Gary C. Biddle

Does Eva Beat Earnings? Evidence on Associations with Stock Returns and Firm Values

This study tests assertions that Economic Value Added (EVA®) is more highly associated with stock returns and firm values than accrual earnings, and evaluates which components of EVA, if any, contribute to these associations. Relative information content tests reveal earnings to be more highly associated with returns and firm values than EVA, residual income, or cash flow from operations. Incremental tests suggest that EVA components add only marginally to information content beyond earnings. Considered together, these results do not support claims that EVA dominates earnings in relative information content, and suggest rather that earnings generally outperforms EVA.

Are Auditors' Judgments Sufficiently Regressive?

The primary purpose of this paper is to test for the use of the representativeness heuristic by auditors in situations in which its use will lead to judgments that systematically depart from the Bayesian optimal responses. No explicit representation of payoffs was made, nor were subjects typically asked to choose a course of action. Thus it cannot be concluded that use of the representativeness heuristic in the experimental situations tested is not cost effective. To the extent, however, that one is willing to assume that action choices are sensitive to judgments of outcome probabilities, and these action choices have differential expected payoffs, a finding of extensive heuristic use by auditors would suggest further research to assess the economic consequences of such use.

Is Comprehensive Income Useful

With the International Accounting Standards Board (IASB) now considering the question, we examine 16 different definitions of income across three applications: information content, predictive ability and executive compensation contracting. Our results reveal that comprehensive income defined by FASB Statement 130 (NI130) dominates both traditional net income (NI) and fully comprehensive income (NIbroad) in explaining equity returns, but that NI dominates NI130 and NIbroad in explaining executive compensation. These findings are strikingly consistent with prior lobbying positions. In predictive ability, no definition clearly dominates. When income components are considered, NIbroad dominates in all three applications, thus lending support to the disclosure of comprehensive income components.

Stock Price Reactions to LIFO Adoptions: The Association Between Excess Returns and LIFO Tax Savings

Changes in inventory costing methods, especially those involving the last-in, first-out (LIFO) cost-flow assumption, can generate potentially large changes in a firms cash flows due to their impact on taxable earnings. These cash-flow effects provide not only a motive for LIFO changes (which is consistent with the market value rule) but also implications for associated stock price effects: if investors react to LIFOs cash-flow implications rather than to its effects on reported earnings, then positive stock price adjustments should be associated with LIFO adjustments. However, it was noted that the previous studies have considered only a dichotomous variable, whether or not a firm has adopted LIFO. Most firms switching to LIFO now reveal in their financial statement disclosures the tax savings which have been realized. This study uses these disclosures to examine the association between unsystematic returns and the magnitudes of first-year LIFO tax savings for all NYSE firms which adopted or extended their use of LIFO during the period 1972-80. The research design employs within-group comparisons based on cumulative monthly unsystematic (excess) returns with appropriate controls for unexpected earnings performance. This design avoids several methodological weaknesses inherent in the previous studies and allows more definitive tests of hypotheses relating investor reactions to the income and cash-flow effects of LIFO adoptions. As reported more fully below, results based on LIFO adoptions made in 1974 are consistent with a positive association between cumulative excess stock returns and the magnitudes of LIFO tax savings. The results also provide evidence that changes in systematic risk may accompany LIFO adoptions. However, contrary to previous studies, most of the sample firms exhibit downward rather than upward changes in systematic risk.

The Estimation and Determinants of Associations between Returns and Earnings: Evidence from Cross-Industry Comparisons

Associations between accounting earnings and stock returns are modeled and tested by examining relationships between earnings response coefficients and industry structure characteristics. Response coefficients are estimated using a new approach that does not require proxies for market earnings expectations. This approach appears to be well specified relative to a traditional approach and may have wider applicability in other research contexts. A randomization procedure for controlling for returns dependence is also applied. The results suggest that response coefficients differ considerably across industries and that these differences are related to industry entry barriers, product type, growth, financial leverage, and operating leverage.

When Capital Follows Profitability: Non-linear Residual Income Dynamics

Economic reasoning suggests that capital follows profitability. This study introduces into residual income valuation “capital follows profitability” investment dynamics whereby capital investments are guided by the profitability of underlying investment opportunities. These investment dynamics predict convex versus linear relations between future and current residual income, with slope and convexity dependent on investment opportunity. We test these predictions against the linear information dynamics (LID) proposed by Ohlson (1995) and Feltham and Ohlson (1996), with supportive results. These findings point the way to further development of links between firm value and the economics of value creation.

Economic Value Added: Some Empirical Evidence

Traces the growth in the use of economic value added (EVA, previously known as residual income) and uses two previous research studies to assess some claims for its merits. Compares EVA’s ability to explain stock returns with that of earnings before extraordinary items (EBEI) and cash flow using 1984‐1993 US data; and finds EBEI is most closely related. Examines EVA’s incentive effects on management investing, financing and operating decisions and shows that, although EVA users decreased new investment, increased dispositions of assets, increased share repurchases, used assets more intensively and increased residual income, market reactions to this were weak. Suggests possible reasons for this and concludes that EVA may align management incentives with shareholders’ interests but this does not necessarily increase shareholder value.

Inflation, taxes, and optimal inventory policies

This study employs an alternative stochastic model which offers important advantages over those proposed by Cohen and Pekelman, and Biddle and Martin. Rather than optimizing with respect to a single order-up-to level determined at the start of each year, the model permits a second order at year-end. This achieves greater descriptive validity by allowing intrayear (as well as interyear) cost changes and additional purchases after demand has been assessed. More important, there is a greater sensitivity to the effects of tax incentives on year-end procurement decisions and a smaller likelihood of year-end stockouts (which unrealistically affect tax incentives by drastically altering inventory cost structures). As a result, the model is uniquely suited for an examination of optimal choices among alternative inventory costing methods and the optimal ordering policies under each. In this study we extend the model to include not only LIFO and FIFO but also AC, a method not previously considered in order quantity models.

Do Adoptions of International Financial Reporting Standards Enhance Capital Investment Efficiency

We examine whether adoptions of International Financial Reporting Standards (IFRS) enhance capital investment efficiency as measured by investment-cash flow sensitivity and value-enhancing risk taking for a comprehensive sample comprised of 10,340 mandatory and voluntary IFRS adoptions across 26 countries during the pre-financial crisis period of 2001-08. In contrast to prior findings for capital market effects of IFRS adoptions, associations between mandatory IFRS adoptions and capital investment efficiency are found to be stronger in countries with weaker legal protections, more concentrated ownership, and prior reporting standards that differ more from IFRS. Thus, our findings lend support to mandatory but not voluntary IFRS adoptions serving to enhance firm-level capital investment efficiency, particularly in countries with weaker investor protections.