John O'Hanlon

Estimating the equity risk premium using accounting fundamentals

This study uses recent developments in the theoretical modelling of the links between unrecorded accounting goodwill, accounting profitability and the cost of equity, together with Capital Asset Pricing Model (CAPM) betas, to estimate the ex-ante equity risk premium in the U.K.. The results suggest that the premium is in the region of 4% to 5%. This lends support to the suggestion that the ex-ante equity risk premium is substantially less than the historical average of the excess of equity returns over the risk-free rate.

Conservative accounting and linear information valuation models

Prior research using the residual income valuation model and linear information models has generally found that estimates of firm value are negatively biased. We argue that this could result from the way in which accounting conservatism effects are reflected in such models. We build on the conservative accounting model of Feltham and Ohlson (1995) and the Dechow, Hutton and Sloan (1999) (DHS) methodology to propose a valuation model that includes a conservatism-correction term, based on the properties of past realizations of residual income and other information. Other information is measured using analyst-forecast-based predictions of residual income. We use data comparable to the DHS sample to compare the bias and inaccuracy of value estimates from our model and from models similar to those used by DHS and Myers (1999). Valuation biases are substantially less negative for our model, but valuation inaccuracy is not markedly reduced.

Dirty surplus accounting flows: international evidence

Abstract It has been suggested that dirty surplus accounting (violation of the clean surplus relationship (CSR)) may result in mismeasurement of performance and value, and that cross-country variation in dirty surplus accounting may cause particular problems for international comparisons. Using articulated data that are largely hand-collected, we evaluate the potential impact of dirty surplus accounting in France, Germany, the UK and the US for the period 1993-2001. First, we report summary statistics on dirty surplus accounting flows. These indicate that distributions of dirty surplus flows are often not centred on zero, and that there is significant cross-country variation in such flows. Then, we use a measure of multi-period abnormal performance to document the bias and inaccuracy, and cross-country variation therein, that would have arisen from omitting dirty surplus flows in measuring performance. Where significant bias and cross-country variation therein arise, they are largely caused by omission of goodwill-related flows, which regulators are eliminating as a dirty surplus item. In contrast, all classes of dirty surplus flow contribute to significant cross-country variation in inaccuracy. Finally, we address the issue of dirty surplus flows from the valuation perspective. We use the residual income valuation model, which relies partly on CSR, to test whether perfect-foresight forecasts of dirty surplus accounting flows explain beginning-of-interval market-to-book ratios after controlling for other inputs to the valuation model. We find little evidence to suggest that omission of dirty surplus flows from residual income value estimates would have caused systematic valuation errors in the period and countries examined.

The Basu Measure as an Indicator of Conditional Conservatism: Evidence from UK Earnings Components

Following the work of Basu in 1997, the excess of the sensitivity of accounting earnings to negative share return over its sensitivity to positive share return (the Basu coefficient) has been interpreted as an indicator of conditional accounting conservatism. Although this interpretation is supported by substantial evidence that the Basu coefficient is associated with likely demands for conservatism, concerns have arisen that it may reflect factors not directly related to conservatism, and that this may adversely affect its validity as an indicator of that phenomenon. We argue that evidence on the validity of the Basu coefficient as an indicator of conditional conservatism can be obtained by disaggregating earnings into components, classifying those components by whether or not they are likely to be affected by conditional conservatism, and examining whether the Basu coefficient arises primarily from components likely to be affected by conditional conservatism. We implement this procedure for UK firms reporting under FRS 3: Reporting Financial Performance from 1992 to 2004. Although a substantial proportion of the Basu coefficient emanates from cash flow from operating and investing activities (CFOI), which cannot directly reflect accounting conservatism, its incidence across other components of earnings is predominantly within those components likely to be affected by conditional conservatism. Also, although the bias documented by Patatoukas and Thomas in 2009 is present in all of our aggregate earnings measures, it is heavily concentrated in the CFOI component of earnings and largely absent from components classified as likely to be affected by conditional conservatism. With the important caveat that researchers should test the robustness of their results to the exclusion of the element of the Basu coefficient due to cash flows, our findings are consistent with the conditional conservatism interpretation of the coefficient.

The value relevance of disclosures of liabilities of equity‐accounted investees: UK evidence

Abstract This study examines the value relevance of mandated disclosures by UK firms of the investor‐firm share of liabilities of equity‐accounted associate and joint venture investees. It does so for the six years following the introduction of FRS 9: Associates and Joint Ventures, which forced a substantial increase in such disclosures by UK firms. Since the increased disclosure requirements were partly motivated by concern that single‐line equity accounting concealed the level of group gearing, and in light of previous US results, it is predicted that the mandated investee‐liability disclosures have a negative coefficient in a value‐relevance regression. The study also examines whether value‐relevance regression coefficients on investee‐liability disclosures are more negative for joint ventures than for associates and whether they are more negative in the presence of investor‐firm guarantees of investee‐firm obligations than in the absence of such guarantees. The study reports that the coefficient on all investee‐liability disclosures taken together has the predicted negative sign, and is significantly different from zero. It finds little evidence that the negative valuation impact of liability disclosures is stronger for joint venture investees overall than for associate investees overall, or stronger for guarantee cases overall than for non‐guarantee cases overall. There is, however, some evidence that the impact for joint venture guarantee cases is stronger than that for joint venture non‐guarantee cases and stronger than that for associate guarantee cases.

Financial Distress and the Earnings‐Sensitivity‐Difference Measure of Conservatism

Following Basu (1997), the difference between the sensitivity of accounting earnings to negative equity return (proxy for bad news) and its sensitivity to positive equity return (proxy for good news) is interpreted as an indicator of conditional accounting conservatism. However, there is concern that the earnings-sensitivity difference (ESD) may be affected by factors other than conditional conservatism, and that this may impair its reliability as an indicator of conditional conservatism. Motivated by such concerns and by recognition that financial distress could contribute to an ESD through a conditional-conservatism route and/or through a non-conditional-conservatism route, we examine the association between financial distress and the ESD for U.S. non-financial firms. By decomposing the association into an element arising from accruals, which can reflect conditional conservatism, and an element arising from cash flow from operating activities (CFO), which cannot directly reflect conditional conservatism, we seek evidence as to whether such association arises through a conditional-conservatism route or through a non-conditional-conservatism route. We find that positive association between financial distress and the ESD arises predominantly through the accruals component of earnings rather than the CFO component, consistent with it arising primarily because of a higher degree of conditional conservatism in relatively financially distressed firms. The inference that there is a positive association between financial distress and conditional conservatism is supported by other non-equity-return-based measures of conditional conservatism. The evidence in this paper suggests that the effect of financial distress does not significantly impair the reliability of the ESD as an indicator of conditional conservatism.

Did loan-loss provisioning by UK banks become less timely after implementation of IAS 39?

Following the financial and banking crisis of the late 2000s, accounting regulators sought to replace the incurred-loss method of loan-loss provisioning by a more forward-looking expected-loss method. Difficulties arose, including with respect to the weight that expected-loss provisioning should place on objective evidence of loss relative to evidence of a less specific and more judgemental nature. This paper provides evidence relevant to this issue by examining whether loan-loss provisioning by UK banks was less timely under the stricter evidence requirements of the IAS 39 incurred-loss regime implemented in 2005 than under the less strict evidence requirements of the previous UK incurred-loss regime. It does so by reference to the relationship in time between loan write-offs and loan-loss expense. The results do not suggest that provisioning became less timely under the stricter evidence requirements of IAS 39. There is no evidence that provisioning became less timely immediately prior to the crisis of the late 2000s. Also, there is no evidence that general provisioning, permitted under the pre-IAS 39 regime, enhanced the timeliness of loan-loss provisioning. The results do not suggest that stricter requirements regarding the evidence necessary to support recognition of loan losses have resulted in less timely loan-loss provisioning.

How to lose at winning strategies

r n udging from the amount of published re5 g search on the topic, the random walk hypothesis must rank as one of the most important ideas in investment. On the other hand, it certainly is not the most popular few other concepts have attracted so many attempts to disprove its rather unpalatable implications. This paper shares with its predecessors the search for profitable trading strategies. It also has the aim of reminding researchers of some ground rules that they should observe if readers are to be convinced that the search has been successful and that the advice should be followed. The essence of our argument is that competent researchers with simple computational skills and historical data will always be able to find trading rtrategies that would have been profitable in the past. The difficulty is identifying strategies that will work tomorrow! +

Portfolio theory applied to on-line financial information: a computer-based graphical approach *

Portfolio Risk Management is a fundamental part of standard business finance courses. This topic, however, is sometimes difficult for students to grasp and demonstration of the practical implications without using a computer is difficult due to the complex and tedious portfolio mathematics. In particular, it can be difficult for students to relate the expected return-risk characteristics of the individual investments that are available to the more favourable risk-return characteristics of the portfolios that can be generated by combining the individual investments. Also, the availability of on-line financial data services is an increasingly prominent aspect of the financial market environment in which students are going out to work after graduation. The Portfolio Risk Management packagehas therefore been developed at Lancaster University in order to provide students with a tool that expedites the application of portfolio mathematics. It helps the students to gain an intuitive grasp of the theory by presen...

Did Loan-Loss Provisioning by UK Banks Become More Timely or Less Timely after Adoption of IAS 39?

From 2005, IAS 39: Financial Instruments: Recognition and Measurement required UK banks to support loan-loss provisioning with objective evidence that losses had been incurred, and thereby eliminated general loan-loss provisioning. It has been argued that the IAS 39 incurred-loss method of loan-loss provisioning delayed the recognition of loan losses by UK banks, and that this caused particular problems by delaying loss recognition until the onset of the financial and banking crisis of the late 2000s. By examining the relationship in time between loan write offs and loan-loss expense for 37 UK banks, this paper provides evidence on whether loan-loss provisioning by UK banks was more timely or less timely in years immediately following the introduction of IAS 39 than it had been previously. Overall, the evidence suggests that provisioning becoming more timely after the introduction of IAS 39, although the effect is only statistically significant for the subset of banks with a stock market quotation during the interval examined. Furthermore, there is no evidence that provisioning became less timely immediately prior to the financial and banking crisis of the late 2000s or that the general-provision element of the pre-IAS 39 loan-loss expense was more timely than the corresponding specific-provision element.