Earnings QualityEarnings Quality
Patricia M. Patricia M. DechowDechowCatherine Catherine SchrandSchrand
We thank the Association of Investment Management and Research (We thank the Association of Investment Management and Research (AIMR) for fundingAIMR) for funding
Accounting Quality ScandalsAccounting Quality Scandals
HIH HIH –– underestimation of underestimation of insurance liabilitiesinsurance liabilitiesHarvey Norman: franchisees Harvey Norman: franchisees revenue (Boston Chicken)revenue (Boston Chicken)ParmalatParmalat –– cash balance cash balance overstated
Enron Enron –– special purpose special purpose entities to hide debtentities to hide debtWorldCom WorldCom –– capitalization capitalization of expensesof expensesTyco Tyco –– disclosure of loansdisclosure of loansQwest International Qwest International ––network capacity swapsnetwork capacity swapsXerox Xerox –– longlong--term leases and term leases and cookie jar reservescookie jar reservesWaste Management Waste Management ––capitalization rules
overstated
capitalization rules
What has caused the observed What has caused the observed decline in earnings quality?decline in earnings quality?
Poor corporate governancePoor corporate governanceManagement compensation packagesManagement compensation packagesDecline in auditing qualityDecline in auditing qualityMovement away from manufacturing towards the Movement away from manufacturing towards the creation of intangible assets that are difficult to valuecreation of intangible assets that are difficult to valuePhilosophical change in accounting standard settingPhilosophical change in accounting standard settingLack of scrutiny by financial analystsLack of scrutiny by financial analystsGrowth of institutional investors with no interest in Growth of institutional investors with no interest in firm’s businessfirm’s businessState of the economyState of the economy
Outline of monographOutline of monograph
Define earnings quality (Define earnings quality (ChptChpt 2)2)Provide evidence from research on financial Provide evidence from research on financial statement analysis to assess earnings quality statement analysis to assess earnings quality ((ChptsChpts 33--6)6)Provide evidence on red flags that suggest Provide evidence on red flags that suggest potential earnings quality issues:potential earnings quality issues:
Incentives for earnings management (Incentives for earnings management (ChptChpt 7)7)Corporate governance (Corporate governance (ChptChpt 8)8)
Provide evidence of the role of voluntary Provide evidence of the role of voluntary disclosures in predicting disclosures in predicting earnings(Chptearnings(Chpt 9)9)
What is earnings quality?What is earnings quality?
Earnings quality is contextual depends on userEarnings quality is contextual depends on userStandard settersStandard settersAuditorsAuditorsCompensation committeesCompensation committeesDebt holdersDebt holdersInvestorsInvestorsFinancial analystsFinancial analysts
All would agree fraudulent reporting is low qualityAll would agree fraudulent reporting is low qualityWe adopt a financial analyst perspectiveWe adopt a financial analyst perspective
What is earnings quality?What is earnings quality?
Objective of the financial analystObjective of the financial analyst1.1. Forecast earningsForecast earnings2.2. Make stock recommendationsMake stock recommendations
Earnings are higher quality: Earnings are higher quality: 1.1. The more predictable and easier to forecast; The more predictable and easier to forecast;
ANDAND2.2. The better they map into intrinsic valueThe better they map into intrinsic value
1. Earnings predictability1. Earnings predictability
What factors make earnings easier to predict What factors make earnings easier to predict compared to cash flows?compared to cash flows?
The higher persistence (The higher persistence (ββ close to one) close to one) EEt+1t+1 = = ββEEtt + + εεtt
The fewer transitory componentsThe fewer transitory componentsThe less volatileThe less volatile
On average, earnings is superior to current cash On average, earnings is superior to current cash flows on these dimensionsflows on these dimensions
Persistence of earnings Persistence of earnings vsvs cash flowscash flows
0.85
0.76 0.760.72 0.71 0.71
0.65
0.41
0.300.25
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
Sales OperatingIncomeBefore
Depreciation
OperatingIncome AfterDepreciation
Pretax Income EarningsBefore
Special Items
IncomeBefore
ExtraordinaryItems
CFO FCF CFF CFI
Estim
ated
Per
sist
ence
Par
amet
er
2. Earnings and intrinsic value2. Earnings and intrinsic value
Do earnings map into value better than do cash flows?Do earnings map into value better than do cash flows?Measuring intrinsic valueMeasuring intrinsic value
Current stock priceCurrent stock priceActual future cash flowsActual future cash flowsResidual income model value (using future prices)Residual income model value (using future prices)
Stock prices Stock prices –– yes yes –– but functional fixation?but functional fixation?Future cash flows Future cash flows –– mixed mixed –– but it’s a noisy measurebut it’s a noisy measureIntrinsic value Intrinsic value –– generally yesgenerally yes
Suggests that on average, earnings map more easily into Suggests that on average, earnings map more easily into value than do current cash flows. value than do current cash flows.
What affects earnings predictability What affects earnings predictability across firms?across firms?
Stage of firms life cycle (steady state Stage of firms life cycle (steady state vsvs growing or growing or declining)declining)
Sources of competition particularly for growing firmsSources of competition particularly for growing firmsTransitory components and losses for declining firmsTransitory components and losses for declining firmsFinancial statement analysis of I/S and B/S componentsFinancial statement analysis of I/S and B/S components
Quality of forecasts and estimates made by management Quality of forecasts and estimates made by management imbedded in accruals (intentional and unintentional imbedded in accruals (intentional and unintentional estimation error)estimation error)Accounting standards followed by the firmAccounting standards followed by the firmManagement’s voluntary disclosuresManagement’s voluntary disclosures
Stage of life cycle and persistence: Stage of life cycle and persistence: Sales growthSales growth
-0.2
-0.1
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
1 2 3 4 5 6
Year Relative To Portfolio Formation Year
Sales Growth Rate
Source: Nissim and Penman (2001)
Stage of life cycle and persistence: Stage of life cycle and persistence: RNOA growthRNOA growth
Figure 4.2: Return on Net Operating Asset (RNOA) over time. Deciles formed on the magnitude of RNOA.
Source: Nissim and Pehman (2001).
-0.1
-0.05
0
0.05
0.1
0.15
0.2
0.25
0.3
0.35
0.4
1 2 3 4 5 6
Year Relative To Portfolio Formation Year
RNOA
0
0.05
0.1
0.15
0.2
0.25
0.3
0.35
0.4
0.45
0 1 2 3 4 5 6 7 8 9
Asset Turnover
Prof
it M
argi
n
Industry Median ISO 14% Line
Health Services, Hospitals etc.
Water SupplyPulp Mills
Communications
Hotels, Lodging
Wholesale Grocers
Grocery StoresDurable Goods, Wholesale
Mobile Homes
Transportation
Mobile Homes Dealers
Accounting ServicesBusiness Services, Photocopying, Art
Petroleum Pipelines
Electric Services
Airport, Terminal Services
Warehouse Storage
Gold and Silver Ores
14% Iso-Return on Net Operating Asset Line
SolimanSoliman (2003) (2003) : This figure plots 248 three: This figure plots 248 three-- digit SIC industry groups from 1970digit SIC industry groups from 1970-- 2001. The sample 2001. The sample consists of 77,199 firmconsists of 77,199 firm--year observations. The points represent median profit margin anyear observations. The points represent median profit margin and median d median asset turnover by industry. The asset turnover by industry. The IsoIso-- RNOA line represents the profit margin and asset turnover RNOA line represents the profit margin and asset turnover combination that would result in an RNOA (return on net operatincombination that would result in an RNOA (return on net operating assets) of 14%.g assets) of 14%.
Persistence is affected by nonPersistence is affected by non--operating componentsoperating components
Model ROEt-1 only Full Model Coefficient (Std. Dev) Coefficient (Std. Dev) Intercept 0.042 (0.004) 0.029 (0.005) ROE 0.664 (0.023) Gross margin 0.636 (0.022) SG&A 0.639 (0.022) Depreciation 0.629 (0.073) Interest 0.621 (0.019) Minority interest
{ Operating income components
0.615 (0.078) Non-operating income 0.548 (0.037) Income taxes 0.445 (0.028) Discontinued operations 0.003 (0.028) Extraordinary items 0.153 (0.058) Adjusted R2 42.3% (0.029) 49.0% (0.023)
Source: Fairfield, Sweeney, and Yohn (1996)
Persistence is predictable using I/S Persistence is predictable using I/S and B/Sand B/S
Signal
Measurement
Coefficient (predicted to be negative) (* for significant)
Inventory ∆Inventory - ∆Sales -0.017* Accounts Receivable ∆Accounts Receivable - ∆Sales 0.009* (wrong sign) Capital Expenditures ∆Industry CAPX - ∆Firm CAPX 0.005 (wrong sign) Gross Margin ∆Sales - ∆Gross Margin -0.031* Selling and Admin ∆SG&A - ∆Sales -0.010 (insignificant) Effective Tax Rate (Average ETR for past 3 years –
ETRt) x ∆EPSt -0.594*
Inventory Method 0 for LIFO, 1 for FIFO or other -0.006* Audit Qualification 0 for unqualified, 1 for qualified 0.014 (insignificant) Labor Force -1*(%∆ in sales per employee) -0.026*
Source: Abarbanell and Bushee (1997): regress the future change in earnings on current red flags
Persistence is a function of accrualsPersistence is a function of accruals
Sloan (1996)Sloan (1996)Earningst+1 = α + βEarningst + ε t+1, and (3.1)
Earningst+1 = α + γ1Accrualst + γ2Cash from Operationst + ε t+1. (3.2)
Sloan obtains the following result using 40,679 firm-years from 1962 – 1991:
Earningst only Accruals and cash flows Model Coefficient (t-statistic) Coefficient (t-statistic) Intercept 0.015 (32.57) 0.011 (24.05) Earnings 0.841 (303.98) Accruals 0.765 (186.53) Cash from operations 0.855 (304.56)
Various decomposition of accruals can provide Various decomposition of accruals can provide more insights into earnings persistencemore insights into earnings persistence
Decomposing accruals into inventory, A/R, A/P, tax Decomposing accruals into inventory, A/R, A/P, tax payable, etcpayable, etcDecomposing accruals into “discretionary” Decomposing accruals into “discretionary” vsvs“nondiscretionary” using Jones model“nondiscretionary” using Jones modelDecomposing accruals based on extent of “estimation Decomposing accruals based on extent of “estimation error”error”Taxable income versus book incomeTaxable income versus book incomeVolatility of cash flows versus magnitude of accrualsVolatility of cash flows versus magnitude of accrualsNature of the business and operating cycle will also Nature of the business and operating cycle will also affect the level of accrualsaffect the level of accruals
Persistence is a function of accrualsPersistence is a function of accruals
0.5
0.6
0.7
0.8
0.9
1
1.1
1 2 3 4 5 6 7 8 9 10
Rank of current accruals (difference between earnings and CFO)
Estim
ated
Per
sist
ence
Par
amet
er
Persistence of Earnings Persistence of CFO
Source: Dechow and Ge (2003)The sample consists of 98,624 firm-years from 1987 to 2002. Decile 1 consists of firms with the most negative accruals. Decile 10 consists of firms with the most positive accruals. Current accruals are calculated as the difference between earnings and CFO. The
persistence coefficients of earnings and operating cash flows (CFO) are estimated from the following regressions: Earningst+1 = at + bEarningst + et
CFOt+1 = at + bCFOt + et
Persistence is a function of both Persistence is a function of both current and longcurrent and long--term accrualsterm accruals
Fig1b. Persistence of Earnings and FCF Based on Ranks of Total Accruals
Persistence of Earnings
Persistence of FCF
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
1.1
1 2 3 4 5 6 7 8 9 10
Ranks of Total Accruals
Pers
isten
Persistence of Earnings Persistence of FCF
Source: Dechow and Ge (2003)
What causes investors to What causes investors to misunderstand the nature of the misunderstand the nature of the
quality of accruals?quality of accruals?
Manipulation of longManipulation of long--term and short term accrualsterm and short term accrualsEstimation error in extreme accruals that reversesEstimation error in extreme accruals that reversesMisunderstanding of future growthMisunderstanding of future growth
Declining returns to scaleDeclining returns to scaleOverOver--optimistic growth forecasts by analysts for high optimistic growth forecasts by analysts for high accrual firmsaccrual firms
Misunderstanding of temporary components Misunderstanding of temporary components (particularly for loss firms)(particularly for loss firms)
High accrual are “glamour” stock , low accrual are High accrual are “glamour” stock , low accrual are “value” stock so driven partly by market sentiment“value” stock so driven partly by market sentiment
Persistence is affected by accounting Persistence is affected by accounting standards usedstandards used
What is income?What is income?Income is an indicator of performance about an Income is an indicator of performance about an enterprise and its management; ORenterprise and its management; ORIncome is an enhancement of wealth or command Income is an enhancement of wealth or command over economic resources.over economic resources.
Standards moving away from performance Standards moving away from performance evaluation towards “balance sheet” focus evaluation towards “balance sheet” focus (measuring assets and liabilities)(measuring assets and liabilities)
Income is an enhancement of wealthIncome is an enhancement of wealth
Accounting rules focus on valuing assets and liabilities (the Accounting rules focus on valuing assets and liabilities (the balance sheet)balance sheet)
Fair value accountingFair value accountingSecuritizationSecuritizationEquity and debt securities “available for sale”Equity and debt securities “available for sale”Asset impairmentsAsset impairmentsGoodwill rulesGoodwill rulesDeferred taxesDeferred taxes
More transitory componentsMore transitory componentsFrequency of losses increasesFrequency of losses increases
Balance sheet approach implies a decline in earnings quality Balance sheet approach implies a decline in earnings quality under our definitionunder our definition
More difficult to forecast earnings More difficult to forecast earnings Harder to map earnings alone into valueHarder to map earnings alone into value
Frequency of special items has Frequency of special items has increased over timeincreased over time
0.000
0.005
0.010
0.015
0.020
0.025
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
Spec
ial I
tem
s/To
tal O
pera
ting
Expe
nses
Q1Q2Q3Q4
Source: Bradshaw and Sloan (2002)
Relation between earnings and Relation between earnings and returns:returns:
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
1952
1954
1956
1958
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
Year
Adj
uste
d R-
squa
re
Source Francis and Source Francis and SchipperSchipper 19991999
Relation between book value and Relation between book value and market valuemarket value
0%
10%
20%
30%
40%
50%
60%
70%
80%
1953
1955
1957
1959
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
Year
Adj
uste
d R-
squa
re
Source Francis and Source Francis and SchipperSchipper 19991999
How has the market coped with decline in How has the market coped with decline in earnings quality? Rise of pro forma earningsearnings quality? Rise of pro forma earnings
PANEL A: QUARTER 1 PANEL B: QUARTER 2
-0.005
0.000
0.005
0.010
0.015
0.020
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
StreetGAAP
-0.005
0.000
0.005
0.010
0.015
0.020
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
StreetGAAP
Panel C: Quarter 3 Panel D: Quarter 4
-0.005
0.000
0.005
0.010
0.015
0.020
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
StreetGAAP
-0.005
0.000
0.005
0.010
0.015
0.020
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
StreetGAAP
Source: Bradshaw and Sloan (2002)
Are Are proformaproforma higher quality than higher quality than GAAP?GAAP?
Proforma adjustments reported in 1,149 press releases (source Bhattacharya, Black, Christensen, and Larson (2002))
0%
5%
10%
15%
20%
25%
Depreciationand
amortization
Stockcompensation
costs
Merger andacquisition
costs
R&D costsand w rite-offson purchased
in-processR&D
Gains andlosses on
sales
Extraordinaryitems and
discontinuedoperations
Alteration ofnumber of
sharesoutstanding
for EPS
Otheradjustments
Perc
enta
ge
Are Are proformaproforma higher quality than higher quality than GAAP?GAAP?
Source: Bradshaw and Sloan (2002)
Panel A: Earnings Response Coefficient
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
8604
8702
8704
8802
8804
8902
8904
9002
9004
9102
9104
9202
9204
9302
9304
9402
9404
9502
9504
9602
9604
9702
9704
Year-Quarter
Ear
ning
s Res
pons
e C
oeff
icie
nt
StreetGAAP
Pro forma more likely to beat analyst Pro forma more likely to beat analyst forecastsforecasts
EPS Above versus Below Mean Analyst Forecast
38.7%
77.5% 80.1%
61.3%
22.5% 19.9%
0.0%10.0%20.0%30.0%40.0%50.0%60.0%70.0%80.0%90.0%
GAAP IBES Pro Forma
EPS at or above Mean Forecast EPS below Mean Forecast
Are items excluded from Are items excluded from proformaproformareally transitory?really transitory?
-10.0%0.0%
10.0%20.0%30.0%40.0%50.0%60.0%70.0%80.0%
1988 1990 1992 1994 1996 1998
Hed
ge R
etur
n
Total ExclusionsOther Exclusions
Source: Doyle, Source: Doyle, LundholmLundholm and and SolimanSoliman (2003)(2003)
Results suggest that items are not as “transitory” as investors Results suggest that items are not as “transitory” as investors thinkthink
Outline of monographOutline of monograph
Define earnings quality (Define earnings quality (ChptChpt 2)2)Provide evidence from research on financial Provide evidence from research on financial statement analysis to assess earnings quality statement analysis to assess earnings quality ((ChptsChpts 33--6)6)Provide evidence on red flags that suggest Provide evidence on red flags that suggest potential earnings quality issues:potential earnings quality issues:
Incentives for earnings management (Incentives for earnings management (ChptChpt 7)7)Corporate governance (Corporate governance (ChptChpt 8)8)
Provide evidence of the role of voluntary Provide evidence of the role of voluntary disclosures (disclosures (ChptChpt 9)9)
Earnings Management Around the World(Leuz, Nanda and Wysocki, 2003)
0
5
10
15
20
25
30
Aust
ria
Gre
ece
Kore
a (S
outh
)
Portu
gal
Italy
Taiw
an
Switz
erla
nd
Sing
apor
e
Ger
man
y
Japa
n
Belg
ium
Hon
g Ko
ng
Indi
a
Spai
n
Indo
nesi
a
Thai
land
Paki
stan
Net
herla
nds
Den
mar
k
Mal
aysi
a
Fran
ce
Finl
and
Phili
ppin
es
Uni
ted
Kin
gdom
Sw
eden
Nor
way
Sou
th A
frica
Can
ada
Irela
nd
Aust
ralia
Uni
ted
Stat
es
Agg
rega
te E
arni
ngs
Man
agem
en
What accounts are managed most?What accounts are managed most?
0%
10%
20%
30%
40%
50%
60%
70%
80%
Ove
rsta
te re
venu
ean
d ac
coun
tsre
ceiv
able
/Und
ersta
teba
d de
bt a
llow
ance
Und
ersta
te a
nex
pens
e (o
ther
than
COG
S)
Ove
rsta
tein
vent
ory/
Und
ersta
teCO
GS
Und
ersta
te A
/Rdi
scou
nts/a
llow
ance
sot
her t
han
bad
debt
s
Ove
rsta
te P
PE
Ove
rsta
te in
tang
ible
san
d ot
her l
ong-
term
asse
ts
Miss
tate
men
t of
accr
ued
liabi
litie
s
Ove
rsta
te se
curit
yva
luat
ion
Perc
enta
g
The sample is collected from the Accounting and Auditing Enforcement Releases from AAER 1 to AAER 1745. The releases that involve manipulations of annual financial statements are identified. The final sample consists of 294 separate firms that had manipulated 426 different accounts. Firms can manipulate more than one account, so the percentages add up to more than 100%.
Incentives for earnings managementIncentives for earnings management
Extensively studied by academicsExtensively studied by academicsBoost stock priceBoost stock price
Cheaper to raise new financing, acquire other firmsCheaper to raise new financing, acquire other firmsBoost value of stock option grant/insider tradeBoost value of stock option grant/insider trade
Meet analysts’ forecastsMeet analysts’ forecastsKeeps interest in the stock high (affects liquidity)Keeps interest in the stock high (affects liquidity)Reputation of managementReputation of management
Contractual incentivesContractual incentivesEarnings based bonuses Earnings based bonuses Debt covenants, unions, etcDebt covenants, unions, etc
Regulatory incentives Regulatory incentives –– loan loss reserve, link to taxesloan loss reserve, link to taxes
Corporate governance and the opportunity to Corporate governance and the opportunity to engage in earnings managementengage in earnings management
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Company has
an auditcommittee
Company hasan
independentoutside
blockholderthat owns
more than 5percent of the
stock
The companyhas a big six
auditor
CEO is alsoChairman of
the Board
CEO is alsothe founder ofthe company
More than 50percent of the
Board areinsiders
Percentage of each sample
SEC enforcement sampleControl sample
Figure 8.1: Comparison of governance structures for firms that violate GAAP to a control group, Source: Dechow, Sloan, and Sweeney (1996)
Earnings quality and audit firmEarnings quality and audit firm
Research generally indicates firms report lower discretionary Research generally indicates firms report lower discretionary accruals whenaccruals when
The auditor has industry expertiseThe auditor has industry expertiseThe auditor has performed the audit for a longer time periodThe auditor has performed the audit for a longer time periodWhen a big 4When a big 4--66--8 auditor is used (client selection may drive this)8 auditor is used (client selection may drive this)
But, are not more likely provide qualified opinions on high But, are not more likely provide qualified opinions on high accrual firms even though more of these firms end up restating accrual firms even though more of these firms end up restating earnings and having SEC enforcement actions. earnings and having SEC enforcement actions. Audit changes are a red flagAudit changes are a red flag
Have low accruals prior to switch more normal level of accruals Have low accruals prior to switch more normal level of accruals afterwardsafterwardsAuditor too conservative or firms want to boost earningsAuditor too conservative or firms want to boost earningsFirms that switch are more likely to have debt covenant violatioFirms that switch are more likely to have debt covenant violations, higher ns, higher leverage, declining earnings (poor performance)leverage, declining earnings (poor performance)
Earnings quality and audit firmEarnings quality and audit firm
Does nonDoes non--audit services reduce earnings quality?audit services reduce earnings quality?Public disclosures on fees only recently disclosed in USPublic disclosures on fees only recently disclosed in USGenerally a little bit is Okay, too much is badGenerally a little bit is Okay, too much is badTax advisory services may not hurt as much as consulting? Tax advisory services may not hurt as much as consulting? -- firms are less likely to restate earnings when they provide firms are less likely to restate earnings when they provide tax advisory services (Kinney, tax advisory services (Kinney, PalmrosePalmrose, and , and ScholzScholz 2003 2003 –– private source of data) private source of data) Frankel, Johnson, Nelson (2003): yes Frankel, Johnson, Nelson (2003): yes –– higher higher discretionary accruals, more likely to meet analyst forecastsdiscretionary accruals, more likely to meet analyst forecastsMore on this tomorrow!More on this tomorrow!
Do analysts play a monitoring role?Do analysts play a monitoring role?
Not much direct evidence on analysts playing a Not much direct evidence on analysts playing a positive monitoring role in marketspositive monitoring role in marketsUnfortunately evidence suggestsUnfortunately evidence suggests
Do not fully adjust forecasts for the fact that high Do not fully adjust forecasts for the fact that high accrual firms are likely to have a decline in EPSaccrual firms are likely to have a decline in EPSParrot what management tell themParrot what management tell themForecasts start optimistic and end pessimistic (so Forecasts start optimistic and end pessimistic (so management can beat the forecast)management can beat the forecast)
Outline of monographOutline of monograph
Define earnings quality (Define earnings quality (ChptChpt 2)2)Provide evidence from research on financial Provide evidence from research on financial statement analysis to assess earnings quality statement analysis to assess earnings quality ((ChptsChpts 33--6)6)Provide evidence on red flags that suggest Provide evidence on red flags that suggest potential earnings quality issues:potential earnings quality issues:
Incentives for earnings management (Incentives for earnings management (ChptChpt 7)7)Corporate governance (Corporate governance (ChptChpt 8)8)
Provide evidence of the role of voluntary Provide evidence of the role of voluntary disclosures (disclosures (ChptChpt 9)9)
Can voluntary disclosure improve the Can voluntary disclosure improve the predictability of earnings?predictability of earnings?
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
-0.51
-0.45
-0.39
-0.33
-0.27
-0.21
-0.15
-0.09
-0.03 0.0
30.0
90.1
50.2
10.2
70.3
30.3
90.4
5More
Deviation from consensus forecast
Perc
enta
ge o
f firm
-qua
rter
s
No Guidance Guidance
Source: Hutton (2003). Sample consists of NIRI members (pre REG. FD)
Management guidance tends to be pessimistic Management guidance tends to be pessimistic
(reduce analyst forecast of EPS(reduce analyst forecast of EPS))Proportion of On Target Management Forecast
0.20.210.220.230.240.250.260.27
1993-1997 1998-2001 Pre RegFD Post RegFD
Year
Prop
ortio
n
Proportion of Pessimistic Management Forecast
0
0.1
0.2
0.3
0.4
0.5
0.6
1993-1997 1998-2001 Pre RegFD Post RegFD
Year
Prop
ortio
n
Source: Cotter, Tuna, and Source: Cotter, Tuna, and WysockiWysocki (2003)(2003)A pessimistic forecast of EPS is A pessimistic forecast of EPS is below actual reported EPS, an below actual reported EPS, an optimistic forecast is above actual optimistic forecast is above actual reported EPS.reported EPS.
Proportion of Optimistic Management Forecast
0
0.1
0.2
0.3
0.4
0.5
1993-1997 1998-2001 Pre RegFD Post RegFD
Year
Pro
porti
on
Management forecasts improve Management forecasts improve analyst forecast accuracyanalyst forecast accuracy
-0.25
-0.2
-0.15
-0.1
-0.05
0
0.05
0.1
1 2 3
Earn
ings
Sur
pris
e
Earnings Surprise based on: Analysts’ prior forecasts Managers’ forecasts Analysts’ posterior forecasts
Source: Source: FengFeng (2003) The graph plots the median of earnings surprises based o(2003) The graph plots the median of earnings surprises based on analysts’ prior n analysts’ prior forecasts, managers’ forecasts and analysts’ posterior updated fforecasts, managers’ forecasts and analysts’ posterior updated forecasts for each group.orecasts for each group.
Voluntary disclosure and Voluntary disclosure and predictability of earningspredictability of earnings
Generally more disclosure is associated with lower costs Generally more disclosure is associated with lower costs of capital (advantage of voluntary disclosure)of capital (advantage of voluntary disclosure)Better MD&A disclosure in annual report is associated Better MD&A disclosure in annual report is associated with lower forecast errors, less dispersion of errorswith lower forecast errors, less dispersion of errorsAcross country results indicates that countries with Across country results indicates that countries with better disclosure have more accurate analystsbetter disclosure have more accurate analystsFirms disclose more when they have financing needs Firms disclose more when they have financing needs and less when there are higher potential proprietary and less when there are higher potential proprietary costs or litigation costs. costs or litigation costs. Firms are more likely to disclose bad news early (before Firms are more likely to disclose bad news early (before earnings announcement).earnings announcement).
Do management act in their self Do management act in their self interest when providing guidance?interest when providing guidance?
Evidence that management release bad news Evidence that management release bad news before option grantsbefore option grantsEvidence that managers like to release all the Evidence that managers like to release all the bad news early but leak out the good news so bad news early but leak out the good news so they can have positive earnings surprisethey can have positive earnings surprise
SummarySummary
Provide an analysts’ perspective on earnings qualityProvide an analysts’ perspective on earnings qualityCareful financial statement analysis can improve the ability to Careful financial statement analysis can improve the ability to forecast earningsforecast earningsQuality of earnings depends on the nature of the business as welQuality of earnings depends on the nature of the business as well l as the integrity and quality of managementas the integrity and quality of managementCorporate governance and auditors play a role in improving Corporate governance and auditors play a role in improving earnings qualityearnings qualityImportant to understand management’s incentives Important to understand management’s incentives –– who are who are they trying to please? What do they want? Are the overly they trying to please? What do they want? Are the overly concerned with stock price and meeting forecasts?concerned with stock price and meeting forecasts?Recent accounting rules generally have not improved earnings Recent accounting rules generally have not improved earnings quality from the perspective that we adopt. quality from the perspective that we adopt.