Guochang Zhang

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.

Limitations and Future Directions

In this, the closing chapter, we discuss the limitations of the extant valuation research and suggest possible directions for moving the literature forward. We also explore the links between accounting-based valuation and other research topics and provide our thoughts on how the development of valuation theory can benefit inquiries into other accounting issues.

Regulated Managerial Insider Trading as a Mechanism to Facilitate Shareholder Control

This paper shows that managerial insider trading, suitably regulated, reduces information asymmetry and helps shareholders better screen corporate decisions. In a setting where a firms manager has private information about potential projects and his preferences differ from those of shareholders, I derive a unique perfect-sequential equilibrium (Grossman and Perry, 1986) where the managers inside information is partially revealed through his voluntary purchase of the firms stock, and shareholders screen investment proposals based on the revealed information. However, to make information revelation credible, the manager should be required to report his trading publicly and be prohibited from making a short-term reversal of his position. Copyright Blackwell Publishers Ltd 2001.

Performance Commitments of Controlling Shareholders and Earnings Management

Since the Split Share Structure Reform took effect in China in 2005, holders of nontradable shares (controlling shareholders) have had to negotiate with holders of tradable shares (minority shareholders) to gain the liquidity right. In a typical deal reached, the controlling shareholder agrees to pay share compensation to minority shareholders and, in many cases, also pledges to meet a specific firm performance target (performance commitments). Using this reform setting, we examine the impact of performance commitments on earnings management behavior, and find the following results. First, less profitable firms have greater incentives to make performance commitments that help to reduce the share compensation that controlling shareholders have to pay. Second, firms entering into such commitments engage in earnings management to meet the promised performance target when actual performance falls short, and firms facing greater default costs tend to manage earnings more aggressively. Third, depending on the performance metric stipulated in the commitment contract, firms employ varying methods to manage earnings. We also find that firms that rely on earnings management to meet their performance targets display inferior performance in the postcommitment years relative to firms that do not. Overall, our evidence is consistent with performance commitment contracts (with costly defaults) between a firms controlling and minority shareholders causing incentives for earnings management.

An Examination of the Incremental Usefulness of Balance-Sheet Information Beyond Earnings in Explaining Stock Returns

Until recently, studies in accounting research have predominantly focused on using earnings information to explain stock returns. This article examines how information provided by the other primary financial statement—the balance sheet—is incrementally useful for determining returns. Based on existing models of equity value, the author shows theoretically that returns should be related to three balance sheet–related variables—the previous period’s (equity) capital investment, contemporaneous capital investment, and the profitability change—in addition to the earnings variables used in previous studies. Our empirical analysis yields the following results. First, the three balance sheet–related variables each have a statistically and economically significant effect that is incremental to those of the earnings variables on equity returns, and together they improve the explanatory power of an earnings-only-based model from 11.5% to 13.9% in annual cross-sectional samples. Second, over time, the incremental explanatory power (IEP) of the balance-sheet variables is negatively correlated with the explanatory power of earnings. Third, in cross sections, the balance sheet–related variables have a greater IEP for firms whose earnings are less informative (negative vs. positive earnings firms and young vs. mature firms) and for firms whose future earnings are more uncertain (firms with high vs. low analyst forecast errors, and firms with high vs. low analyst forecast dispersions). These results suggest that information from the balance sheet complements that contained in the income statement about equity returns.

The Market's Valuation of Fraudulently Reported Earnings

This study examines the market valuation of accounting earnings during the period before it is publicly revealed that the earnings are fraudulent. Using both cross-sectional and time-series valuation models, we first find that the market accords less weight to earnings when the accounting numbers are fraudulent. We also show that the market better anticipates the presence of fraud when there is information in the public domain indicating a high ex-ante risk of fraud. Our findings suggest that investors are able to accurately assess the probability of fraud and that such assessments affect the markets valuation of earnings even before it is publicly announced that fraud has occurred.

Mandatory IFRS Adoption, Accounting Quality, and Investment Efficiency: Evidence from China

Abstract This paper investigates changes in accounting quality (AQ) and corporate investment efficiency around the mandatory adoption of International Financial Reporting Standards (IFRS) in China in 2007. We find that Chinese firms experience an overall decline in both AQ (measured by accrual characteristics) and investment efficiency post-IFRS relative to pre-IFRS. There are both similarities and differences in how IFRS impacts investment behaviour between state-owned enterprises (SOEs) and non-SOEs which are confronted with distinct agency problems. Specifically, both under- and over-investment problems are aggravated among SOEs, whereas among non-SOEs only under-investment worsens, not over-investment. We also find that for both SOEs and non-SOEs, declines in investment efficiencies are concentrated on firms with more severe AQ drops. We rationalise these findings in the context of the various agency problems faced by Chinese firms, and infer that mandatory IFRS adoption has led to deteriorating reporting quality and real investment efficiency in China’s transitional economy.

The Scale and Scope of the Client Portfolio and Audit Pricing at the Individual Auditor Level: Evidence from China

This study examines the relation between the scale and scope of an individual auditor’s client portfolio and audit pricing to better understand how auditors of heterogeneous characteristics are differentiated in the audit market. Using a sample from the Chinese market for the period 2001-2010, where the personal identities of signing auditors are publicly disclosed, we find that audit price charged by an individual auditor is positively related to the scale of his/her client portfolio, measured in terms of either total audit fees or the number of clients. However, the industry scope (diversity) of the client portfolio attenuates this positive relation between portfolio scale and pricing. Further analyses indicate that auditors of higher ability and reputation tend to have larger client scales and wider client scopes, and that scale is not related to audit delays whereas industry scope is positively related to delays. Taken together, our results suggest that at the individual auditor level, the scale of the client portfolio conveys the auditor’s ability (type), and given the scale, the industry scope of clients signals the auditor’s workload. Finally, our findings are mostly confined to auditors from non-Big N audit firms.

Fair Value Accounting and Income Measurement: An Application to Standard Setting

In this chapter, we employ the ROM framework outlined in previous chapters to address the relevance of fair value accounting for equity valuation purposes. In recent times, companies worldwide are increasingly required to adopt fair value measurement for financial reporting, moving gradually away from the historical cost convention. This shift is widely believed to have important ramifications for both firms and user groups, but its exact impact is not yet well understood. By extending the ROM developed in previous chapters, we explore here how, and to what extent, fair value measures help to convey an enterprise’s income generation in a way that is pertinent to equity investors.