Peter D. Easton

Earnings Management? The Shapes of the Frequency Distributions of Earnings Metrics Are Not Evidence Ipso Facto

We provide evidence that the shapes (particularly around zero) of the frequency distributions of earnings metrics examined in the extant earnings management literature are affected by (1) deflation (using, for example, price or market capitalization), (2) sample selection criteria that lead to differential inclusion/exclusion of observations to the left of zero versus observations to the right of zero (implicit in studies focusing on firms followed by I/B/E/S and explicit in studies partitioning on a variable differing between loss observations and profit observations), (3) differences between the characteristics of observations to the left of zero and observations to the right of zero (such as market pricing and analyst optimism/pessimism), or (4) a combination of these factors. Since the shapes of the frequency distributions of earnings metrics at zero are likely due to one of the above effects, we conclude that the shapes cannot be used as ipso facto evidence of earnings management.

An Investigation of Revaluations of Tangible Long-Lived Assets

This paper documents the revaluation practice over a ten-year period from 1981 of a large sample of Australian firms and examines the association between these revaluations and stock market prices and returns. The analysis uses several different approaches in order to obtain a thorough understanding of the revaluation process in Australia. We include a description of hand-collected data from published financial statements, follow-up interviews with chief financial officers of the sample firms, and association tests between hand-collected accounting data and stock market measures. The possibility of revaluing long-lived assets to reflect market prices has been, and continues to be, controversial. Historically, part of the debate revolved around the issue of accounting for changing prices. For example, in the United States (U.S.), Statement of Financial Accounting Standards (SFAS) No. 33 (FASB [1979]) required supplementary information based on current cost (constant dollar) inventory and property, plant, and equipment. In the United Kingdom (U.K.), Statement of

Discussion of Revalued Financial, Tangible, and Intangible Assets: Association with Share Prices and Non Market-Based Value Estimates

The focus of this discussion is on the possible effects of scale in regressions that have price (or value) per share as the dependent variable. My argument rests on the fact that this dependent variable may reflect no more than the choice by management of the number of shares outstanding. Management may change the per share magnitude of firm attributes by means of stock-splits, stock dividends and/or reverse stock-splits without changing the economic characteristics of the firm. It follows that statistically significant coefficient estimates in regressions of share price on balance sheet data and income statement data may be of a spurious effect of scale.

Estimating the Cost of Capital Implied by Market Prices and Accounting Data

Estimating the Cost of Capital Implied by Market Prices and Accounting Data focuses on estimating the expected rate of return implied by market prices, summary accounting numbers, and forecasts of earnings and dividends. Estimates of the expected rate of return, often used as proxies for the cost of capital, are obtained by inverting accounting-based valuation models. The author describes accountingbased valuation models and discusses how these models have been used, and how they may be used, to obtain estimates of the cost of capital.

Accounting Earnings and Security Valuation: Empirical Evidence of the Fundamental Links

Considerable accounting research has been devoted to analyzing the relation between accounting data and contemporaneous security prices. A conceptual framework that explains this relation is provided by the information perspective on accounting. This framework involves an information link, between accounting data and the future stream of benefits from an equity investment, and a valuation link, between the future benefits and security price.1 The aim of this paper is to provide empirical evidence of these fundamental links. In a world with rational wealth-maximizing investors, security price is generally regarded as being tautologically equal to the present value of expected future benefits of share ownership. The contemporaneous association between accounting earnings and security price is therefore a

Accounting for the impairment of long-lived assets: Evidence from the petroleum industry

We investigate write-downs of assets of oil and gas firms due to the application of the SEC full-cost ceiling test during the period of the largest decline in oil and gas prices since this test was mandated. The correlation between the write-down amounts and contemporaneous returns is statistically significant, but it is lower than the correlation with lagged returns. This and other evidence suggests that, although the market perceived that some of the decline in asset value occurred in the quarter in which the write-down was recorded, much of the share market price adjustment due to this decline occurred earlier.

The Market Pricing of Other-Than-Temporary Impairments

____________________________________________________________________________ Abstract: When the fair value of an investment security falls below amortized cost and there is significant doubt that the firm can hold the security until the fair value recovers, managers must recognize an other-than-temporary impairment (OTTI) in net income. Thus, OTTIs represent managers’ attempts to distinguish more certain from less certain losses. We find that the distinctions between more and less certain losses made by commercial bank managers during the financial crisis were informative to investors. Investors were unable to fully anticipate quarterly OTTI charges, and priced OTTIs incrementally to reported fair value gains/losses. We also find that the recent OTTI bifurcation rule isolated a useful component of OTTIs for investors. Our results suggest that investors do not assign the same valuation multiple to all types of unrealized security losses, even though unrealized losses are commonly thought of as transitory items. The results inform recent standard-setting initiatives to expand disclosure about the reasons for changes in fair value.

Dissecting Earnings Recognition Timeliness: DISSECTING EARNINGS RECOGNITION TIMELINESS

We dissect the portion of stock price change of the fiscal year that is recognized in reported accounting earnings of the year. We call this portion earnings recognition timeliness (ERT). The emphasis in our analysis is on the empirical identification of two fundamental precepts of financial accounting: (1) the matching principle, which is manifested in the recognition of expenses in the same period as the related benefits (i.e., sales revenue) accrue; and, (2) recognition of expenses in the current period due to changes in expectations regarding earnings in future periods. The distinction is important because the accounting for these elements (and the associated ERT) differs considerably and it follows that the mapping from returns to these elements, which is the empirical manifestation of ERT, may also differ. The elements of expenses that are matched to sales of the current period and those that are related to expectations of future periods are identified via regressions of annual sales and annual expenses on contemporaneous returns within the fiscal year. The change in the expenses/return coefficient over the year captures the element of expenses that is related to sales of the current year and the end-of-year coefficient captures the expenses that are related to changes in expectations of future sales and future related expenses.

Pre-Earnings Announcement Drift

We present evidence of a predictable drift in stock prices before the earnings announcements of firms that announce their earnings later than other firms in their industry. We form portfolios based on the returns of later announcers that are implied by the abnormal returns of earlier announcers and the historical pair-wise covariance of the abnormal earnings announcement date returns of earlier and later announcers. A long-short trading strategy based on these implied returns generates monthly returns of more than 100 basis points. The drift is neither due to the well-known momentum effect nor a manifestation of post-earnings announcement drift; it is evident both between the earlier announcers’ earnings announcement dates and the later announcers’ earnings announcement dates and at the later announcers’ earnings announcement dates. The continued under-reaction after later announcers’ earnings announcements is shown to be an under-reaction to the later announcers’ own earnings announcements (i.e., post-earnings announcement drift) rather than a continued under-reaction to the earnings news of earlier announcers (i.e., pre-earnings announcement drift). We show that transaction costs explain the predictability of later announcers’ returns.

Accounting Earnings, Change in Market Value and Cash Flows

We suggest and show the efficacy of two fundamental changes to the methodology at the core of the vast empirical literature examining the extent to which accounting captures concurrent changes in market value. First, we focus on the part of the earnings/returns relation that is not dollar-for-dollar because, at best, the part that is recorded dollar-for-dollar is uninteresting empirically and, at worst, including this part may lead to incorrect inferences. Second, we suggest the inclusion of an omitted variable, capturing transactions with owners, in the earnings/change in value relation. Absent unconditional conservatism, this additional variable should provide no explanatory power in the model we propose. However, our empirical analyses demonstrate that this added variable contributes similar explanatory power for earnings to that provided by cum-distribution value change, and that the sign of this variable also affects estimates of conditional conservatism derived from either our model or that of Basu [1997].