity incentives, stock-based compensation, stock ownership, insider trading, earnings management, meeting or beating analysts' forecasts, abnormal accruals

Abstract:
This paper investigates the determinants of residual income scaled by book value of equity, i.e., abnormal return on equity (ROE), by analyzing the impact of value-creation (economic rents) and value-recording (conservative accounting) processes on abnormal ROE. I rely on economic theories to characterize economic rents and develop an empirical measure - the conservative accounting factor - to capture the effect of conservative accounting. As expected, industry abnormal ROE increases with industry concentration, industry level barriers to entry, and industry conservative accounting factors. Also as expected, the difference between firm and industry abnormal ROE increases with market share, firm size, firm level barriers to entry, and firm conservative accounting factors. Integrating these determinants into the residual income valuation model significantly increases its explanatory power for the variation in the market-to-book ratio.

equity valuation, the residual income valuation model, economic rents, conservative accounting

Abstract:
This paper investigates the determinants of residual income scaled by book value of equity, i.e., abnormal return on equity (ROE), by analyzing the impact of value-creation (economic rents) and value-recording (conservative accounting) processes on abnormal ROE. I rely on economic theories to characterize economic rents and develop an empirical measure - the conservative accounting factor - to capture the effect of conservative accounting. As expected, industry abnormal ROE increases with industry concentration, industry level barriers to entry, and industry conservative accounting factors. Also as expected, the difference between firm and industry abnormal ROE increases with market share, firm size, firm level barriers to entry, and firm conservative accounting factors. Integrating these determinants into the residual income valuation model significantly increases its explanatory power for the variation in the market-to-book ratio.

Equity valuation, the residual income valuation model, economic rents, conservative accounting

Abstract:
This paper examines how governance and regulatory reforms surrounding the Sarbanes-Oxley Act (SOX) of 2002 and the Global Settlement (GS) affect the analysts’ information environment, specifically the quality of financial analysts’ common and private information. Our information quality measures are based on characteristics of financial analyst forecasts as developed in Barron, Kim, Lim and Stevens (1998). We find that the passage of SOX and the concurrent analyst regulations are associated with a temporary increase in the quality of common information upon their adoption, but the increase is not maintained. By one year after the introduction of the reforms both common and private information quality decline and continue to stay below their pre-SOX/GS levels. This decline is clearly seen in firms with high information quality prior to the reforms, but firms with moderate or low prior information quality experience little if any improvement. These results suggest that overall, financial analysts have not experienced an increase in their information quality as measured by the characteristics of their forecasts.

the Sarbanes-Oxley Act, information quality, analyst forecast, Global Settlement

Abstract:
There is limited direct evidence on the impact of analyst coverage on the cost of capital. In this paper, we hypothesize that the amount and nature of analyst coverage can reduce information asymmetry among investors and thus lower the cost of raising equity capital. We investigate the effect of analyst coverage on the underpricing of seasoned equity offerings (SEOs), which is a substantial cost of issuing new shares. Based on 4,766 SEOs in the period 1984-2000, our results suggest that more analyst coverage is associated with lower SEO underpricing. Compared with firms without analyst coverage, firms with the median level of analyst coverage - three analysts - have a 1.19% lower SEO underpricing, a relative decrease of 38%. This effect is robust to controlling for other factors affecting SEO underpricing. We also examine additional attributes of analyst coverage and find that firms followed by analysts working for the lead underwriter, with a reputation for superior ability, or with lower forecast dispersion have incrementally lower SEO underpricing.

Analyst coverage, information asymmetry, cost of capital, seasoned equity offering

Abstract:
Prior research (e.g., Xie 2001) documents that future stock returns are negatively correlated with abnormal accruals (referred to as the abnormal accrual-based anomaly), but the underlying reason is not clear. In this paper, we investigate the impacts of managers' motivations to record abnormal accruals on this anomaly. We hypothesize and find that the abnormal accrual-based anomaly is systematically associated with managers' motivations to record abnormal accruals. Future returns are negatively (positively) associated with abnormal accruals recorded for opportunistic earnings management (performance/signaling) purposes. These results suggest that investors' failure to detect managers' motivations to record abnormal accruals provides a potential explanation for the abnormal accrual-based anomaly. This failure provides managers with an opportunity to engage in opportunistic earnings management, and thus hinders managers' ability to communicate private information to the stock market via abnormal accruals.

abnormal accruals, managers' motivations, market efficiency, operating cash flows

Abstract:
We hypothesize that insiders strategically choose disclosure policies and the timing of their equity trades to maximize trading profits, subject to the litigation costs associated with disclosure and insider trading. Accounting for endogeneity between disclosures and trading, we find that when managers plan to purchase shares, they increase the number of bad news forecasts to reduce the purchase price. In addition, this relation is stronger for trades initiated by chief executive officers than for those initiated by other executives. Confirming this strategic behavior, we find that managers successfully time their trades around bad news forecasts, buying fewer shares beforehand and more afterwards. We do not find that managers adjust their forecasting activity when they are selling shares, consistent with higher litigation concerns associated with insider sales. Overall, our evidence suggests that insiders do exploit voluntary disclosure opportunities for personal gain, but only selectively, when litigation risk is sufficiently low.

Voluntary Disclosure, Management Forecasts, Insider Trading

Abstract:
We hypothesize that insiders strategically choose disclosure policies and the timing of their equity trades to maximize trading profits, subject to the litigation costs associated with disclosure and insider trading. Accounting for endogeneity between disclosures and trading, we find that when managers plan to purchase shares, they increase the number of bad news forecasts to reduce the purchase price. In addition, this relation is stronger for trades initiated by chief executive officers than those initiated by other executives. Confirming this strategic behavior, we find that managers successfully time their trades around bad news forecasts, buying fewer shares beforehand and more afterwards. We do not find that managers adjust their forecasting activity when they are selling shares, consistent with higher litigation concerns associated with insider sales. Overall, our evidence suggests that insiders do exploit voluntary disclosure opportunities for personal gain, but only selectively, when litigation risk is sufficiently low.

Voluntary Disclosure, Management Forecasts, Insider Trading

Abstract:
Prior studies document that institutional investors outperform the market. We investigate whether this superior performance is partly derived from institutional investors' use of sell-side analysts' stock recommendations. First, we find that the quarterly change in institutional ownership is positively correlated with consensus recommendations. After controlling for other determinants of institutional holdings, the quarterly change in institutional ownership is on average 0.90% higher for firms with favorable recommendations than for those with unfavorable recommendations. Second, using large trades to proxy for institutional trading, we find that there are more buyer-initiated than seller-initiated large trades around favorable recommendations and vice versa for unfavorable recommendations. Lastly, we find that the change in institutional ownership that is explained by stock recommendations is associated with positive abnormal returns in the future, about 4.2% per year. Overall, these results indicate that institutional investors trade upon stock recommendations and such trading contributes to their superior performance.

Financial analysts, institutional trading, stock recommendations

Abstract:
Prior studies document that institutional investors outperform the market. We investigate whether this superior performance is partly derived from institutional investors' use of sell-side analysts' stock recommendations. First, we find that the quarterly change in institutional ownership is positively correlated with consensus recommendations. After controlling for other determinants of institutional holdings, the quarterly change in institutional ownership is on average 0.90% higher for firms with favorable recommendations than for those with unfavorable recommendations. Second, using large trades to proxy for institutional trading, we find that there are more buyer-initiated than seller-initiated large trades around favorable recommendations and vice versa for unfavorable recommendations. Lastly, we find that the change in institutional ownership that is explained by stock recommendations is associated with positive abnormal returns in the future, about 4.2% per year. Overall, these results indicate that institutional investors trade upon stock recommendations and such trading contributes to their superior performance.

Financial analysts, stock recommendations, institutional trading

Abstract:
Prior research finds that earnings restatements are linked to CEOs' excessive option-based compensation and equity holdings. In this paper, we investigate whether firms that experience earnings restatements recontract with their CEOs to reduce their option-based compensation and if so, whether this leads to improved firm performance. Based on 289 restatement firms over the period 1997-2001, we find that the proportion of CEOs' compensation in the form of options declines significantly in the two years following the restatement. Furthermore, we document that this reduction is accompanied by a decrease in the riskiness of investments, as reflected in lower stock return volatility and subsequent improvements in operating performance. Our results suggest that a decrease in option-based compensation reduces CEOs' incentives to take excessively risky investments, resulting in improved profitability. Overall, our findings provide insights into the design and efficacy of CEO compensation contracts.

Earnings restatements, Stock options, CEO compensation, Operating performance

Abstract:
Prior research finds that earnings restatements are linked to CEOs' excessive option-based compensation and equity holdings. In this paper, we investigate whether firms that experience earnings restatements recontract with their CEOs to reduce their option-based compensation and if so, whether this leads to improved firm performance. Based on 289 restatement firms over the period 1997-2001, we find that the proportion of CEOs' compensation in the form of options declines significantly in the two years following the restatement. Furthermore, we document that this reduction is accompanied by a decrease in the riskiness of investments, as reflected in lower stock return volatility and subsequent improvements in operating performance. Our results suggest that a decrease in option-based compensation reduces CEOs' incentives to take excessively risky investments, resulting in improved profitability. Overall, our findings provide insights into the design and efficacy of CEO compensation contracts.

Earnings restatements, Stock options, CEO compensation, Operating performance

Abstract:
This paper critically evaluates the use of analysts' forecasts in accounting-based valuation. Specifically, I assess the usefulness and the limitation of analysts' forecasts in predicting future earnings and in explaining the market-to-book ratio, in light of a comprehensive set of twenty-two explicit information items, including: economic rent proxies, conservative accounting proxies, earnings quality signals, transitory earnings proxies, industry characteristics, and risk and growth proxies. While analysts' forecasts capture 45-83% of the information from these sources depending on model specifications, they do not appear to fully incorporate certain information items. In particular, proxies for conservative accounting and transitory earnings are incrementally useful in predicting future earnings; proxies for economic rents, conservative accounting, and risk are incrementally useful in explaining the market-to-book ratio. Collectively, these results validate the use of analysts' forecasts as a parsimonious proxy for forward-looking information in accounting-based valuation and suggest how to improve on their use.

Accounting-based valuation, earnings, analysts' forecasts, market-to-book ratios

Abstract:
This paper critically evaluates the use of analysts' forecasts in accounting-based valuation. Specifically, I assess the usefulness and the limitation of analysts' forecasts in predicting future earnings and in explaining the market-to-book ratio, in light of a comprehensive set of twenty two explicit information items, including: economic rent proxies, conservative accounting proxies, earnings quality signals, transitory earnings proxies, industry characteristics, and risk and growth proxies. While analysts' forecasts capture 45-83% of the information from these sources depending on model specifications, they do not appear to fully incorporate certain information items. In particular, proxies for conservative accounting and transitory earnings are incrementally useful in predicting future earnings; proxies for economic rents, conservative accounting, and risk are incrementally useful in explaining the market-to-book ratio. Collectively, these results validate the use of analysts' forecasts as a parsimonious proxy for forward-looking information in accounting-based valuation and suggest how to improve on their use.

Accounting-based valuation, earnings, analysts' forecasts, market-to-book ratios

Abstract:
In this paper, we investigate determinants of the market impact of stock recommendations issued by sell-side financial analysts. We propose a simple framework for understanding the process that financial analysts use to issue stock recommendations. The framework yields three testable predictions: The market impact of stock recommendations increases with analysts' perceived ability and investors' uncertainty about firm value, and decreases with analyst experience after controlling for analysts' innate ability. We empirically test these predictions and find consistent results. Using Institutional Investor All-American analyst status to proxy for high perceived ability and return volatility for uncertainty about firm value, we find that the market impact of recommendations increases with analysts' perceived ability and return volatility. Using the number of quarters an analyst has been issuing recommendations or earnings forecasts to proxy for experience, we find that the market impact of recommendations decreases with analyst experience after controlling for analyst-company specific effects. These results hold when we control for other characteristics of financial analysts and brokerage firms that might affect the market impact of stock recommendations. The results hold for recommendation revisions as well.

stock recommendations, analysts' perceived ability, uncertainty about firm value, analyst experience

Abstract:
We examine the voluntary disclosure practices of family firms. We find that, compared to non-family firms, family firms provide fewer earnings forecasts and conference calls, but more earnings warnings. Whereas the former is consistent with family owners having a longer investment horizon, better monitoring of management, and lower information asymmetry between owners and managers, the higher likelihood of earnings warnings is consistent with family owners having greater litigation and reputation cost concerns. We also document that family ownership dominates non-family insider ownership and concentrated institutional ownership in explaining the likelihood of voluntary disclosure. Using alternative proxies for founding family's presence in the firm leads to similar results.

founding family, equity ownership, voluntary disclosure, earnings forecasts, earnings warnings

Abstract:
Taxes represent a significant cost to the firm and shareholders, and it is generally expected that shareholders prefer tax aggressiveness. However, this argument ignores potential non-tax costs that can accompany tax aggressiveness, especially those arising from agency problems. Firms owned/run by founding family members are characterized by a unique agency conflict between dominant and small shareholders. Using multiple measures to capture tax aggressiveness and founding family presence, we find that family firms are less tax aggressive than their non-family counterparts, ceteris paribus. This result suggests that family owners are willing to forgo tax benefits in order to avoid the non-tax cost of a potential price discount, which can arise from minority shareholders' concern with family rent-seeking masked by tax avoidance activities (Desai and Dharmapala 2006). This inference is further strengthened by our finding that family firms without long-term institutional investors (as outside monitors) and family firms expecting to raise capital exhibit even lower tax aggressiveness. Our result is also consistent with family owners being more concerned with the potential penalty and reputation damage from an IRS audit than non-family firms. We obtain similar inferences when using a small sample of tax shelter cases.

family firm, tax aggressiveness, entrenchment

Abstract:
This paper investigates the impact of the founding family's presence in US public firms on the extent of agency problems related to CEO turnover decisions and on firm valuations after poor performance. In particular, we focus on three types of US public firms: family CEO firms, professional CEO family firms (family firms managed by a hired CEO outside the founding family), and non-family firms. We hypothesize that, the agency problem arising from the expropriation of small shareholders by large shareholders in family CEO firms and the agency problem arising from the separation of ownership and control in non-family firms, lead to a lower CEO turnover-performance sensitivity, compared to professional CEO family firms. Professional CEO family firms are subject to lesser agency problems due to the separation of family ownership and management as well as the founding family's effective monitoring of management. The empirical findings are consistent with our prediction. We further hypothesize and find that the more severe agency problems in both family CEO firms and non-family firms manifest themselves in lower firm value after poor performance, relative to professional CEO family firms. Overall, our results indicate that in the CEO turnover setting, family ownership, when separated from management, can mitigate agency problems as in professional CEO family firm, but when combined with management, can aggravate agency problems as in family CEO firms.

Agency problems, family firms, CEO turnover, firm valuation

Abstract:
Prior studies (e.g., Lys and Sohn 1990; Ali, Klein and Rosenfeld 1992) have documented a positive association between analysts' forecast errors and past stock returns and suggested cognitive bias on the part of analysts as a possible explanation. In this paper, we separately analyze the association between forecast errors and past negative returns and that between forecast errors and past positive returns. We find that forecast errors are only positively associated with past negative returns and are not associated with past positive returns. These results are robust to a series of sensitivity tests. They are inconsistent with analysts being subject to cognitive bias; instead, they are consistent with several explanations related to accounting conservatism or analysts' incentives: analysts having difficulty in forecasting discretionary charges associated with past negative returns, analysts not exerting effort in forecasting earnings of firms with poor performance, or analysts ignoring bad news in order to please managers.

Abstract:
While prior theoretical studies suggest that analyst research substitutes for corporate disclosures, recent empirical studies find that the two complement each other - the aggregate market impact of analyst research and that of earnings announcements are positively correlated. We conjecture and find that the role of analyst research depends on the timing of analyst reports relative to earnings announcements. In the week before firms announce earnings, analyst research contains information that substitutes for earnings announcements while in the week following firms' earnings announcements, analysts serve a complementary role by interpreting the announced earnings information. In addition, we predict and find that the complementary role of analyst research is more important for firms with financial accounting information that is difficult to interpret. Analysis of all 12 weeks surrounding each earnings announcement shows that overall analyst research and corporate disclosures are substitutes. We are able to reconcile this result with the complementary relation found in Francis et al. (2002).

Analyst research, information content, earnings announcements, complements and substitutes

Abstract:
We examine the relationship between equity incentives and earnings management in the banking industry. By focusing on this regulated industry and using industry-specific earnings management proxies, we provide evidence on the impact of regulation on earnings management arising from CEOs' equity incentives. We find that bank managers with high equity incentives are more likely to manage earnings, but only when capital ratios are closer to the minimum regulatory capital requirements. This finding indicates that in the banking industry, potential regulatory intervention induces, rather than mitigates, earnings management arising from equity incentives.

equity incentives, earnings management, the banking industry

Abstract:
In this paper, we investigate how aggressive financial reporting affects a firm’s ability to obtain external funds and its choices of external financing. First, we find that after earnings restatements, firms become significantly more financially constrained compared to a group of control firms with similar size and operating performance. Second, consistent with the increase in financial constraints, we find that restatement firms are less likely to obtain external financing after restatements. Third, for restatement firms that do obtain external financing after restatements, we find that they rely more on private debt financing and less on equity financing, consistent with increased information asymmetry after earnings restatements. Our investigation is important because it sheds light on the impact of aggressive financial reporting on firms’ financing options and on what causes, at least partially, the dramatic decrease in firm value upon the detection of aggressive financial reporting.

restatements, external financing, financial constraint

Abstract:
We examine the voluntary disclosure practices of family firms. We find that, compared to non-family firms, family firms provide fewer earnings forecasts and conference calls, but more earnings warnings. Whereas the former is consistent with family owners having a longer investment horizon, better monitoring of management, and lower information asymmetry between owners and managers, the higher likelihood of earnings warnings is consistent with family owners having greater litigation and reputation cost concerns. We also document that family ownership dominates non-family insider ownership and concentrated institutional ownership in explaining the likelihood of voluntary disclosure. Using alternative proxies for founding family's presence in the firm leads to similar results.

founding family, equity ownership, voluntary disclosure, earnings forecasts, earnings warnings

Abstract:
There is limited direct evidence on the impact of analyst coverage on the cost of capital. In this paper, we hypothesize that the amount and nature of analyst coverage can reduce information asymmetry among investors and thus lower the cost of raising equity capital. We investigate the effect of analyst coverage on the underpricing of seasoned equity offerings (SEOs), which is a substantial cost of issuing new shares. Based on 4,766 SEOs in the period 1984-2000, our results suggest that more analyst coverage is associated with lower SEO underpricing. Compared with firms without analyst coverage, firms with the median level of analyst coverage - three analysts - have a 1.19% lower SEO underpricing, a relative decrease of 38%. This effect is robust to controlling for other factors affecting SEO underpricing. We also examine additional attributes of analyst coverage and find that firms followed by analysts working for the lead underwriter, with a reputation for superior ability, or with lower forecast dispersion have incrementally lower SEO underpricing.

Analyst coverage, information asymmetry, cost of raising capital, seasoned equity offering