S.P. Kothari

Capital Markets Research in Accounting

I review empirical research on the relation between capital markets and financial statements. The principal sources of demand for capital markets research in accounting are fundamental analysis and valuation, tests of market efficiency, and the role of accounting numbers in contracts and the political process. The capital markets research topics of current interest to researchers include tests of market efficiency with respect to accounting information, fundamental analysis, and value relevance of financial reporting. Evidence from research on these topics is likely to be helpful in capital market investment decisions, accounting standard setting, and corporate financial disclosure decisions.

An analysis of intertemporal and cross-sectional determinants of earnings response coefficients

Abstract Stock pride change associated with a given unexpected earnings change (the earnings response coefficient) exhibits cross-sectional and temporal variation. We predict and document evidence that the earnings response coefficient is a function of riskless interest rates and the riskiness, growth and/or persistence of earnings. The earnings response coefficient also varies cross-sectionally with the holding period return interval. Collectively, our results explain the previously reported differential earnings response coefficient with respect to size. Moreover, by including the factors noted above, the empirical specification of the earnings/returns relation is significantly improved.

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.

Measuring Long-Horizon Security Price Performance

This paper studies the specification of tests for long-horizon (i.e., multiyear) abnormal security returns around firm-specific events, using samples of randomly selected securities and simulated event dates. The main result is that typical long-horizon tests are misspecified. The tests have a severe tendency to indicate abnormal performance when none is present, with rejection frequencies sometimes exceeding 5 to 10 times the significance level of the test. The result is not sensitive to the specific model used for estimating abnormal returns. The parametric test statistics do not satisfy their assumed properties. We identify several sources of misspecification.

A Market-Based Evaluation of Discretionary-Accrual Models

Considerable research in accounting focuses on the role of accruals in capital market valuation and in contracting. The research shows accruals enable managers to improve on cash flows as a mesure of firm performance. However, since accruals provide managers with a means of managing reportedearnings, previous research also documents evidence of opportunistic accrual management. Opportunistic accruals are estimated using discretionary-accrual models that seek to separate earnings into discretionary accruals and nondiscretionary earnings.

Econometrics of Event Studies

Abstract The number of published event studies exceeds 500, and the literature continues to grow. We provide an overview of event study methods. Short-horizon methods are quite reliable. While long-horizon methods have improved, serious limitations remain. A challenge is to continue to refine long-horizon methods. We present new evidence illustrating that properties of event study methods can vary by calendar time period and can depend on event sample firm characteristics such as volatility. This reinforces the importance of using stratified samples to examine event study statistical properties.

Book-to-Market, Dividend Yield, and Expected Market Returns: A Time-Series Analysis

We find reliable evidence that both dividend yield and book-to-market (B/M) track time-series variation in expected real one-year stock returns over the period 1926-91 and the subperiod 1941-91. The B/M relation is stronger over the full period, while the dividend yield relation is stronger in the subperiod. For the equal-weighted index, the full- period slope coefficient on B/M is so large as to imply that expected real returns are sometimes negative, raising doubts about market efficiency. In this case, the hypothesis that expected real returns are never negative is rejected, using bootstrap methods, at the 0.02 level. A Bayesian bootstrap procedure implies that an investor with prior belief 0.5 that expected real returns are never negative comes away from the B/M evidence dramatically revising that belief, with posterior probability only about 0.05 for the hypothesis. The post-40 evidence is consistent with expected returns always being positive, however.

Capitalization versus Expensing: Evidence on the Uncertainty of Future Earnings from Capital Expenditures versus R&D Outlays

We propose and implement a new method to estimate the relation between R&D investments and the uncertainty of future benefits from those investments. The empirical analysis compares the relative contributions of current investments in R&D and PP&E to future earnings variability using a sample of roughly 50,000 firm-year observations from 1972–1997. Evidence is strongly consistent with the hypothesis that R&D investments generate future benefits that are far more uncertain than benefits from investments in PP&E. Our results should help the current discussion on accounting for R&D and the methodology might be helpful in standard setting in other contexts as well.

Nonstationary expected returns: Implications for tests of market efficiency and serial correlation in returns

Abstract Recent evidence reveals significant negative serial correlation in aggregate (market-wide) stock returns. We extend this result to relative (market-adjusted) returns, demonstrating negative serial correlation in five-year returns. We then test two competing explanations: (1) market mispricing and (2) changing expected returns in an efficient market. The tests are conducted using the capital asset pricing model to estimate relative returns. The evidence suggests that negative serial correlation in relative returns is due almost entirely to variation in relative risks, and therefore expected relative returns, through time. We document substantial relative risk shifts, particularly for extreme-performing stocks.

Firm size and the information content of prices with respect to earnings

Abstract Beaver, Lambert and Morse (1980) suggest that prices may be useful in forecasting future earnings. We explore the information content of prices with respect to earnings by focusing on firm size and its relation to the predictive accuracy of price-based earnings forecasts. Firm size proxies for the amount of information and for the number of traders and professional analysts processing the available information about an enterprise. Our empirical results are consistent with the hypothesis that price-based earnings will outperform univariate time series forecasts by a greater margin for larger firms than for smaller firms.