Carla Hayn

The information content of losses

Abstract This study hypothesizes that because shareholders have a liquidation option, losses are not expected to perpetuate. They are thus less informative than profits about the firms future prospects. The results are consistent with the hypothesis. They also show that the documented increase in the earnings response coefficent as the cumulation period increases appears to be due exclusively to the effect of losses. The liquidation option effect extends to profitable cases where earnings are low enough to make the option attractive. Alternating explanations for the low informativeness of losses such as mean reversal of earnings are not supported by the tests.

The Changing Time-Series Properties of Earnings, Cash Flows and Accruals: Has Financial Reporting Become More Conservative?

This paper documents changes in the patterns of earnings, cash flows and accruals over the last four decades that provide an indication of a trend in reporting conservatism. In the absence of a generally accepted definition of conservatism, a number of measures consistent with the general notion of reporting conservatism are identified and examined. These measures rely on the accumulation of nonoperating accruals, the timeliness of earnings with respect to bad and good news, characteristics of the earnings distribution, the association between cash flows and earnings and the market-to-book ratio. The patterns that emerge are consistent with more conservative financial reporting beginning in the late 1970s. The findings have implications for accounting standard setting, the regulation of financial information and financial statement analysis.

Measuring Reporting Conservatism

The paper examines the power and reliability of the differential timeliness (DT) measure developed by Basu (1997) to gauge reporting conservatism. We identify certain characteristics of the information environment unrelated to conservatism that affect the DT measure and find that it is sensitive to the degree of uniformity in the content of the news during the examined period, the types of events occurring in the period, and firms’ disclosure policies. Our tests, based on both actual and simulated data, indicate that assessing the extent of reporting conservatism requires the recognition of, and control for, these characteristics. We also find that the difference in the timeliness of reporting bad versus good news is likely to be more pronounced than previously reported. Further, we provide additional evidence on the negative association between the DT measure and alternative aspects of conservatism, suggesting that the exclusive reliance on any single measure to assess the overall conservatism of a reporting regime (firms, countries or time periods) is likely to lead to incorrect inferences. Measuring Reporting Conservatism

Measurement Errors and Information Content of Segment Reporting

This paper assesses the measurement errors inherent in segment reporting. Measurement errors are gauged by comparing the correlation of segment results with their industry to the corresponding correlation for single line-of-business firms operating in the same industry. The findings show that the measurement errors in segment information, particularly earnings, are larger than those in the financial information reported by single line-of-business firms. The cross-sectional variation in the measurement errors can be traced to cost/revenue allocations, management intervention in segment reporting, and the operational structure of multi-segment firms. Market tests indicate that the information content of segment information is inversely related to the estimated measurement errors.

Rising Conservatism: Implications for Financial Analysis

We provide evidence that is consistent with an increase in reporting conservatism by U.S. companies in the past few decades. Using a constant sample of almost 900 companies, we examined several measures of accounting conservatism, including the level and rate of accumulation over time of negative nonoperating accruals, the differential timeliness of incorporating good news versus bad news in reported earnings, the skewness and variability of the earnings distribution relative to the cash flows distribution, and changes in the market-to-book ratio. The increased conservatism has contributed to a persistent and prevalent decline in reported profitability, an increase in the incidence of losses, and an increase in the dispersion of earnings. Increased conservatism affects financial ratios and P/E multiples. Thus, incorporating information on the level of a companys reporting conservatism improves valuations and the yield to investment strategies that are based on these ratios. Anecdotal evidence suggests that financial reporting by U.S. companies has become more conservative in recent decades. For example, most of the new accounting pronouncements have had the effect of accelerating expense recognition and further deferring the recognition of revenues. Furthermore, U.S. capital markets have become more litigious, which induces company managers to be less aggressive in their financial reporting and auditors to be more cautious and prudent in their audits. The observation of an increase in the frequency of losses in recent years, although undoubtedly caused by a number of factors, is consistent with an increase in reporting conservatism. The fact that generally accepted accounting principles have a built-in conservative bias is widely recognized, but the recent trend toward an even greater conservatism has not been systematically documented. We examine the change in the degree of conservatism in financial reporting over the 1950–98 period and discuss its implications for financial statement analysis. Using a constant sample of almost 900 companies, we identify several measures of conservatism, including the level and rate of accumulation over time of negative nonoperating accruals (defined as the difference between net income and cash flows from operations, excluding depreciation and changes in the balance of noncash working capital accounts), the differential speed of incorporating good and bad news in reported earnings, the skewness and variability of the earnings distribution relative to the cash flows distribution, and changes in the market-to-book ratio (M/B). The results of a series of tests are consistent with an increase in reporting conservatism, particularly since about 1980. For example, reported profitability gauged by such ratios as return on assets shows a persistent decline over time without a parallel drop in operational cash flows. In fact, the gap between reported earnings and operational cash flows has widened in recent years, which reflects a systematic and material accumulation of negative nonoperating accounting accruals. This trend is consistent with a transition to a more conservative reporting regime. Other measures of conservatism, among them the speedier incorporation in the financial statements of bad news relative to good news, indicate a similar trend. The finding of increased conservatism suggests that the high M/B values and P/E multiples that peaked in the late 1990s arose, in part, because of changes in the financial reporting regime. Thus, they may indicate more than overpricing. When adjusted for conservatism, an adjustment that takes the form of removing from the income numbers the accumulation of negative nonoperating accruals, the sharp rise in M/Bs and P/Es in the 1980s and 1990s becomes much more modest. We provide at least one measure of change in reporting conservatism that is readily available to analysts as a way to improve fundamental analysis—the current accumulation of nonoperating accruals. We demonstrate that this measure can be used to characterize the reporting regime of individual companies and, therefore, to adjust the earnings and equity multiples computed for a company.

Do Analysts Account for Earnings Management

This paper examines whether analysts earnings forecasts incorporate or exclude the managed earnings component. The results, based on a sample of 285 restatements and a much larger sample of cases where earnings are likely to have been managed upward, are consistent with analysts predicting the earnings number that will eventually be reported by the firm.. Further, the managed earnings component appears to influence analysts’ subsequent earnings forecasts, leading to upward forecast revisions and upgraded stock recommendations. The findings are further consistent with management signaling through earnings management favorable future performance. What do Analysts Really Predict? Inferences from Earnings Restatements and Managed EarningsWe examine whether analysts include the managed earnings component in their forecasts or are surprised by the managed earnings component. We also investigate whether analysts’ earnings forecasts for future periods and their stock recommendations are affected by earnings management in the current period. The results, based on a sample of 583 restatements and a much larger sample of cases where earnings are likely to have been managed upward, are consistent with analysts forecasting the managed earnings number. Further, the managed earnings component appears to influence analysts’ subsequent earnings forecasts, leading to upward forecast revisions and upgraded stock recommendations which appear to be unwarranted given the firms’ subsequent operating performance.

The Changing Relevance of Accounting Information to Debt Holders over Time

We examine the change over time in the information content of accounting numbers from the perspective of bondholders and the causes for this change. Using proprietary longitudinal data, we find that, in contrast to the decline in the information content of accounting numbers to equity holders over time, the information content to bondholders has held steady or risen. The rise is attributable to economic factors such as an increase in risk and in the frequency of unfavorable news to which the valuation of debt is more sensitive than that of equity. There are indications, however, that reporting factors, specifically an increase in conservatism over the last four decades, is associated with this rise. The findings contribute to the scant literature on the use of financial information by bondholders and the extent to which financial reporting meets their unique information needs. Given debt holders prominence as users of financial statements, the findings have important implications for accounting standard setting.