Lakshmanan Shivakumar

Momentum, Business Cycle and Time Varying Expected Returns

A growing number of researchers argue that time-series patterns in returns are due to investor irrationality and thus can be translated into abnormal profits. Continuation of short-term returns or momentum is one such pattern that has defied any rational explanation and is at odds with market efficiency. This paper shows that profits to momentum strategies can be explained by a set of lagged macroeconomic variables and payoffs to momentum strategies disappear once stock returns are adjusted for their predictability based on these macroeconomic variables. Our results provide a possible role for time-varying expected returns as an explanation for momentum payoffs. Copyright The American Finance Association 2002.

The Role of Accruals in Asymmetrically Timely Gain and Loss Recognition

We investigate the role of accrual accounting in the asymmetrically timely recognition (incorporation in reported earnings) of gains and losses. Timely recognition requires accruals when it precedes complete realization of the gains and losses in cash. We show that nonlinear accruals models incorporating the asymmetry in gain and loss recognition (timelier loss recognition, or conditional conservatism) offer a substantial specification improvement, explaining substantially more variation in accruals than equivalent linear specifications. Conversely, conventional linear accruals models, by omitting the loss recognition asymmetry, exhibit substantial attenuation bias and offer a comparatively poor specification of the accounting accrual process. Linear specifications also understate the ability of current earnings to predict future cash flows. These findings have implications for our understanding of accrual accounting and conservatism, as well as for researchers estimating discretionary accruals, earnings management, and earnings quality. Copyright University of Chicago on behalf of the Institute of Professional Accounting, 2006.

Do firms mislead investors by overstating earnings before seasoned equity offerings

I examine earnings management around seasoned equity offerings and, consistent with Rangan (1998) and Teoh et al. (1998), find evidence of earnings management around the offerings. However, in contrast to their conclusions, I show that investors infer earnings management and rationally undo its effects at equity offering announcements. The investor naïveté conclusion of Teoh et al. (1998) and Rangan (1998) appears to be due to test misspecification. I conclude that seasoned equity issuers’ earnings management may not be designed to mislead investors, but may merely reflect the issuers’ rational response to anticipated market behavior at offering announcements.

Cross-sectional estimation of abnormal accruals using quarterly and annual data: effectiveness in detecting event-specific earnings management

Abstract This paper addresses certain methodological issues that arise in estimating abnormal (or discretionary) accruals for detection of event-specific earnings management. Unlike prior studies (e.g., Dechow, Sloan, and Sweeney, 1995; Guay, Kothari, and Watts, 1996) that rely primarily on time-series models, we focus on the specification of cross-sectional models of expected accruals using quarterly as well as annual data. Perhaps more importantly, we present a variation of the Jones model that is shown to be well specified for all cash flow levels. We show that the cross-sectional Jones model yields systematically positive (negative) estimates of abnormal accruals for firms whose cash flows are below (above) their industry median. Using mean squared prediction errors as well as simulation analysis, we show that our model is more powerful than the cross-sectional Jones model in detecting earnings management. In addition, we examine differences in the power of current accrual models in detecting earnings...

Liquidity and the Post-Earnings-Announcement Drift

The post-earnings-announcement drift is a longstanding anomaly that conflicts with market efficiency. This study documents that the post-earnings-announcement drift occurs mainly in highly illiquid stocks. A trading strategy that goes long high-earnings-surprise stocks and short low-earnings-surprise stocks provides a monthly value-weighted return of 0.04 percent in the most liquid stocks and 2.43 percent in the most illiquid stocks. The illiquid stocks have high trading costs and high market impact costs. By using a multitude of estimates, the study finds that transaction costs account for 70–100 percent of the paper profits from a long–short strategy designed to exploit the earnings momentum anomaly. One of the most persistent anomalies that seem to violate the semi-strong-form market efficiency as defined by Fama is the post-earnings-announcement drift (PEAD), or earnings momentum. This anomaly refers to the fact that companies reporting unexpectedly high earnings subsequently outperform companies reporting unexpectedly low earnings. More specifically, a company’s standardized unexpected earnings (SUE) is defined as the difference between the last available quarterly earnings and the earnings during that same quarter in the previous year, scaled by the standard deviation of this difference over the previous eight quarters. A trading strategy that each month goes long the stocks in the top decile of SUE and short the stocks in the bottom decile of SUE earns, on average, 90 bps per month (10 percent annually) over the 1972–2005 period. The goal of this article is to demonstrate that stock liquidity is an important consideration for understanding the persistence of the PEAD anomaly over the years. Previous studies have not taken trading costs into account in the calculation of abnormal returns. We studied the impact of illiquidity on the profitability of the PEAD trading strategy and show that this strategy is likely to be unprofitable after adjusting for transaction costs. First, we studied the relationship between the PEAD and illiquidity by using double-sorted portfolios. Our findings suggest that the PEAD is prevalent mainly in illiquid stocks. We examined the profitability of the long–short SUE strategy after sorting stocks into decile portfolios on the basis of their illiquidity. For this analysis, we used the Amihud measure of stock illiquidity, which is the average of the daily price impacts of the order flow (i.e., the daily absolute price change per dollar of daily trading volume). Returns to the long–short SUE strategy increased monotonically from 0.04 percent per month for the most liquid stocks to 2.43 percent for the most illiquid stocks. Because we found that the PEAD is more prevalent in illiquid stocks, following a PEAD trading strategy will generate high transaction costs and a substantial price impact. We used several transaction-cost estimates to calculate the net returns to PEAD trading strategies. Our results show that transaction costs consume 70–100 percent of the potential profits. This lack of profitability can thus explain the persistence of the PEAD anomaly and is consistent with Jensen’s definition of market efficiency and Rubinstein’s definition of minimally rational markets.

Inflation Illusion and Post-Earnings-Announcement Drift

This paper examines the cross-sectional implications of the inflation illusion hypothesis for the post-earnings-announcement drift. The inflation illusion hypothesis suggests that stock market investors fail to incorporate inflation in forecasting future earnings growth rates, and this causes firms whose earnings growths are positively (negatively) related to inflation to be undervalued (overvalued). We argue and show that the sensitivity of earnings growth to inflation varies monotonically across stocks sorted on standardized unexpected earnings (SUE) and, consistent with the inflation illusion hypothesis, show that lagged inflation predicts future earnings growth, abnormal returns, and earnings announcement returns of SUE-sorted stocks. Interestingly, controlling for the return predictive ability of inflation weakens the ability of lagged SUE to predict future returns of SUE-sorted stocks.

Does Market Structure Affect the Immediacy of Stock Price Responses to News

This study compares the speed of price adjustments to seasoned equity offering announcements by NYSE/AMEX and Nasdaq stocks. We find that price adjustments are quicker by as much as one hour on Nasdaq. This result is not due to differences in issuer characteristics or announcement effects across the markets, but due to differences in market structures. Greater risk taking by dealers, more rapid order execution, and more frequent informed trading (SOES bandits) on Nasdaq, as well as stale limit orders and a less efficient opening price-setting mechanism on the NYSE/AMEX, all contribute to faster stock price adjustments on Nasdaq.

Aggregate Earnings, Stock Market Returns and Macroeconomic Activity: A Discussion of 'Does Earnings Guidance Affect Market Returns? The Nature and Information Content of Aggregate Earnings Guidance'

Anilowski, Feng and Skinner (Journal of Accounting and Economics, 2006, this issue) examine the relationship between aggregate earnings guidance, aggregate earnings news and market returns. They provide evidence that changes in aggregate proportions of downward or upward earnings guidance are associated with aggregate earnings news and weakly associated with market returns. However, the study is unable to establish causality or the precise nature of the relationship between aggregate earnings guidance and market returns. To better understand the relationship, this paper analyses the relation between aggregate earnings, stock market returns and the macroeconomy. I empirically document that aggregate earnings primarily contain information about future inflation. This inflation information in aggregate earnings causes aggregate earnings to be negatively correlated with stock returns. The paper concludes with suggestions for future research.

The Role of Financial Reporting in Debt Contracting and in Stewardship

In this paper, I review the role that financial accounting plays in contracts aimed at mitigating agency problems between shareholders and managers and between shareholders and debtholders. The paper discusses the reasons why and how financial accounting numbers are used in debt and stewardship contracting. It further considers the effects of conservatism and fair-value accounting on the relevance of financial reports for contracting. The paper provides some key takeaways from academic literature for accounting practice and regulation.

Mark-to-Market Accounting and Information Asymmetry in Banks

We examine the relation between mark-to-market (MTM) accounting for securities and information asymmetry among bank investors. Relative to historical cost, MTM incorporates more timely information in financial statements. The primary effect of more timely disclosure most likely is to reduce information asymmetry. Nevertheless, models in which public information triggers private information acquisition imply some offsetting increase in asymmetry due to differential information production among investors. Incrementally to disclosure effects, recognition (incorporating MTM gains and losses in earnings) can increase information asymmetry through a variety of channels. We document an economically and statistically significant relation between banks’ use of MTM and their bid-ask spreads, analyst following and management forecasting. Introduction of mandatory MTM by SFAS No. 115 reveals a significant increase in spreads for affected banks, no such increase for banks that previously used MTM voluntarily, but similar increases for banks that previously disclosed but did not MTM their gains and losses in earnings. Thus, information asymmetry appears to arise primarily from recognition effects and not from more timely disclosure. These results should not be interpreted as advocating abandoning MTM, but as highlighting the tradeoffs involved in choosing historical cost versus MTM rules.