• Selected
• Entire List

Abstract:
This paper suggests a new measure of one aspect of the quality of accruals and earnings. The major benefit of accruals is to reduce timing and mismatching problems in the underlying cash flows. However, accruals accomplish this benefit at the cost of making assumptions and estimates about future cash flows, which implies that accruals include errors of estimation or noise. Since estimation noise reduces the beneficial role of accruals, this study suggests that the quality of accruals and earnings is decreasing in the magnitude of estimation noise in accruals. More specifically, we develop a simple model of working capital accruals where accruals correct the timing problems in cash flows at the cost of including errors in estimation. Based on the model, we derive an empirical measure of accrual quality as the residual from firm-specific regressions of changes in working capital on past, present, and future operating cash flow realizations. The study concludes with two empirical applications that illustrate the usefulness of our measure of accrual quality. First, we explore the relation of accrual quality to economic fundamentals. We find that accrual quality is negatively related to the magnitude of total accruals, length of the operating cycle, and the standard deviation of sales, cash flows, and earnings, while it is positively related to firm size. Second, we show a strong positive relation between accrual quality and earnings persistence.

Quality; Accruals; Earnings; Persistence; Estimation; Errors

Abstract:
We find strong lunar cycle effects in stock returns. Specifically, returns in the 15 days around new moon dates are about double the returns in the 15 days around full moon dates. This pattern of returns is pervasive; we find it for all major U.S. stock indexes over the last 100 years and for nearly all major stock indexes of 24 other countries over the last 30 years. In contrast, we find no reliable or economically important evidence of lunar cycle effects in return volatility and volume of trading. Taken as a whole, this evidence is consistent with popular beliefs that lunar cycles affect human behavior.

Lunar cycle, stock returns, investor behavior

Abstract:
The existing literature typically does not differentiate between security returns and the returns of investors in these securities; usually implicitly, these two concepts are assumed to be the same. However, the returns of stock investors depend not only on the returns of the securities they hold but also on the timing of their capital flows into and out of these securities. This paper suggests a new and more accurate measure of stock investors' historical returns, which involves dollar-weighting of the returns and properly reflects the effect of investors' timing. Theoretically, the essence of dollar-weighted returns is that they value-weight both the cross-section and the time-series of returns. In practical terms, dollar-weighted returns are computed as internal rate of returns (IRRs) from investment projects in which initial market values and contributions from investors (e.g., stock issues) enter with negative signs, and distributions to investors (e.g., dividends, stock repurchases) and final market values enter with positive signs. The empirical results indicate that aggregate dollar-weighted returns are systematically lower than buy-and hold returns. The annual difference is 1.3 percent for the NYSE/AMEX market over 1926-2002, 5.3 percent for Nasdaq over 1973-2002, and averages 1.5 percent for 19 major stock markets around the world over 1973-2004. Thus, this study provides comprehensive evidence that stock investors' actual returns are considerably lower than those from passive holdings and from those documented in the existing literature on historical stock returns. These results have implications for the debate on the equity premium, for the literature on long-run returns following capital flows, for building successful investment strategies, and others.

Stock returns, capital flows, dollar-weighting

Abstract:
Using essentially all Moody's bond ratings changes between 1970 and 1997, we find no reliable abnormal returns following bond rating upgrades. However, we find negative abnormal returns on the magnitude of 10 to 14 percent in the first year following downgrades. Additional results reveal that this underperformance is especially pronounced for small, low credit quality firms. Also, downgrades underperform in nearly all years in the sample, and a large part of the abnormal returns occur at subsequent earnings announcements. Thus, the evidence suggests that the poor returns result from an underreaction to the announcement of downgrades, rather than from lower systematic risk.

Key Words: Bond ratings; Long-run returns; Market efficiency

Abstract:
We use a comprehensive sample that comprises essentially all Moody's bond rating changes between 1970 and 1997 to examine the long-run stock returns following the changes. Our main finding is that stocks with upgrades outperform stocks with downgrades for up to one year following the announcement but we find little or no reliable difference in returns thereafter. The return differential between stocks with upgrades and downgrades is on the magnitude of 10 to 14 percent in the year following the announcement, and is mostly due to the poor performance of stocks with downgrades. Additional tests reveal that the underperformance of downgrades is primarily due to the poor returns of small and low credit quality firms, which are likely the firms with the largest information problems. Probing into the causes for this phenomenon, we find that current ratings changes predict changes in future ratings and future profitability. More importantly, we find some evidence of significant differences in returns at subsequent earnings announcements of stocks with upgrades and downgrades, which suggests that the market does not fully anticipate the predictable future changes in earnings. We also find strong evidence that the magnitude of the post-announcement returns is increasing in the magnitude of the pre-announcement returns, consistent with a delayed and gradual adjustment to the announcement information. Thus, the limited duration of abnormal returns, the pattern of predictable reactions at subsequent earnings announcements, and the strong relation between pre and post-announcement returns suggest that the abnormal post-announcement returns are at least partly due to incomplete adjustment to information.

Abstract:
We use Dealscan, a database of private corporate lending agreements, to provide large-sample tests of the debt covenant hypothesis. Dealscan offers several advantages over the data available in previous debt covenant studies, principally through much larger sample sizes, more representative samples, and the availability of extensive actual covenant detail. These data advantages allow us to construct powerful tests, in which we find clear support for the debt covenant hypothesis. Apart from direct tests of the debt covenant hypothesis, we exploit these data to provide broad evidence on the economic role of debt covenants. Specifically, we find that private lenders use debt covenants as "trip wires" for borrowers, that private debt covenants are set tightly, and that technical violations occur relatively often, in about 30% of all loans. We also find that violations are not necessarily associated with financial distress, consistent with the idea that the consequences of violation vary considerably depending on the borrowers' economic circumstances, and that violations are often waived for healthy firms. Finally, since we measure covenant slack directly, we report evidence that the extensively-used leverage variable is a relatively poor proxy for closeness to covenants.

Debt covenants; Violations; Dealscan

Abstract:
Properly anticipated equity values (e.g., prices in efficient markets) summarize all available information, and change only in response to new information. New information is by definition unpredictable, which implies that unpredictability of changes is a fundamental characteristic of all proper measures of equity value. Thus, investigating the unpredictability of changes of accounting-based measures of equity value (e.g., EBO values and earnings) is potentially useful in assessing their value-relevance. A major advantage of the unpredictability of changes approach is that it allows for value-relevance investigations which are impossible or problematic with market-based data. To explore whether the unpredictability approach is suitable for practical applications, I formulate predictions based on existing market-based research. Using first-order autocorrelation in changes as a proxy for predictability, I obtain results which are consistent with the findings of market-based research. This agreement in findings provides further assurance about existing results, and suggests that the unpredictability approach is powerful and flexible enough to be of practical use. The paper concludes with a section that illustrates how the unpredictability approach might serve the needs of standard setters in accounting.

Abstract:
Performance pricing is a recent contractual innovation, which ties interest rates to a pre-specified grid of some measure of credit risk. We investigate performance pricing because it is becoming a common feature in bank debt, and essentially represents a rare example of market pricing directly tied to accounting-based measures of performance. Our major findings can be summarized as follows. First, we argue that performance pricing emerged as a response to increasing competitive pressures in the market for corporate financing. It reduces transaction and agency costs, and allows for more efficient contracts, furthering the competitive appeal of bank debt. Second, accounting-based performance pricing provisions are detailed, sophisticated, and expansive. The typical pricing grid accommodates ranges of credit risk and interest rate changes, which seem large compared to the economics of private lending. Third, there is a strong pattern of complementarity between same-variable performance pricing and covenant provisions. Probing further, we find that the typical contract sets the initial pricing at the high-cost end of the performance grid, with a same-variable covenant set tightly beyond the top of the grid. Thus, performance pricing and covenants form a well-defined contractual package, where performance pricing provisions are typically designed to handle credit improvements, while credit deteriorations are handled with covenant provisions.

performance pricing, bank debt, accounting ratios, debt/EBITDA

Abstract:
Survey evidence indicates widely held managerial beliefs that earnings volatility is negatively related to earnings predictability. In addition, existing research suggests that earnings volatility is determined by economic and accounting factors, and both of these factors reduce earnings predictability. We find that the consideration of earnings volatility brings substantial improvements in the prediction of both short and long-term earnings. Conditioning on volatility information also allows one to identify systematic errors in analyst forecasts, which implies that analysts do not fully understand the implications of earnings volatility for earnings predictability.

earnings volatility, earnings predictability

Abstract:
This study makes a critical distinction between the returns of hedge funds and the returns of investors in these funds. Investor returns depend not only on the returns of the funds they hold but also on the timing and magnitude of their capital flows into and out of these funds. The capital flow effect exists for any investment but is especially relevant for hedge funds because of the large magnitude and variation in the associated capital flows. We use dollar-weighted returns (a form of IRR) to assess the properties of actual investor returns on hedge funds and compare them to buy-and-hold fund returns. Our first finding is that annualized dollar-weighted returns are on average about 4 percent lower than corresponding buy-and-hold fund returns. This performance gap rises to as much as 9 percent for “star” funds with the highest buy-and-hold returns and for funds with high volatility of capital flows, a remarkable difference in assessing long-run investment performance. In addition, dollar-weighted returns are below comparable returns for broad-based stock indexes. Our second finding is that dollar-weighted returns are more variable than their buy-and-hold counterparts. The combined impression from these results is that the return experience of hedge fund investors is much worse than previously thought.

Hedge fund, Investor capital flows, Dollar-weighting

Abstract:
This study makes a critical distinction between the returns of hedge funds and the returns of investors in these funds. Investor returns depend not only on the returns of the funds they hold but also on the timing and magnitude of their capital flows into and out of these funds. The capital flow effect exists for any investment but is especially relevant for hedge funds because of the large magnitude and variation in the associated capital flows. We use dollar-weighted returns (a form of IRR) to assess the properties of actual investor returns on hedge funds and compare them to buy-and-hold fund returns. Our first finding is that annualized dollar-weighted returns are on average about 4 percent lower than corresponding buy-and-hold fund returns. This performance gap rises to as much as 9 percent for “star” funds with the highest buy-and-hold returns and for funds with high volatility of capital flows, a remarkable difference in assessing long-run investment performance. In addition, dollar-weighted returns are below comparable returns for broad-based stock indexes. Our second finding is that dollar-weighted returns are more variable than their buy-and-hold counterparts. The combined impression from these results is that the return experience of hedge fund investors is much worse than previously thought.

Hedge fund, Investor capital flows, Dollar-weighting

Abstract:
This study investigates the long-run stock returns following issues of corporate debt. The investigation of long-run returns allows us to use a balance sheet-based method of identifying debt issuers, which has two major advantages. First, the balance sheet method identifies both public and private debt issues. This feature is important because there have been no studies of the information content of private debt issues, while private debt is substantially more prevalent than public debt. Second, the balance sheet-based method yields a comprehensive sample that is approximately eight times larger than those from other studies that investigate long-run performance after debt issues. We find no abnormal mean or value-weighted returns in the five years following straight debt issues. However, we find that convertible debt issuers underperform the market on the order of 50 to 70 percent in the following five years. In pursuit of explanations, we find that convertible debt issues signal a deterioration of future profitability, which accounts for at least part of the stock price underperformance.

Abstract:
The FASB adopted a balance sheet-based model of financial reporting about 30 years ago, and this model has been gradually expanded and solidified to become the required norm around the world today. This article argues that the balance sheet orientation of accounting standard-setting is flawed for the following reasons. First, accounting is supposed to reflect business reality, and thus the essential features of the financial reporting model need to reflect the essential features of the underlying business model. However, the balance sheet orientation of financial reporting is at odds with the economic process of advancing expenses to earn revenues, which governs how most businesses create value, and which represents how managers and investors view most firms. Second, the adoption of the balance sheet approach was driven by conceptual considerations; standard setters argued that the concept of assets is more fundamental and logically prior to the concept of income. However, this article argues that the concept of income is clearer and practically more useful than the concept of assets, especially with the recent proliferation of intangible assets. Third, earnings is the single most important output of the accounting system. Thus, intuitively, improved financial reporting should lead to improved usefulness of earnings. However, the continual expansion of the balance sheet approach is gradually destroying the forward-looking usefulness of earnings, mainly through the effect of various asset re-valuations, which manifest as noise in the process of generating normal operating earnings. During the last 40 years, the volatility of reported earnings has doubled and the persistence of earnings is down by about a third, while there is little change in the properties of the underlying business fundamentals.

financial reporting, conceptual framework, FASB

Abstract:
This paper presents a theory and empirical evidence that investigate the effects of poor matching on the properties of accounting earnings. The key intuition of this theory is that poor matching manifests as noise in the economic relation between revenues and expenses. As a result, poor matching decreases the correlation between contemporaneous revenues and expenses and increases the correlation between non-contemporaneous revenues and expenses. With regards to earnings effects, poor matching increases earnings volatility, decreases earnings persistence, and induces a negative autocorrelation in earnings changes. Since poor matching resolves over time, we expect that all of these effects are less pronounced over longer-horizon definitions of earnings. The empirical tests concentrate on documenting the effects of matching and the associated properties of earnings in a sample of the 1,000 largest U.S. firms over the last 40 years. We find a clear and economically substantial trend of declining contemporaneous correlation between revenues and expenses, while the correlation between revenues and non-contemporaneous expenses is increasing. We also find strong evidence of increased volatility of earnings, declining persistence of earnings, and increased negative autocorrelation in earnings changes. As expected, these trends are less pronounced for longer-horizon definitions of earnings. Based on this evidence we conclude that accounting matching has become worse over time and that this trend has produced a pronounced effect on the properties of the resulting earnings. This evidence also suggests that the FASB's stated goal of moving away from matching and towards more fair-value accounting is likely to continue and deepen the identified trends in the properties of earnings.

matching, earnings properties

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:
We present a theory that poor matching manifests as noise in the economic relation of advancing expenses to earn revenues. As a result, poor matching decreases the correlation between contemporaneous revenues and expenses, increases earnings volatility, decreases earnings persistence, and induces a negative autocorrelation in earnings changes. The empirical tests document these effects in a sample of the 1,000 largest U.S. firms over the last 40 years. We find a clear and economically substantial trend of declining contemporaneous correlation between revenues and expenses, increased volatility of earnings, declining persistence of earnings, and increased negative autocorrelation in earnings changes. The combined evidence suggests that accounting matching has become worse over time and that this trend has a pronounced effect on the properties of the resulting earnings. This evidence also suggests that the standard setters' stated goal of moving away from matching and towards more fair-value accounting is likely to continue and deepen the identified trends in the properties of earnings.

matching principle, fair-value accounting, earnings properties

Abstract:
Changes in Business Week and U.S. News graduate business school rankings have a strong tendency to revert. It seems that existing rankings are essentially simple aggregations of "noisy" information, and reversals of this noise are the most likely cause of reversibility in the rankings. Additionally, there is an almost puzzling lack of correlation between the contemporaneous changes of the two rankings, suggesting that most changes are not driven by common revisions of information. Thus, existing rankings should be probably be viewed as useful but noisy and one-sided signals, rather than as comprehensive and efficient measures of the unobservable "school quality."

Abstract:
This paper develops a model in which earnings and book value are complementary factors in determining equity value. Current earnings relative to book value provides information about how well the firm is currently using its resources. When current earnings to book value is high, the firm is likely to continue its current way of employing resources and earnings is the more important determinant of equity value. When current earnings to book value is low, the firm is more likely to adapt its resources to a superior alternative use, and book value becomes the more important determinant of equity value because book value provides a measure of the value of the firm's resources, independent of how well the resources are currently utilized. The model leads to two main empirical predictions: First, equity value is a convex function of expected earnings and book value. Second, the change in equity value associated with changes in expected earnings increases with the relative level of earnings to book value. Evidence from a variety of specifications is consistent with predictions. Thus, the results imply that equity value is a function of both expected earnings and book value (in contrast to models which incorporate one or the other) and that the form of the function is convex (in contrast to models which assume the two elements of value are simply additive).

Abstract:
This paper examines cross-sectional distributions of scaled annual earnings and earnings changes for all available observations on the annual industrial Compustat database for the years 1975-1993. The distributions are bell- shaped and relatively smooth except in the regions near zero. For both earnings and earnings change distributions there is a trough immediately to the left of zero and a peak immediately to the right of zero which is inconsistent with the overall shape of the remainder of the distribution i.e. the frequencies of small losses and small decreases in earnings are unusually low and the frequencies of small positive income and small increases in earnings are unusually high. We follow up on the distributional evidence that earnings are managed to avoid losses by defining five components of earnings: Cash flow from operations changes in working capital non-operating income special items and other accruals. The evidence suggests that the cash flow and change in working capital components play the primary role in earnings management in the vicinity of zero.

Abstract:
Anecdotal evidence and recent research suggest there are incentives to avoid earnings decreases and losses. This paper provides systematic evidence that firms increase reported earnings to achieve these goals. Specifically, using all available observations on the annual industrial and research Compustat database for the years 1976-1994, cross-sectional distributions of scaled annual earnings changes and earnings are bell-shaped and fairly smooth except in the regions near zero. For both earnings changes and levels distributions, there is a trough immediately to the left of zero and a peak immediately to the right of zero which are inconsistent with the overall shape of the remainder of the distribution, i.e., the frequencies of small decreases in earnings and small losses are unusually low and the frequencies of small increases in earnings and small positive income are unusually high. Exploring the methods of earnings management, we find evidence that two components of earnings, cash flow from operations and changes in working capital, are used to achieve the manipulation of earnings. Finally, we present two theories about the motivation for avoidance of earnings decreases and losses. We find that the main results of this paper are consistent with both prospect theory and managerial opportunistic behavior motivated by stakeholder use of earnings-related heuristics.

Abstract:
Several studies suggest that a firm distress risk factor could be behind the size and the book-to-market effects. A natural proxy for firm distress is bankruptcy risk. If bankruptcy risk is systematic, one would expect a positive association between bankruptcy risk and subsequent realized returns. However, the results demonstrate that bankruptcy risk is not rewarded by higher returns. Thus, a distress factor is unlikely to account for the size and the book-to-market effects. Surprisingly, firms with high bankruptcy risk earn lower than average returns since 1980. Additional results suggest that a risk-based explanation cannot fully explain the anomalous post-1980 evidence.

Abstract:
This study investigates whether the risk of bankruptcy is a systematic risk. Measures of bankruptcy risk are derived from Altman's (1968) and Ohlson's (1980) models of bankruptcy prediction. Systematic risk is proxied by subsequent realized returns. If the risk of bankruptcy is at least partly systematic, one would expect a positive association between present bankruptcy risk and subsequent realized returns. However, the results demonstrate that bankruptcy risk is not rewarded by higher returns for NYSE, AMEX, and NASDAQ firms. In fact, more insolvent firms earn significantly lower than average returns in the NASDAQ subsample. Additional tests suggest that a risk-based explanation is unlikely to fully account for the anomalous NASDAQ result. However, there is evidence that the security prices of the most insolvent NASDAQ firms do not fully reflect the negative implications of available information.