Patricia M. Dechow

Earnings Management: Reconciling the Views of Accounting Academics, Practitioners, and Regulators

A technique for encoding and decoding an image includes the following steps: subsampling the image to obtain a number of subsampled frames of spatially offset image-representative signals; transforming each of the subsampled frames to obtain a corresponding number of frames of transform coefficient-representative signals; forming vector-representative signals from corresponding coefficient-representative signals of the respective frames of coefficient-representative signals; performing a thresholding operation on the vector-representative signals to obtain thresholded vector-representative signals; vector quantizing the thresholded vector-representative signals to obtain encoded signals; storing the encoded signals; and decoding the encoded signals to obtain a recovered version of the image.

Executive incentives and the horizon problem: An empirical investigation

Abstract This paper investigates the hypothesis that CEOs in their final years of office manage discretionary investment expenditures to improve short-term earnings performance. We examine the behavior of R & D expenditures for a sample of firms in industries that have significant ongoing R & D activities. The results suggest that CEOs spend less on R & D during their final years in office. However, we find the reductions in R & D expenditures are mitigated through CEO stock ownership. There is no evidence that the reduced R & D expenditures are associated with either poor firm performance or reductions in investment expenditures that are capitalized for accounting purposes.

The Relation Between Earnings and Cash Flows

A model of earnings, cash flows and accruals is developed assuming a random walk sales process, variable and fixed costs, and that the only accruals are accounts receivable and payable, and inventory. The model implies earnings better predict future operating cash flows than current operating cash flows and the difference varies with the operating cash cycle. Also, the model is used to predict serial and cross-correlations of each firms series. The implications and predictions are tested on a 1337 firm sample over 1963-1992. Both earnings and cash flow forecast implications and correlation predictions are generally consistent with the data.

Why are Earnings Kinky? An Examination of the Earnings Management Explanation

Prior research has documented a “kink” in the earnings distribution: too few firms report small losses, too many firms report small profits. We investigate whether boosting of discretionary accruals to report a small profit is a reasonable explanation for this “kink.” Overall, we are unable to confirm that boosting of discretionary accruals is the key driver of the kink. We caution the use of the ratio of small profit firms to small loss firms as a measure of earnings management. We investigate and discuss a number of alternative explanations for the kink.

Short-sellers, fundamental analysis and stock returns *

Abstract Firms with low ratios of fundamentals (such as earning and book values) to market values are known to have systematically lower future stock returns. We document that short-sellers position themselves in the stock of such firms, and then cover their positions as the ratios mean-revert. We also show that short-sellers refine their trading strategies to minimize transactions costs and maximize their investment returns. Our evidence is consistent with short-sellers using information in these ratios to take positions in stocks with lower expected future returns.

Economic consequences of accounting for stock-based compensation

The Financial Accounting Standards Boards (FASB) project on employee stock-based compensation was one of the most controversial in the Boards 20-year history. In particular, the Boards 1993 Exposure Draft proposing the recognition of an expense for employee stock options generated predictions of dire economic consequences and prompted the threat of regulatory intervention from Congress and the White House. This study employs three complementary research approaches to evaluate the nature and extent of the predicted economic consequences. First, we examine the characteristics of firms lobbying against the 1993 Exposure Draft (FASB [1993]). Second, we examine the characteristics of firms using employee stock options under the original financial reporting rules. Finally, we examine stock price reactions to announcements concerning the new financial reporting rules.

The Persistence of Earnings and Cash Flows and the Role of Special Items: Implications for the Accrual Anomaly

We argue that high accruals are likely to be the outcome of rules with an income statement perspective, while low accruals are likely to be the outcome of rules with a balance sheet perspective, and that this has implications for the properties of earnings. Specifically, earnings persistence is affected both by the magnitude and sign of the accruals. Accruals improve the persistence of earnings relative to cash flows in high accrual firms, but reduce earnings persistence in low accrual firms. We show that the low persistence of earnings in low accrual firms is primarily driven by special items. We then show that special item-low accrual firms have higher future stock returns than other low accrual firms. This is consistent with investors misunderstanding the transitory nature of special items. Further analysis reveals that special item-low accrual firms have poor past performance and declines in investor recognition (analyst coverage and institutional holdings). Special items continue to explain future returns after controlling for these factors.

The Persistence and Pricing of the Cash Component of Earnings

Prior research shows that the cash component of earnings is more persistent than the accrual component. We decompose the cash component into: (1) the change in the cash balance, (2) issuances/distributions to debt, and (3) issuances/distributions to equity. We find that the higher persistence of the cash component is entirely due to the subcomponent related to equity. The other subcomponents have persistence levels almost identical to accruals. We investigate whether investors understand the implications of the differential persistence of the three subcomponents. Our results suggest that investors correctly price debt and equity issuances/distributions but misprice the change in the cash balance in a similar manner to accruals. Our tests enable us to empirically distinguish the “accrual” and “external financing” anomalies with results implying that the accrual anomaly subsumes the external financing anomaly. Our results also suggest that naive fixation on earnings is unlikely to be a complete explanation for the accrual anomaly. Our findings are more consistent with investors misunderstanding diminishing returns to new investments. ∗Haas School of Business, University of California, Berkeley; †Barclays Global Investors. We are grateful for the comments of Todd Doersch, Wayne Guay, Abbie Smith, an anonymous referee, and workshop participants at Georgetown University, UCLA, the American Accounting Association 2005 meetings, the University of Utah Accounting Conference, and the Prudential Quantitative Research Conference 2006. We thank Seungmin Chee for research assistance.

Analysts’ Motives for Rounding EPS Forecasts

We investigate analysts’ motives for rounding annual EPS forecasts (placing a zero or five in the penny location of the forecast). We first show that an intuitive reason for analysts to engage in rounding is in circumstances where the penny location of the forecast is of less economic significance. By rounding, analysts reveal that their forecasts are not intended to be precise to the penny. We also show that analyst incentives impact the likelihood of rounding. Specifically, we predict that analysts will exert less effort forecasting earnings for firms that generate less brokerage or investment banking business since such firms create less value for the analysts’ employers. As a consequence of this lack of effort and attention, the analyst will be more uncertain about the penny digit of the forecast and so will round. Our results are consistent with this prediction. One implication of our findings is that a rounded forecast is a simple and easily observable proxy for a more noisy measure of the market’s expectation of earnings. Consistent with this implication, we show that rounded forecasts bias down earnings response coefficients at earnings announcements.

The Use of Financial Ratio Models to Help Investors Predict and Interpret Significant Corporate Events

A firm in a steady state generates predictable income and investors can generally agree on its valuation. However, when a significant corporate event occurs this creates greater uncertainty and disagreement about firm valuation, and investors could prefer to avoid holding such a stock. We examine research that has developed financial ratio models to: (a) predict significant corporate events; and (b) predict future performance after significant corporate events. The events we analyze include financial distress and bankruptcy, downsizing, raising equity capital, and material earnings misstatements. We find that financial ratio models generally help investors avoid stocks that are likely to have significant corporate events. We also find that, conditional on a significant event occurring, financial ratio models help investors distinguish good firms from bad. However, we find that research design choices often make it difficult to determine model predictive accuracy. We discuss the role of accounting rule changes and their impact over time on the predictive power of models, and provide suggestions for improving models based on our cross-event analysis.