Ashiq Ali

Permanent versus transitory components of annual earnings and estimation error in earnings response coefficients

Abstract Previous research has generally estimated unexpected earnings as the change relative to the previous year, assuming that shocks to annual earnings are purely permanent. In the presence of transitory components of annual earnings, we predict that using earnings changes as a proxy for unexpected earnings causes earnings response coefficients to be understated and the estimation error to be negatively cross-sectionally correlated with persistence. The negative correlation causes the association between earnings response coefficients and persistence to be overstated. We use the IMA (1,1) model to capture transitory components of annual earnings and obtain results that are consistent with our predictions.

Changes in Institutional Ownership and Subsequent Earnings Announcement Abnormal Returns

This study documents an association between changes in institutional ownership during a calendar quarter and abnormal returns at the time of subsequent announcements of quarterly earnings. The result is driven by the portfolio returns of the extreme deciles of changes in institutional ownership, suggesting that institutions trade based on information about future earnings, but that such trading is not widespread. We also find that the difference between earnings announcement returns of the extreme deciles of change in institutional ownership is much greater when change in institutional ownership of a stock is driven by relatively few institutions, measured using the skewness of the distribution of change in institutional ownership of the stock. This result suggests that when fewer differentially informed investors make disproportionately large purchases or sales of stocks, a greater amount of the information on which they base their trades is not impounded in prices until the subsequent earnings announcement. Finally, we show that our results obtain for institutional investors with short-term focus, such as independent advisors, investment companies and insurance companies, but not for institutional investors with long- term focus, such as internally managed pension funds, educational institutions, and private foundations. This result further supports our conclusions regarding informed trading by institutions based on information about forthcoming earnings.

Accruals and Future Stock Returns: Tests of the Naive Investor Hypothesis

We explore whether the association between accruals and future returns documented by Sloan (1996) is due to fixation by naïve investors on the total amount of reported earnings without regard for the relative magnitude of the accrual and cash flow components. Contrary to the predictions of the naïve investor hypothesis, we find that the predictive ability of accruals for subsequent annual returns and for quarterly earnings announcement stock returns is not lower for large firms or for firms followed more by analysts or held more by institutions. Further, we find that the ability of accruals to predict future returns does not seem to depend on stock price or transaction volume, measures of transaction costs, also contrary to predictions of the naïve investor hypothesis. These results are robust to regression and hedge portfolio tests. We conclude that the predictive ability of accruals for subsequent returns does not seem to be due to the inability of market participants to understand value-relevant information.

The magnitudes of financial statement effects and accounting choice: The case of the adoption of SFAS 87☆

Abstract We examine the accounting choice decision in the context of the timing of adoption of SFAS 87. Unlike most prior studies, we consider interactions between firm characteristics and the magnitudes of the financial statement effects of an accounting decision. We expect that including interactions will both enhance the ability to explain accounting choice, and facilitate distinction between omitted variables (Ball and Foster, 1982) and hypothesized relations. Results are consistent with these expectations.

Investor Sentiment, Accruals Anomaly, and Accruals Management

This study examines the effect of investor sentiment on the accruals anomaly. We find that for small stocks mispricing per unit of accruals is greater in high sentiment periods as compared with low sentiment periods. This result is consistent with the notion that in high sentiment periods individual investors pay less attention toward understanding the accruals and cash flow components of earnings. This effect is observed primarily for small stocks because these stocks are more likely to be followed by individual investors, who tend to have limited attention. We also find that for small stocks reported accruals are greater during high sentiment periods as compared with low sentiment periods, suggesting that managers exploit the greater overvaluation per unit of accruals during high sentiment periods.

Market Underestimation of the Implications of R&D Increases for Future Earnings: The US Evidence

This study shows that future abnormal returns to R&D increases are concentrated around subsequent earnings announcements. It further shows that market expectations, implied from stock prices, underestimate the future earnings benefits of increase in R&D. Finally, it documents that in their forecasts of future earnings, security analysts also underestimate the effect of increase in R&D spending. 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. The finding in this study contributes to the longstanding debate in accounting on whether the U.S GAAP requirement to expense R&D costs when incurred causes investors to underestimate the benefits of R&D.

Dividend increases and future earnings

We examine the relation between dividend increases and unexpected changes in future earnings. This issue has been the subject of numerous empirical studies. However, the extant evidence on this issue is inconclusive. We allow for the fact that investor demand for dividend paying stocks is time-varying and the market pays a premium for such stocks when the demand is high. Moreover, when the dividend premium (DP) is high, dividend increases could be due to managers catering to high demand for dividends by investors. We find that when the DP is low, there is a significant positive relation between dividend increases and unexpected future earnings changes, consistent with the signaling theory of dividends. However, when the DP is high, the relation between dividend increases and unexpected future earnings changes is insignificant. This finding suggests that when the DP is high, managers increase dividends primarily to cater to investors’ demand for dividends rather than to signal an increase in the future profitability of the firm. Finally, as is the case with prior studies, we find an insignificant relation between dividend increases and unexpected changes in future earnings when we constraint the relation to be constant over time.

Discussion--Security Analyst Experience and Post-Earnings-Announcement Drift

Mikhail, Walther, and Willis (2003a) (hereafter MWW) show that the postearnings-announcement drift (PEAD) is less for firms followed by more experienced analysts. They motivate their study by noting that prior studies (e.g., Bernard and Thomas [1990]) show that PEAD is due to the market’s failure to properly incorporate in security prices serial correlation in seasonally differenced quarterly earnings. Furthermore, analysts fail to properly incorporate in their forecasts serial correlation in forecast errors (e.g., Ali et al. [1992]; Abarbanell and Bernard [ 19921). However, with experience, they become better at it (Mikhail, Walther and Willis 2003). Also, as analysts’ experience increases, the market’s expectations tend to become more consistent with analysts’ forecasts than with seasonal random walk forecasts (Mikhail, Walther, and Willis [ 19971). Based on these prior findings, MWW predict that the amount of PEAD would be smaller for firms followed by more experienced analysts because the serial correlation in their forecast errors is likely to be smaller and the market is more likely to use analysts’ forecasts rather than seasonal random walk forecasts in forming their expectations. My discussion of MWW is organized as follows. The first section discusses the contribution MWW makes to the literature on the post earnings announcement drift phenomenon. The second section comments on their research design. The final section discusses opportunities for future research.

Restrictions on Managers’ Outside Employment Opportunities and Asymmetric Disclosure of Bad versus Good News

This study examines the effect of restrictions on managers’ outside employment opportunities on voluntary corporate disclosure. The recognition of the Inevitable Disclosure Doctrine (IDD) by courts in the U.S. states in which the firms are headquartered place greater restrictions on their managers from joining or forming a rival company. We find that on average the IDD adoption increases the asymmetric withholding of bad news. We further show that the IDD adoption increases the asymmetric withholding of bad news relative to good news for firms whose managers are mainly concerned about losing their current job. However, an opposite effect is observed for firms whose managers are mainly interested in seeking promotion elsewhere. Furthermore, these effects are less pronounced for firms subject to greater monitoring of their disclosure policy. These results suggest that managers’ career concerns affect corporate disclosure policy and the effect varies with the type of career concerns.

The Effect of SFAS 141 and 142 on the Likelihood and the Form of Financing of Corporate Takeovers

We investigate the effects of the elimination of the pooling method, under SFAS 141, and of goodwill amortization, under SFAS 142, on the form of acquisition financing and on a firm’s takeover probability. We find that before these accounting rules, target firms’ step-up value is positively associated with the probability of using stock-for-stock as against partial stock financing. Afterwards, this association decreases significantly and is indistinguishable from zero. These results suggest that the pooling method of accounting is a significant determinant of the form of acquisition financing. These rules also led to a greater decrease in takeover probability for firms with larger predicted step-up values, and this effect is less pronounced for firms with more of the predicted step-up value made up of goodwill. These results suggest that both the pooling method and the method for goodwill amortization are significant determinants of takeover probability. Overall, the study uses a natural experiment to provide a novel finding that certain acquisition related accounting methods significantly influence the form of acquisition financing and takeover probability.We investigate the effects of accounting rule changes that eliminate the pooling method (SFAS 141) and goodwill amortization (SFAS 142) on the form of acquisition financing and on a firm’s takeover probability. The primary requirement to qualify for the pooling method is structuring the transaction as a stock-for-stock exchange. We find that before the new accounting rules, target firms’ step-up value is positively associated with the probability of using stock-for-stock as against partial stock financing. After the new rules, this association decreases significantly and is indistinguishable from zero. These results suggest that in the pre SFAS 141 period, greater use of stock-for-stock exchanges for target firms with larger step-up values was motivated by the favorable effect of the pooling method on the reported income of the acquirer, and this motivation to use stock-for-stock exchanges goes away with the elimination of the pooling method. The new rules also resulted in a greater decrease in takeover probability for firms with larger step-up values than for firms with smaller step-up values, presumably due to the elimination of the pooling method. When the step-up value of a firm is composed primarily of goodwill, the above effect is attenuated, consistent with the elimination of goodwill amortization. Overall, the study uses a natural experiment to provide a novel finding that accounting methods have significant effects on the form of acquisition financing and on takeover probability. We appreciate the helpful comments of Jarrad Harford, Bob Holthausen, and workshop participants at Hong Kong University of Science and Technology, London Business School, London School of Economics, State University of New York at Buffalo, and the University of Houston.