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Abstract:
Rational expectations models of financial markets largely based on the path breaking work by Grossman and Stiglitz (1980) are playing an increasing role in motivating empirical analyses addressing the role of information in contemporary equity markets. This paper provides an intuitive and distinctly non-mathematical critical presentation of aspects and attributes of these models that any researcher who is interested in developing associated empirical applications or, possibly, a rational expectations model of their own should be familiar with.

Rational Expectations

Abstract:
This paper identifies a distinct immediate announcement period negative relation between earnings announcement surprises and aggregate market returns. Such a relation implies that market participants use earnings information in forming expectations about expected aggregate discount rates and, specifically, that good earnings news is associated with a positive shock to required returns. We also find some evidence that this negative relation persists well beyond the immediate announcement period, suggesting that market participants do not immediately fully impound these future market return implications of aggregate earnings news.

Earnings, Market Efficiency

Abstract:
A recent analysis by Kothari, Lewellen and Warner(2006) report negative relations between aggregate earnings surprise and market return in quarterly earnings disclosure and reporting periods and no evidence of a positive relation between aggregate earnings and market return in any post-disclosure quarters. In this analysis we develop approaches aimed at better isolating aggregate earning's news component and find strong evidence of a positive relation between aggregate earnings surprise and return in the quarter following the earnings disclosure quarter. This pattern is consistent with the market not fully incorporating discount rate shock and cash flow implications of aggregate earnings in the disclosure period.

Corporate Earnings, Information, Market Efficiency

Abstract:
McVay (2006, 2008) report compelling evidence that firms reclassify ordinary expense items as special item in order to boost benchmark core earnings numbers. We show that another far more innocuous explanation exists for this evidence. The effects that McVay attributes to classification shifting activities can arise as an artifact of the approaches used in deriving expected core earnings values. This can happen because expected core earnings and expected change in core earnings values are determined, in part, by special item accruals. When we focus on either subsamples where this special item accrual effect on the expected core earnings values is a priori expected to be small or incorporate controls for it into the analysis, there is no reliable evidence of widespread classification shifting activities by managers.

Earnings Management, Special Items, Earnings Components, Accruals

Abstract:
Ernstberger and Vogler (2007) employ the concurrent use of three distinct accounting standard regimes (German GAAP; U.S. GAAP; and IAS/IFRS GAAP) in Germany as a foundation for evaluating the relation between accounting standard regime and equity return attributes. They find that firms using U.S. or IAS/IFRS GAAP have higher Betas but yield lower returns (cost of capital) relative to firms employing German GAAP. They also find that portfolios designed to isolate the return impacts of U.S. and IAS/IFRS GAAP relative to German GAAP are priced in a risk-factor like fashion. In this discussion I suggest that a good bit of this empirical evidence is problematic. I also discuss the implausibility of information quality being priced in a Fama and French (1992) factor-like fashion. Finally, I introduce the importance of conditioning analyses of the relation between firm-level information quality and equity market return (cost of capital) on the degree to which the shareholder bases of firms hold diversified portfolios.

IFRS, US GAAP, German GAAP, cost of equity capital, information quality, diversification

Abstract:
Prior studies document that firms with an increase in research and development (R&D) expenditures experience positive abnormal returns for up to five years. The reason for this association is unclear, however. This result may reflect an unidentified R&D correlated risk factor and/or it may reflect a systematic underestimation by market participants of future benefits from current R&D increases. We document that future abnormal returns to R&D increases are concentrated around subsequent earnings announcements. We further show that that the market underestimates the association between R&D increases and future earnings. Finally, we document that in their forecasts of future earnings security analysts also underestimate the effect of R&D increases. These results suggest that future abnormal returns following R&D increases are at least in part due to the market's underestimation of the earnings benefits of R&D increases.

Abstract:
Burgstahler, Jiambalvo, and Shevlin (2002) evaluate the implications of special items for future earnings and report evidence consistent with the notion that firms use negative special items to accelerate the recognition of future period expenses. That is, negative special items serve as an income-transfer device. In this analysis, we examine additional predictions suggested by this income-transfer hypothesis not considered in their analysis. Specifically do the augmented future income values they report decline in future quarters as the transfer effect dissipates? Contrary to this prediction, we find that future income values increase in post-special-item quarters beyond the four quarters considered in Burgstahler et al. (2002). Thus, our results are more consistent with real future rewards to costly short-term business decisions than with income-transfer. We also find that the tax rate assumptions made in the Burgstahler et al. (2002) greatly impact the magnitude of the estimated special items future income effect. Utilizing an empirically derived tax rate, we find that the magnitudes of income increases associated with the recognition of negative special items are substantially smaller than those they report.

Negative special items, income-transfer, tax rates, Restructuring

Abstract:
Strategic alliances are voluntarily initiated cooperative agreements between firms, which involve exchanging, sharing and developing resources (Gulati, 1995). Separating financial activities of the partner firms' entity from those of the strategic alliances is an ongoing challenge for accounting practitioners both in terms of financial and tax reporting issues (Wallman, 1995). This challenge is especially severe in contractual alliances, where the involved firms do not form a new corporate entity that is separate from the parent organization. In this study we find that the information environments of firms involved in such arrangements, termed contractual alliances, are broadly associated with indicators of low quality accounting information. Relative to other firms, they have higher levels of discretionary accruals, lower accrual quality, and earnings that are less persistent, less smooth, less relevant, less timely, and less conservative. They also have lower earnings response coefficients.

Information Environment, Strategic Alliances, ERC

Abstract:
McVay (2006) concludes that managers opportunistically shift core expenses to special items to inflate current core earnings, resulting in a positive relation between unexpected core earnings and income-decreasing special items. However, she further notes that this relation disappears when contemporaneous accruals are dropped from the core earnings expectations model. McVay (2006, 2008) calls for research to improve the core earnings expectations model and to provide additional cross-sectional tests of classification shifting. Using a core earnings expectations model that is not dependent on accrual special items, we show that classification shifting is more likely in the fourth quarter than in interim quarters. We also find more evidence of classification shifting when the ability of managers to manipulate accruals appears to be constrained and in meeting a range of earnings benchmarks. Overall, our evidence provides broad support for McVay’s (2006, 2008) conclusion that managers engage in classification shifting. Our study also sheds new understanding of the conditions under which managers are more likely to employ classification shifting.

Classification shifting, special items, earnings thresholds, accruals manipulation constraints

Abstract:
Prior research generally concludes that compensation committees completely shield executive compensation from the effect of restructuring charges on earnings. In contrast, we find that after controlling for the growth in annual inflation-adjusted CEO cash compensation, compensation committees only partially shield CEO compensation from the adverse effect of restructuring charges on earnings, on average. In further analyses, we identify factors associated with cross-sectional differences in the extent of shielding. Specifically, we find that compensation committees appear to: (1) completely shield initial and subsequent restructuring charges for CEOs with long tenure, provided that the firm had not recorded a charge in the two immediately prior years, (2) provide no shielding of subsequent restructuring charges taken by short-tenured CEOs if the firm reported a prior restructuring charge within two years of the current charge, (3) and partially shield the other categories of restructuring charges. Overall, this study provides evidence that compensation committees evaluate the context of each restructuring in determining the extent to which they will intervene to shield executive compensation from the effect of these charges.

executive compensation, restructuring charges, compensation committee

Abstract:
Prior research addressing questions such as whether investors respond to a hypothesized information event used tests of unusual return and/or trading activity as alternative measures of investor response. We investigate which of these two metrics maximizes the likelihood that a researcher correctly detects the presence or absence of a response. Building on the repeated-sample framework established in Brown and Warner (1980, 1985) and Dyckman et al. (1984), we provide evidence that (1) volume-based metrics, especially measures based on numbers of transactions, provide more powerful tests of investor response to public disclosures than do return-based metrics; and (2) supplementing return-based measures with trading-based measures increases the power of tests designed to detect investor response. Our conclusions are particularly relevant when power is critical (i.e., when sample sizes are small or anticipated investor response is small). Our evidence also suggests that before concluding that investors do not respond to a public disclosure, based on a returns analysis, researchers should confirm the nonresponse inference with trading-based measures.

Absolute Returns, Event Study, Information Content, Unexpected Return, Volume

Abstract:
This study documents that investors exercise their liquidation option on firms facing less severe financial distress than bankruptcy filings or negative earnings. Our sample is 124 firms which survive their first time violation of debt covenants. We find that the valuation shift from earnings to book value of equity in the violation manifestation period is reversed in the post-violation recovery period. This suggests that the valuation distortion in the pre-violation period is temporary rather than permanent.

Covenants violation; Value relevance

Abstract:
Numerous studies, both empirical and analytical, identify causes and provide possible interpretations of cross-sectional variation in trading responses to information releases such as earnings announcements. We extend this line of inquiry within the empirical domain by partitioning volume into two components: (1) participation rate, and (2) participation magnitude. This partitioning explicitly recognizes the fact that similar levels of observed volume response may arise from very different sources. We find that participation rate accounts for approximately 80 percent of the increase in trading around earnings announcements and more than three times the predicted cross-sectional variability in this response. The rate component increases with price response (Karpoff 1986) and large investor activity (Cready 1988) and decreases with firm size and both explicit and liquidity-related costs of transacting (Karpoff 1986). In contrast to Atiase and Bamber's (1994) finding in relation to total volume response, we do not find any evidence that participation magnitude increases with analyst forecast dispersion.

Abstract:
This study examines the relation between ownership structure, as revealed by the percentage of outstanding shares held by institutional investors, and trading volume at earnings announcement dates. We find that volume response as a function of institutional ownership is a quadratic curve that reaches a maximum at around 50% institutional ownership. We show that this relation is consistent with Kim and Verrecchia's (1991) proposition that trading volume response to public announcements increases with the level of cross-investor variation in precision of private predisclosure information.