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Abstract:
We investigate the use of a warrant-pricing approach to incorporate employee stock options (ESOs) into equity valuation and to account for the dilutive effect of ESOs in the valuation of option grants for financial reporting purposes. Our valuation approach accounts for the jointly determined nature of ESO and shareholder values. The empirical results show that our stock-price estimate exhibits lower prediction errors and higher explanatory powers for actual share price than does the traditional stock-price estimate. We use our valuation approach to assess the implications of dilution on the fair value estimates of ESO grants. We find that the fair value is overstated by six percent if we ignore the dilutive feature of ESOs. Further, this bias is larger for firms that are heavy users of ESOs, small, and R&D intensive, and for firms that have a broad-based ESO compensation plan.

Abstract:
We investigate the use of a warrant-pricing approach to incorporate employee stock options (ESOs) into equity valuation and to account for the dilutive effect of ESOs in the valuation of option grants for financial reporting purposes. Our valuation approach accounts for the jointly determined nature of ESO and shareholder values. The empirical results show that our stock-price estimate exhibits lower prediction errors and higher explanatory powers for actual share price than does the traditional stock-price estimate. We use our valuation approach to assess the implications of dilution on the fair value estimates of ESO grants. We find that the fair value is overstated by six percent if we ignore the dilutive feature of ESOs. Further, this bias is larger for firms that are heavy users of ESOs, small, and R&D intensive, and for firms that have a broad-based ESO compensation plan.

Employee stock options, warrant-pricing model, equity valuation

Abstract:
This paper examines the relationship between annual report readability and firm performance and earnings persistence. This is motivated by the Securities and Exchange Commission's plain English disclosure regulations that attempt to make corporate disclosures easier to read for ordinary investors. I measure the readability of public company annual reports using both the Fog Index from computational linguistics and the length of the document. I find that the annual reports of firms with lower earnings are harder to read (i.e., they have higher Fog and are longer). Moreover, the positive earnings of firms with annual reports that are easier to read are more persistent. This suggests that managers may be opportunistically choosing the readability of annual reports to hide adverse information from investors.

Disclosure, Annual report readability, Earnings Persistence

Abstract:
I test the stock market efficiency with respect to the information in the texts of annual reports. More specifically, I examine the implications of corporate annual reports' risk sentiment for future earnings and stock returns. I measure the risk sentiment of annual reports by counting the frequency of words related to risk or uncertainty in the 10-K filings. I find that an increase in risk sentiment is associated with lower future earnings: Firms with a larger increase in risk sentiment have more negative earnings changes in the next year. Risk sentiment of annual reports can predict future returns in a cross-sectional setting: Firms with a large increase in risk sentiment experience significantly negative returns relative to those firms with little increase in risk sentiment in the twelve months after the annual report filing date. A hedge portfolio based on buying firms with a minor increase in risk sentiment of annual reports and shorting firms with a large increase in risk sentiment generates an annual Alpha of more than 10% measured using the four-factor model including the Fama-French three factors and the momentum factor.

Annual report, risk sentiment, earnings, stock returns

Abstract:
This paper examines a new approach of measuring earnings quality based on firms' capital and labor investment decisions. More specifically, I measure earnings quality as the contemporaneous association between the changes in the level of capital and labor investment and the change in reported earnings. The approach relies on the following intuition: (1) firms make investment decisions based on the net present value (NPV) of the investment projects; and (2) a reported earnings with higher quality (i.e., it is closer to the permanent earnings or the annuitized NPV) should be more associated with the real investment decisions. I find that the measures of earnings quality based on managerial labor and capital decisions are positively correlated with earnings persistence and have incremental explanatory power relative to the earnings quality measures used in the literature.

corporate investment, earnings quality, earnings persistence

Abstract:
We develop a comprehensive and large-sample measure of a firm's information quality. The measure is the ratio of firm-specific return variation to firm-specific cash-flow variation. Empirical evidence supports the validity of our measure. Using this measure, we find that cost of equity capital decreases by about -0.4% on an annual basis if a firm's information quality increases by one standard deviation. This is consistent with the joint hypotheses that (1) firm-specific stock returns contain economic information as argued by Morck, Yeung, and Yu (2000) and (2) better information quality can lower the cost of equity.

Abstract:
We investigate for a positive relation between growth and the aggressiveness of accounting choices. Our motivation is that this relation is an unexamined and very general implication from most existing theories and types of aggressive accounting choice. Note that the firms' decision to use aggressive choices is a function of two factors: specific motivations to increase earning like maximizing compensation, and the ability to increase earnings, which is captured by growth. For example, choice of straight-line vs. accelerated depreciation method has no income effect on no-growth firms and has an income-increasing effect on growth firms, so assuming aggressive reporting motivations exist, growth firms should have higher propensity to use straight line depreciation. Since growth captures the ability to increase income, holding other factors constant, a ranking on growth provides a clean ranking on the incentives to use income-increasing choices. Note that this intuition is extremely general and applies to almost all conceivable theories and types of aggressive accounting choice. Thus, a ranking on growth can be used as a powerful lens that summarizes the economic importance of many disparate accounting theories and settings of aggressive choice. Our empirical tests use a large sample of 260,000 observations over the last 50 years and a wide set of 9 accounting choices to provide a comprehensive investigation of the hypothesized relation. Our results are as follows. First, our main finding is that there is essentially no reliable relation between growth and aggressive accounting choice. A number of additional specifications and sensitivity analyses confirm this main finding. Second, changes in accounting choice are rare, which implies that accounting choice looks like a blunt and unwieldy instrument to achieve aggressive accounting objectives. Third, there is no reliable positive correlation between the aggressiveness of individual accounting choices, which implies that companies make no concerted efforts to increase income over the available set of accounting choices. Our main conclusion from these findings is that visible and long-term accounting choices are seldom used for achieving income-increasing objectives.

Growth, accounting choice

Abstract:
In this study, we investigate the implications of financial reporting quality for a country’s economic growth. The results show no evidence of a relation between financial reporting quality and economic growth at the country level, suggesting that financial reporting quality is unlikely to have a first-order impact on growth. However, we find that high information asymmetry industries grew disproportionately faster in countries with good financial reporting quality over the 1990s and early 2000s; specifically, industries prone to information asymmetry problems grew between 0.12% and 0.22% faster in countries with good financial reporting quality. Additional evidence using a difference-in-difference estimation procedure based on twenty-six countries that adopted International Financial Reporting Standards (IFRS) around 2005 is consistent with this finding.

Financial reporting quality, transparency, earnings quality, information uncertainty, IFRS, information asymmetry, economic growth

Abstract:
This paper examines the tone and content of the forward-looking statements (FLS) in corporate 10-K and 10-Q filings using a Naive Bayesian machine learning algorithm. I first manually categorize 30,000 sentences of randomly selected FLS extracted from the MD&As along two dimensions: (1) tone (i.e., positive versus negative tone); and (2) content (i.e., profitability, operations, and liquidity etc.). These manually coded sentences are then used as training data in a Naive Bayesian machine learning algorithm to classify the tone and content of about 13 million forward-looking statements from more than 140,000 corporate 10-K and 10-Q MD&As between 1994 and 2007.

I find that firms with better current performance, lower accruals, smaller size, lower market-to-book ratio, and less return volatility tend to have more positive forward-looking statements in MD&As. The average tone of the forward-looking statements in a firm's MD&A is positively associated with future earnings and liquidity, even after controlling for other determinants of future performance and there is no systematic change in the information content of MD&As over time. Finally, the evidence indicates that financial analysts do not fully understand the information content of the MD&As in making their forecasts.

MD&A, Information content, Machine learning

Abstract:
We study the pairwise stock return correlations at the firm level. We find that 85% of the total variation in firm-level pairwise correlations of stock returns is not explained by an exhaustive list of variables that may affect return comovement. We also find that stocks with high correlation in the past have similar returns in the future, even after controlling for the possible determinants of the return correlation. Finally, a trading strategy based on stocks that deviate from their comovers generates abnormal returns.

Abstract:
Theories of the firm such as Aghion and Tirole (1997) distinguish formal authority from real authority: A manager could be formally responsible for a decision, but in reality may acquiesce to her better-informed subordinate. These models, as well as organizational theorists (e.g., Simon 1997), suggest that employee communication patterns during critical decision-making reveal most clearly the underlying patterns of real authority. We propose the extent to which CEOs communicate in the high-stakes setting of earnings conference calls as a measure of their real authority over top management. Using a large database of firm conference call transcripts, we find that our real authority measure is distinct from formal authority measures of CEOs, and is significantly associated with theoretically predicted organizational factors. CEOs with real authority also receive higher wages. Real authority is a thus a distinct and measurable organizational feature.

Authority, Control, Delegation, Organization

Abstract:
This paper examines the effect of the complexity of firm written communication on the behavior of sell-side financial analysts. Using a measure of the readability of corporate 10-K filings we document that analyst following, effort (measured as the length of time required for analysts to issue their first forecast revision following the 10-K filing), and the informativeness of their reports are positively related to firm communication complexity. Additionally, we find that communication complexity reduces earnings forecast accuracy and increases forecast dispersion. Overall, our results are consistent with the prediction of an increasing demand for analyst services for firms with more complex communication and a greater collective effort by analysts for firms with less readable disclosures. Our results contribute to our understanding the role of analysts as information intermediaries for investors, as well as to the long-standing debate about the intended audience of financial information and the effect of the complexity of written financial communication on the usefulness of this information.

analyst coverage, analyst's forecasts, disclosure, annual report readability

Abstract:
I examine the implications of corporate annual reports' risk sentiment for future earnings and stock returns. I measure the risk sentiment of annual reports by counting the frequency of words related to risk or uncertainty in the 10-K filings. I find that an increase in risk sentiment is associated with lower future earnings: Firms with a larger increase in risk sentiment have more negative earnings changes in the next year. Risk sentiment of annual reports can predict future returns in a cross-sectional setting: Firms with a large increase in risk sentiment experience significantly negative returns relative to those firms with little increase in risk sentiment in the twelve months after the annual report filing date. A hedge portfolio based on longing firms with a minor increase in risk sentiment of annual reports and shorting firms with a large increase in risk sentiment generates an Alpha of more than 10% annually measured using the four-factor model including the Fama-French three factors and the momentum factor.

Annual report, risk sentiment, earnings, stock returns