C.S. Agnes Cheng

The valuation accuracy of the price-earnings and price-book benchmark valuation methods

This paper evaluates the valuation accuracy of the price-earnings (P/E), the price-book (P/B) and a combined price-earnings and price-book (P/E-P/B) benchmark valuation methods. Performance of the benchmark valuation methods relies on the definition of comparable firms. In this paper, comparable firms are selected based on industry membership, size and return on equity as well as combinations of industry membership with size and with return on equity. We find that within the P/E and P/B benchmark valuation methods, the best definition of the comparable firms are based on industry membership combined with return on equity. However, only the industry membership is necessary to define the comparable firms for the combined P/E-P/B method. In sum, the results suggest that, when firms value is unknown, the combined P/E-P/B valuation approach selecting comparable firms based on industry membership performs the best among all the approaches evaluated in this paper.We also find that the P/E benchmark valuation method performs better than the P/B benchmark valuation method and the combined method outperforms either the P/E or the P/B method. These results imply that earnings are more important than book value as a single-number firm valuator over our sample years (from 1973 to 1992) and that both earnings and book values are value relevant, one does not substitute perfectly for the other.

Abnormal Accrual Estimates and Evidence of Mispricing

To estimate abnormal accruals, prior research employs a wide variety of models and estimation procedures. We evaluate the performance of three representative models – modified Jones model (MJ), MJ with operating cash flows (MJOCF), and MJ with return on assets (MJROA) – and two estimation procedures – industry-specific and firm-specific regressions. In evaluating the performance of various models, we use mispricing tests (i.e. relating current accruals to future returns) as our main test. We find that the best performing model is the firm-specific MJOCF model followed by the industry-specific MJROA model. However, when we use the recursive firm-specific procedure (i.e. based on current and previous years’ information only), we do not find the firm-specific MJOCF model outperforms the industry-specific MJROA model. We recommend that researchers use the industry-specific MJROA model to estimate abnormal accruals when investigating earnings management. For evaluating earnings quality that can include management estimation error, the firm-specific MJOCF remains clearly the best model from the perspective of abnormal accrual mispricing.

When do firms revalue their assets upwards? Evidence from the UK

Purpose - The purpose of this paper is to investigate the timing of upward asset revaluations using large UK data. Design/methodology/approach - A standard logistic model is used to examine the timing of upward asset revaluations. The result is further confirmed by using the ordinary least squares regression. Findings - UK firms with higher industrial leverage and share performance two years before the revaluation year are inclined to write up their assets, suggesting that firms choose not to recognise good news unless it has been supported by their superior market performance and industry norm. This finding differs from the leverage reduction as well as the signalling objective suggested by previous literature. Originality/value - This paper provides the first UK evidence on the timing of upward asset revaluation, which further enhance the understanding of the economic determinants of upward asset revaluations.

Abnormal Accrual Estimates and Evidence of Mispricing: ABNORMAL ACCRUAL ESTIMATES AND EVIDENCE OF MISPRICING

To estimate abnormal accruals, prior research employs a wide variety of models and estimation procedures. We evaluate the performance of three representative models – modified Jones model (MJ), MJ with operating cash flows (MJOCF), and MJ with return on assets (MJROA) – and two estimation procedures – industry�?specific and firm�?specific regressions. In evaluating the performance of various models, we use mispricing tests (i.e., relating current accruals to future returns) as our main test. We find that the best performing model is the firm�?specific MJOCF model followed by the industry�?specific MJROA model. However, when we use the recursive firm�?specific procedure (i.e., based on current and previous years’ information only), we do not find the firm�?specific MJOCF model outperforms the industry�?specific MJROA model. We recommend that researchers use the industry�?specific MJROA model to estimate abnormal accruals when investigating earnings management. For evaluating earnings quality that can include management estimation error, the firm�?specific MJOCF remains clearly the best model from the perspective of abnormal accrual mispricing.

Hedge Fund Intervention and Accounting Conservatism

Hedge fund intervention has been associated with many positive corporate changes and is an important vehicle for informed shareholder monitoring. Effective monitoring has also been positively associated with accounting conservatism. Building upon these prior results, we predict an increase in accounting conservatism after hedge fund intervention. We use a large sample of hedge fund activist events and identify control firms with similar likelihoods of being targeted using the propensity score matching method to apply difference-in-difference tests. We find that when hedge fund activists have relatively large ownership and sufficient time to exert their monitoring power, target firms experience significant increases in conditional conservatism. CFO turnovers, upward/lateral auditor switches, and improvements in audit committee independence after intervention are accompanied by greater increases in conditional conservatism. Finally, we find greater increases in conditional conservatism when there is a lack of monitoring by dedicated institutional investors before the intervention. Our study suggests that hedge fund activists improve accounting monitoring tools and thus adds important new evidence on the effectiveness of shareholder monitoring on accounting practices.

The Value Relevance of Earnings and Book Value Under Pooling and Purchase Accounting

Abstract This study examines the value relevance of reported earnings and book value under pooling-of-interests and purchase accounting. Using a sample of 110 merger or acquisition transactions from the period 1988 to 1996, the value relevance of the two accounting approaches is investigated by examining the correlation of post-merger earnings and book value with share price. Regression analysis using Ohlsons (1995) valuation model is conducted for the merger year (m) and the subsequent year ( m + 1 ) using three samples (pooling only, purchase only and a combined sample). The results are as follows: • When pooling accounting is used, only earnings are value relevant, and the results are consistent with earnings under pooling being more value relevant than book value. • When purchase accounting is used, both earnings and book value are value relevant and no significant difference was found between the value relevance of earnings and book value. • A Vuong test indicates that the adjusted R2 of the valuation model under purchase accounting significantly exceeds that under pooling for the merger year only for the combined sample. Thus, this result provides weak evidence that the earnings and book value under purchase accounting better explain firm value than those under pooling. • The relative value relevance of earnings and book value under the two methods is pooling earnings>purchase earnings and purchase book value>pooling book value. • Using proxy variables for earnings and book value reflecting the consolidation framework of Statement of Financial Accounting Standards (SFAS) Nos. 141 and 142, the results indicate that the proxy variables yield earnings and book value data that better explain firm value than those produced using either pooling accounting or purchase accounting for half of the testing periods and sample groups. Thus, our results provide some evidence to support the FASBs decision to eliminate pooling accounting.

State Ownership and Earnings Management around Initial Public Offerings: Evidence from China

This study investigates earnings management by firms around their initial public offerings (IPOs) in domestic Chinese equity markets. Using a sample of 437 IPO firms, we find that Chinese firms tend to inflate earnings around their IPOs. We also show that state-owned enterprises (SOEs) manage earnings to a lesser degree than non-state-owned enterprises (NSOEs) do around IPOs. Furthermore, using path analysis, we find that two incentive factors, CEO shareholding and accessibility to bank loans, explain 48% of the correlation between state ownership and earnings management for IPO firms. In particular, accessibility to bank loans is a more important incentive factor that leads to less earnings management for SOEs than NSOEs.

Value relevance of the earnings impact of lease capitalization

We investigate value relevance of the earnings impact of the Statement of Financial Accounting Standards No. 13 (SFAS 13). SFAS 13 requires committed long-term leases to be capitalized as assets and liabilities along with recognition of depreciation expense and interest charges. This requirement tends to have adverse effects on risk, debt ratios, and earnings numbers. Previous research finds significance of capital lease information through its impact on risk and debt ratios from a balance sheet statement perspective. Unlike previous studies, we evaluate the value relevance of SFAS 13 from an income statement prospective. SFAS 13 requires a restatement of prior years income for the SFAS 13 effect when adopting the standard. Thus, we measure earnings impact of SFAS 13 for the year (t) prior to the adoption as the difference between the restated earnings minus the reported earnings of year t. The earnings impact of SFAS 13 can be reasonably inferred from the footnote disclosure in year t due to the disclosure requirement of Accounting Series Report No. 147. Based on the efficient market hypothesis, the disclosed earnings impact of SFAS 13 of year t should be reflected in the stock price of year t. We employ a return-earnings model to investigate whether the market participants incorporate earnings impact of SFAS 13 in the assessment of market value of firms. We do not find significant value relevance for the earnings impact of SFAS 13 using the traditional linear model. However, we find evidence supporting value relevance for the earnings impact of SFAS 13 using nonlinear models but only when the earnings impact is large. In addition, based on a rank-adjusted earnings model developed in this paper, we find that the earnings impact of SFAS 13 has larger value relevance than do the pre-SFAS No. 13 earnings. While our main objective is to evaluate the value-relevance of earnings caused by SFAS 13, our paper also contributes to an extensive investigation of the performance of different return-earnings models and to the development of a rank-adjusted earnings model.

The value relevance of earnings levels in the return-earnings relation

Purpose - – Prior studies provide mixed propositions on whether earnings levels or earnings changes provide the better explanatory power for variations of stock returns and whether the time-series behavior of earnings affects the value relevance of both earnings variables. This paper aims to compare the value relevance of earnings levels with that of earnings changes in the return-earnings relations. Design/methodology/approach - – The unobservable components model is used to estimate permanent and transitory components of earnings. Findings - – The finding shows that the proxy ability of earnings changes for unexpected earnings is sensitive to a firms time-series earnings permanence property and is unstable and noisy when earnings contain predominantly transitory components, but that of earnings levels is not. The results support earnings levels are a stable and better value relevant proxy in the return-earnings relations. Research limitations/implications - – The findings imply that the valuation role of earnings levels is important in the research relating to earnings components, earnings innovations, and equity valuation, especially when earnings permanence is of interest. Practical implications - – The results provide a new understanding on the role of earnings levels in many business decisions such as executive compensations, institutional investment and conservative accounting where they often involve the choice of using levels and/or changes of earnings variables in making decisions. Originality/value - – The paper contributes to the accounting literature by providing a new insight into the valuation role of earnings levels in the return-earnings relations. The stable value relevance of earnings levels also has important implications, especially for studies that use only earnings levels to assess earnings quality and earnings attributes.

The yellow brick company: An instructional case for integrating the teaching of tax and managerial accounting

Abstract In recent years, the emphasis in accounting education has shifted from technical instruction to a broader understanding of the role of accounting in decision-making. One outgrowth of this new emphasis has been an integration of the accounting curriculum, whereby courses assimilate and explore the interrelationships among the various accounting subareas as well as with other disciplines. The aim of this instructional case is to help bridge the gap that typically exists between tax and management accounting teaching. Through the evaluation of three mutually exclusive alternatives, students are systematically introduced to the ways that implicit taxes, alternate tax structures, and the treatment of net operating losses (NOLs) can alter the relative profitability and risk of alternative courses of action. The case thereby helps students who do not take courses in taxation to appreciate that taxes are not simply payments to the government after the fact. Rather, they play an important and integral role in managerial decision-making.