Richard M. Morton

Accounting Conservatism and the Valuation of Accounting Numbers: Evidence on the Feltham-Ohlson (1996) Model

We empirically investigate the effects of accounting conservatism on (1) the stock market valuation of operating assets in the context of the Feltham-Ohlson (1996) model and (2) the weight on operating assets in the Feltham-Ohlson abnormal operating earnings dynamics (hereafter referred to as the LIM conservatism parameter). Consistent with the Feltham-Ohlson (1996) model, we find that accounting-based conservatism proxies are positively related to the valuation weight on operating assets. Furthermore, the accounting-based conservatism proxies have incremental explanatory power even after controlling for (1) size, (2) book value (or sales) growth, and (3) leverage. These results are robust with respect to alternative empirical specifications of the valuation model and the choice of proxies for accounting conservatism. We also find, consistent with prior research but not with the Feltham-Ohlson model, that the sign of the LIM conservatism parameter is on-average negative. We provide evidence on the types of firms for which the linear information dynamics appears to hold better or worse. More specifically, the firms with negative values of the parameter are significantly smaller, less profitable and experiencing lower growth rates than firms with positive values of the parameter. Moreover, the relation between accounting-based conservatism proxies and the LIM conservatism parameter is fairly strong for the subsample of firms with high levels of profitability.

Why Are Analysts Less Likely to Follow Firms with High Managerial Ownership

Prior research finding a negative relation between managerial ownership and analyst coverage argues that greater managerial ownership lessens the need for external monitoring by financial analysts due to fewer agency problems (Moyer, Chatfield, and Sisneros [1989]). Other research, based on foreign firms, argues that greater managerial ownership leads to entrenchment, and the negative relation with analyst following reflects analyst reluctance to follow firms with incentives to withhold information (Lang, Lins, and Miller [2004]). We further evaluate these two explanations by directly examining the link between ownership structure and a firms disclosure environment. Using a sample of 25,855 U.S. firm-year observations from 1995 to 2006, we confirm a negative relation between managerial ownership and analyst coverage. We also find that managerial ownership is negatively related to the likelihood of management issuing earnings forecasts and find that this negative relation is most pronounced for firms with impending “bad news.” Furthermore, firms with higher managerial ownership release less accurate and more optimistic forecasts, particularly when faced with bad news. Overall, our results support the view that agency problems associated with greater managerial ownership contribute to less disclosure and a more opaque information environment, which discourage analyst following. We examine these two explanations from an investor perspective and find that the joint effect of greater managerial ownership and greater analyst coverage enhance firm value. This result is again inconsistent with the notion that greater managerial ownership reduces the need for analyst monitoring.

Valuation Implications of Investment Opportunities and Earnings Permanence

This study investigates the value-relevance of accounting earnings in the presence of investment (growth) opportunities after making two theoretical and methodological research design refinements. First, we test for the incremental effect of growth on firms’ earnings response coefficients after controlling for the extent of transitory earnings under the assumption that the value-relevance of earnings with respect to growth should be stronger when earnings are more permanent. Second, we perform comprehensive factor analysis using market-based and accounting-based measures to construct a composite proxy for investment opportunities. We find that firms’ investment opportunities and the relative permanence of current earnings affect the value-relevance of those earnings. Additionally, we find that the interaction between permanent earnings and investment opportunities produces an even stronger price response to earnings.

Earnings Management in Takeovers of Privately Held Targets

We investigate patterns of earnings management by the acquiring firm in a merger, considering both the form of payment and the target firms listing status. We find that the acquiring firm is more likely to report income-increasing abnormal accruals when it uses stock to acquire a privately held target. The bidders abnormal accruals are also higher when it acquires a privately held target operating in a different industry and when it acquires a smaller target. These results suggest that greater estimation risk in the valuation of an acquisition target motivates the bidder to avoid overpayment by manipulating earnings upward prior to the merger. We also find that for a bidder acquiring a privately held target, stock returns around the merger announcement are negatively related to the abnormal accruals, but long-term returns show no relation to the abnormal accruals. Thus, it appears that investors price the bidders earnings management at the time of the acquisition, and we find no evidence of a delayed market reaction or price correction.

The information environment and the ability of logit-based financial statement analysis to predict abnormal returns

Holthausen and Larcker (1992) show that logit-based financial statement analysis can predict abnormal returns on investments in equity securities. We argue that if this success of financial statement analysis is due to market inefficiency, then the procedure should work better for small firms than larger firms, where firm-size proxies for the amount of information processing in the firms information environment. We do not find greater predictable hedge portfolio returns associated with the analysis of small-firm financial statements. Thus, our results conflict with the market inefficiency explanation. Our results are more consistent with financial statement analysis providing summary information about expected returns not subsumed by other risk proxies and not accounted for in the researchers definition of abnormal returns.

Pre-Tax Income Forecasts and Tax Avoidance

When analysts issue both earnings and pre-tax income forecasts, they implicitly provide a forecast of income tax expense. We find that these pre-tax income forecasts have a negative (positive) effect on corporate tax avoidance for firms with relatively aggressive (non-aggressive) tax policy. We also find evidence that analysts providing implicit income tax expense forecasts have more accurate earnings forecasts and have a better appreciation of how tax expense affects future earnings. Overall, these results suggest that analysts’ implicit tax expense forecasts increase transparency and play an important role in deterring both overly aggressive and overly conservative corporate tax avoidance.

Investor Overreaction to Earnings Surprises and Post-Earnings-Announcement Reversals

Prior literature suggests that the market underreacts to the positive correlation in a typical firm’s seasonal earnings changes, which leads to a post-earnings-announcement drift (PEAD) in prices. We examine the market reaction for a distinct set of firms whose seasonal earnings changes are uncorrelated and show that the market incorrectly assumes that the earnings changes of these firms are positively correlated. We also document that positive (negative) seasonal earnings changes in the current quarter are associated with negative (positive) abnormal returns in the following quarter. Thus, we observe a reversal of abnormal returns, consistent with a systematic overreaction to earnings, rather than the previously documented PEAD. Additional analysis indicates that financial analysts similarly overestimate the autocorrelation of these firms, although to a lesser extent. We also find that the magnitude of overestimation and the subsequent price reversal are inversely related to the richness of the information environment. Our results challenge the notion that investors recognize but consistently underestimate earnings correlation and provide a new perspective on the inability of prices to fully reflect the implications of current earnings for future earnings.

The Effect of Earnings Announcement Timing on Liquidity

The proportion of after-market-close (AMC) earnings announcements has recently increased to more than 40% of the total number of earnings announcements (Berkman & Truong, 2009). Doyle and Magilke (2009) conclude that managers do not announce AMC to hide bad news; however, they do not directly address other explanations for the AMC announcement increase. Thus, the cause(s) remains an open question. Interestingly, the increase in AMC earnings announcements has coincided with the emergence of a 24/7 news environment and a marked increase in noise trading. We posit that managers are increasingly announcing earnings AMC instead of before-market-open (BMO) to take advantage of this increased noise trading—thereby increasing the liquidity of their stock. We show evidence, after controlling for other factors, that announcing AMC instead of BMO increases liquidity. In addition, the relationship between AMC and liquidity is increasing in analysts’ coverage—consistent with the view that AMC announcements generate the largest increase in liquidity for those stocks with high investor interest.