Mark T. Soliman

The Use of Dupont Analysis by Market Participants

DuPont analysis, a common form of financial statement analysis, decomposes return on net operating assets into two multiplicative components: profit margin and asset turnover. These two accounting ratios measure different constructs and, accordingly, have different properties. Prior research has found that a change in asset turnover is positively related to future changes in earnings. This paper comprehensively explores the DuPont components and contributes to the literature along three dimensions. First, the paper contributes to the financial statement analysis literature and finds that the information in this accounting signal is in fact incremental to accounting signals studied in prior research in predicting future earnings. Second, it contributes to the literature on the stock market’s use of accounting information by examining immediate and future equity return responses to these components by investors. Finally, it adds to the literature on analysts’ processing of accounting information by again testing immediate and delayed response of analysts through contemporaneous forecast revisions as well as future forecast errors. Consistent across both groups of market participants, the results show that the information is useful as evidenced by associations between the DuPont components and stock returns as well as analyst forecast revisions. However, I find predictable future forecast errors and future abnormal returns indicating that the information processing does not appear to be complete. Taken together, the analysis indicates that the DuPont components represent an incremental and viable form of information about the operating characteristics of a firm.

Going, Going, Gone? The Apparent Demise of the Accruals Anomaly

Consistent with public statements made by sophisticated practitioners, we document that the hedge returns to Sloans (Sloan, R. G. 1996. Do stock prices fully reflect information in accruals and cash flows about future earnings? Accounting Rev.71(3) 289--315) accruals anomaly appear to have decayed in U.S. stock markets to the point that they are, on average, no longer reliably positive. We explore some potential reasons why this has happened. Our empirical analyses suggest that the anomalys demise stems in part from an increase in the amount of capital invested by hedge funds into exploiting it, as measured by hedge fund assets under management and trading volume in extreme accrual firms. A decline in the size of the accrual mispricing signal, as measured by the magnitude of extreme decile accruals and the relative persistence of cash flows and accruals, may also play a (weaker) role. This paper was accepted by Stefan Reichelstein, accounting.

Non-GAAP Earnings and Board Independence

We examine the association between board independence and the characteristics of non-GAAP earnings. Our results suggest that companies with less independent boards are more likely to opportunistically exclude recurring items from non-GAAP earnings. Specifically, we find that exclusions from non-GAAP earnings have a greater association with future GAAP earnings and operating earnings when boards contain proportionally fewer independent directors. Consistent with the association between board independence and the permanence of non-GAAP exclusions reflecting opportunism rather than the economics of the firm, we find that the association declines following Regulation G and that managers appear to use exclusions to meet earnings targets prior to selling their shares more often in firms with fewer independent board members. Overall, our results suggest that board independence is positively associated with the quality of non-GAAP earnings.

Do Alternative Methods of Reporting Non-Controlling Interests Really Matter?

Researchers have long been interested in whether the classification of various items on the balance sheet matters to investors. This paper provides evidence on whether reporting non-controlling interests (NCI) as equity or as non-equity matters in terms of value relevance. We use a sample of German firms that voluntary adopted International Financial Reporting Standards early. This adoption required them to change their reporting of NCI from the non-equity to the equity portion of the balance sheet. After conducting sensitivity tests for self-selection bias and controlling for weight of NCI, firm size and leverage, our results suggest that NCI are priced by the market in the same manner irrespectively of being reported as equity or non-equity. This finding reinforces the notion that equity markets are efficient in their processing of information, regardless of the classification by standard setters. JEL Classification: M41-Accounting.

Attracting Attention in a Limited Attention World: Exploring the Causes and Consequences of Extreme Positive Earnings Surprises

We investigate why extreme positive earnings surprises occur and the consequences of these events. We posit that managers know before analysts when extremely good earnings news is developing, but can have incentives to allow the earnings news to surprise the market at the earnings announcement. In particular, managers can use an extreme positive earnings surprise to attract investor attention when they believe their stock is neglected and future performance is expected to be strong. Analysts, who must allocate scarce resources across many firms, can also be inattentive and miss signals that suggest good performance is going to be announced. Using various proxies for extreme positive earnings surprises, management expectations for future performance and desire for attention, and analyst neglect, we find evidence that an extreme positive earnings surprise is a predictable event. These findings are incremental to controlling for a firms information environment, earnings volatility, and operating leverage. Finally, we show that extreme positive earnings surprises are a successful method for attracting attention, with significant increases in the number of institutional owners, the number of analysts, and trading volume during the subsequent three years. This paper was accepted by Mary Barth, accounting.

Meeting, Beating, Streaks and Bubbles

The literature in economics and finance document that asset bubbles can emerge and remain sustained for a variety of reasons. In this paper, we develop an analytical model to characterize two types of rational bubbles linked to accounting disclosures, drift bubbles and sensitivity bubbles. We conjecture that both types of bubbles are likely to do so when firms experience streaks of good news. We use our analytical model to generate a number of hypotheses that are expected to hold if drift and/or sensitivity bubbles arise when firms experience streaks of good news, which we proxy for using lengths of meet or beat streaks. In price level regressions, we provide evidence consistent with meet or beat streaks associated with both non-linear drift and non-linear sensitivity price bubbles, consistent with the predictions drawn from the model. We offer less compelling evidence consistent with the model predictions that the drift and sensitivity bubbles should accelerate as a firm continues a streak. We provide reasonable evidence consistent with the drift and sensitivity bubbles unwinding when a firm fails to continue a meet or beat streak. Finally, we find evidence that the industry-wide streak related bubble-like patterns are incremental to the firm-specific patterns we document.

Internal Control Quality, Disclosure and Cost of Equity Capital: The Case of an Unregulated Market

This paper examines the direct effect of internal control quality (ICQ) on cost of equity capital and whether the former has a moderating effect on the association between voluntary disclosure and cost of equity capital in an emerging market (Egypt). ICQ is measured using a survey of external auditors. A content analysis approach is used to proxy for the level of voluntary disclosure in annual. Finally, the Capital Asset Pricing Model (CAPM) framework is used to estimate cost of equity capital. Based on a sample of 256 firm-year observations over the period of 2007-2010, we find that ICQ is negatively and significantly associated with cost of equity capital indicating that better controls reduce cost of capital. In addition, ICQ moderates the association between voluntary disclosure and cost of equity capital since this association is only negative and significant for companies characterized by high ICQ. Our study contributes to the internal control literature by focusing on an emergent unregulated market with respect to internal control disclosure and documents that ICQ plays an important role in reducing cost of equity capital (either directly or indirectly) by increasing the value relevance of voluntary disclosure among investors on the Egyptian stock exchange.

Is the Relation between Non-Controlling Interests and Parent Companies Misleading?

This paper investigates whether different levels of investor protection affect the market valuation of Non-Controlling Interests (NCI)’ share of subsidiaries in a consolidated entity. Using a set of European publicly listed firms, our findings suggest a positive association of NCI with parent companies’ share prices in countries with low levels of investor protection and a negative association in countries with higher levels. This suggests that when non-controlling investors are not well protected, parent companies have an opportunity to extract rents from non-controlling owners which leads to a positive valuation of NCI’s equity. However, in countries where non-controlling investors are well protected, parent companies are not able to extract rents but still must monitor and govern the related subsidiary so NCI becomes a net cost and the relation flips.