A. Irem Tuna

Why are Earnings Kinky? An Examination of the Earnings Management Explanation

Prior research has documented a “kink” in the earnings distribution: too few firms report small losses, too many firms report small profits. We investigate whether boosting of discretionary accruals to report a small profit is a reasonable explanation for this “kink.” Overall, we are unable to confirm that boosting of discretionary accruals is the key driver of the kink. We caution the use of the ratio of small profit firms to small loss firms as a measure of earnings management. We investigate and discuss a number of alternative explanations for the kink.

An Accounting-Based Characteristic Model for Asset Pricing

We develop a framework to identify firm characteristics that forecast stock returns. We show that forecasting returns is equivalent to forecasting earnings and earnings growth. Thus a characteristic indicates expected returns if it indicates expected earnings and earnings growth that the market prices as being at risk. The model identifies two important characteristics that explain cross-sectional variation in equity returns: (1) earnings-to-price (E/P) and (2) book-toprice (B/P). Because E/P is a yield, it is a valid characteristic to indicate expected returns, though it has not been emphasized in most prior research. B/P is a valid characteristic because it is positively associated with future (risky) earnings growth. This positive correlation is surprising since most prior research labels low B/P stocks as growth stocks. As a validation of our model, we revisit the puzzling negative relation that has been observed between leverage and realized returns. We find evidence of a positive relation between leverage and returns only when returns are conditioned on the set of characteristics identified by our model.The paper presents an accounting framework for identifying characteristics that indicate expected returns. A model links expected returns to expected earnings and earnings growth, so a characteristic indicates expected returns if it indicates expected earnings and earnings growth that the market prices as being at risk. In applying the framework, the paper confirms book-to-price (B/P) as a valid characteristic in asset pricing: B/P is associated with higher expected earnings growth and also captures the risk of that growth not being realized. However, the framework also points to the forward earning-to-price (E/P) as a risk characteristic. Indeed, E/P, rather than B/P, is the relevant characteristic when there is no expected earnings growth, but the weight shifts to B/P with growth. The framework also enables the separation of the expected return for operating risk from that due to financing risk. With this separation, the paper revisits the puzzling negative relation that has been observed between leverage and realized returns, a finding that has been attributed to failure to control for operating risk. We find a positive relation between leverage and returns when operating risk characteristics identified by our model are recognized.

Asset Measurement Uncertainty and Credit Term Structure

In this paper, we test the impact of uncertainty in asset measurement on credit term-structure. The theory of Duffie and Lando (2001) suggests that the inability of creditors to assess asset values precisely will support the existence of non-zero short term credit spreads. Developments in recent years enable us to directly test this theory. First, the development of the credit default swap market allows for examination of more precise and cross-sectionally comparable short term credit spreads. Second, FAS 157, which requires detailed disclosures of the fair values of financial assets to be included in financial statements, provides us a proxy for asset measurement uncertainty. Third, the financial crisis over the last two years presents a natural setting where asset measurement uncertainty was in focus, allowing for powerful tests of the theory. For a sample of U.S. financial institutions over the period August 2007 to March 2009, we find strong support for the Duffie and Lando (2001) theory. Specifically, we find that asset measurement uncertainty, attributable to Level 2 and Level 3 financial assets, is a significant determinant of short term credit spreads. Our findings are robust to a variety of control variables and research design choices.

Premium Pay for Executive Talent: An Empirical Analysis

We examine the extent to which executive talent at the time of the hire affects the design of the executive’s compensation contract at the hiring firm. Using a sample of executives who switched jobs at least once between 1992 and 2007, we find that our proxies for executive talent are positively associated with compensation premiums at the new employer, after controlling for the standard determinants of pay. Moreover, tests for the association between pay for executive talent and performance at the hiring firm indicate that it does not always pay off to pay a premium to attract and retain talented executives, and that this association varies with the type of talent (i.e., “perceived” versus “objective”) the hiring firm rewards.

Do Common Inherited Beliefs and Values Influence CEO Pay

We use the ethnicity of CEOs across 31 countries as a proxy for their common inherited beliefs and values and find an ethnicity effect in CEO variable pay. We find that the ethnicity effect in variable pay is not driven by the ethnicity effects in corporate policy decisions, and that changes in CEO compensation are significantly larger when CEOs are replaced with a person from a different ethnicity. Our estimated ethnicity effect captures the future time reference and religion of CEOs’ ancestors. Finally, we find an ethnicity effect in performance-firing sensitivities (i.e., the sensitivity to being fired due to poor performance).

A Framework for Identifying Accounting Characteristics for Asset Pricing Models, with an Evaluation of Book-to-Price

The paper presents a framework for identifying accounting numbers that indicate risk and expected return. The framework establishes conditions under which book-to-price (B/P), so prominent in asset pricing, indicates expected returns: B/P indicates expected returns if it forecasts future earnings growth and the risk that the growth will not be realized. However, that condition is satisfied only under specific accounting conditions — it depends on the accounting for book value and associated earnings. The empirical analysis confirms that the conditions are satisfied under GAAP accounting, and so identifies book-to-price (B/P) as a valid risk characteristic for asset pricing. However, the framework also points to earnings-to-price (E/P) as a risk characteristic. Indeed, E/P, rather than B/P, is the relevant characteristic when there is no expected earnings growth, but the weight shifts to B/P with growth. The framework also enables the separation of the expected return for operating risk from that due to financing risk. With this separation, the paper revisits the puzzling negative relation that has been observed between leverage and realized returns, a finding that has been attributed to failure to control for operating risk. We find a positive relation between leverage and returns when operating risk characteristics identified by our framework are recognized.