Steve C. Lim

Testing for Income Smoothing Using the Backing Out Method: A Review of Specification Issues

This study investigates potentially spurious correlation in prior studies of income smoothing which use a research method that we call backing out. If E is reported income, Y a discretionary earnings component hypothesized to smooth income, and T the smoothing target, the backing out method consists of regressing Y on E − Y − T. A negative regression coefficient is interpreted as evidence that Y is being managed to smooth earnings. We argue that the negative regression coefficient may simply reflect the positive correlation between E and T, which may or may not be the result of manipulating Y. If E is not manipulated by Y, the negative regression coefficient reflects measurement errors in E − Y as an estimate of unmanaged earnings.We replicate the backing out method of prior studies and use each of the accrual and cash flow components of earnings in the Statement of Cash Flows for Y. We find that the regression coefficient, hypothesized to be negative because of smoothing with Y, is always negative and its magnitude depends on the variances of Y and E − T (smoothing error) independent of the nature of Y (discretionary or nondiscretionary). We conclude that the negative coefficient on E − Y − T is equally consistent with three possibilities: (1) managers smooth earnings with Y, (2) managers smooth earnings with something other than Y, and (3) managers do not smooth earnings at all.

The Declining Association Between Earnings and Returns: Diminishing Value Relevance of Earnings or Noisier Markets?

Purpose - This paper aims to identify what drives the temporal reduction in the value relevance of earnings documented in the literature. Is it the increasing noise in stock returns over time, noise in earnings, or both? Design/methodology/approach - The authors develop hypotheses from the lead/lag structure between stock returns and accounting earnings and perform empirical tests using data from annual COMPUSTAT and monthly CRSP over the sample period of 39 years (1970-2008). Findings - The test results show that increasing noise in stock returns over time is primarily responsible for the temporal reduction of Research limitations/implications - The Originality/value - The paper contributes to the limited body of research on noise in stock returns as the main driver for the temporal reduction in value relevance of earnings.

The Effect of Tax-Related Material Weaknesses in Internal Controls on the Market Valuation of Unrecognized Tax Benefits

This paper examines the effect of tax-related material weakness in internal controls on investors’ valuation of unrecognized tax benefits (UTBs). Firms are required to record a UTB when their uncertain tax positions are unlikely to be sustained upon tax return audit. While Koester (2012) finds that investors positively value UTBs, we posit that a tax-related material weakness in internal controls over financial reporting (MWIC) represents information risk in the tax account, reducing the value-relevance of UTBs. We predict that the positive relation between market value of equity and UTBs is attenuated when firms report a tax-related MWIC, and our empirical tests reveal that the relation is completely mitigated in the presence of a tax-related MWIC. Falsification tests confirm that non-tax related MWICs do not attenuate the positive relation between market value of equity and UTBs, consistent with tax-related MWICs capturing low information quality specific to the tax account.

Differential Levels of Disclosure and the Earnings-Return Association: Evidence from Foreign Registrants in the United States

Foreign companies listing on U.S. exchanges are required to report financial information under U.S. GAAP on Form 20-F using either Item 17 or Item 18 disclosure rules. These two disclosure rules differ in that Item 17 allows many exemptions from U.S. GAAP, while Item 18 requires disclosure of all financial information in accordance with U.S. GAAP. This study examines the differential earnings-return association between Item 17 and Item 18 filers. We find significantly higher earnings-return associations for Item 18 filers than for Item 17 filers. While the earnings-return association of Item 18 foreign firms is not different from that of matched U.S. firms (which fundamentally use Item 18 rules), the earnings-return association of Item 17 foreign firms is significantly lower than that of matched U.S. firms. Overall, the results are consistent with the idea that higher levels of disclosure may be related to lower discount rates and higher earnings response coefficients.

Do operating leases expand credit capacity? Evidence from borrowing costs and credit ratings

We document that borrowing costs and credit ratings are less sensitive to off-balance sheet lease financing than to on-balance sheet debt financing, particularly for firms that are financially constrained and firms that have limited ability to use tax shields. This evidence is consistent with theoretical predictions based on tax benefits as well as bankruptcy costs. Our evidence on borrowing costs and credit ratings suggests that credit markets treat operating leases differently from balance sheet debt. Consistent with this interpretation, we document that firms closer to ratings borderlines lease more, particularly around the investment grade borderline.

Market Recognition of the Accounting Disclosure and Economic Benefits of Operating Leases: Evidence from Borrowing Costs and Credit Ratings

We contribute to the current debate on the accounting treatment of operating leases by providing evidence from bond markets and private lending on the market recognition of the role of leasing in determining borrowing costs and credit ratings. Borrowing costs and credit ratings are less sensitive to lease obligations than to debt financing for firms that are financially constrained or have lower marginal tax rates, consistent with theoretical predictions based on tax sharing and bankruptcy costs. Firms closer to ratings borderlines lease more, especially those firms around the investment grade borderline. Our evidence suggests that leasing provides financial flexibility to some firms, relative to debt financing, by preserving or extending credit capacity, and that the credit markets evaluate the economic characteristics of operating leases and treat them differently in their pricing. Our finding on the differential pricing in the credit market is particularly relevant to the current lease accounting debate because the mandatory capitalization under the proposed new accounting rule might curtail such differentiation, diminishing the information value of financial statements. We expect to observe a continuing demand for leases independent of accounting treatments as long as there are economic benefits associated with lease transactions such as preserving or expanding credit capacity.

The Value Relevance of Earnings and the Prediction of One-Year-Ahead Cash Flows

In this paper we examine the validity of using one-year-ahead cash flows prediction tests as a substitute for the value relevance test of earnings. We show theoretically that the R2 of the cash flows prediction regression is contaminated by the presence of (1) noise in the cash flows and (2) spurious, i.e., value-unrelated, correlation between one-year-ahead cash flows and current earnings. We test if either of the above two factors contribute to the result of Kim and Kross (2005) that the ability of earnings to predict one-year-ahead cash flows has increased over the recent decades, in contrast to the evidence of decreasing value relevance of earnings. We find empirical evidence that both factors contributed to their result and conclude that the cash flows prediction test is a poor substitute for the value relevance test of earnings.

An Analytical Measure of Market Underreactions to Earnings Surprises

We show that strategic informed trading that arises from information asymmetry (i.e., the difference in the precision of information) between the liquidity demander and the liquidity provider results in underreaction to earnings announcements. The price impact of a trade increases with the precision of the information used exclusively by the liquidity demander, but decreases with the precision of the information used by the liquidity demander and provider. The post-earnings announcement drift increases with both the price impact of a trade and the squared correlation coefficient between order imbalance and earnings surprise. We discuss several testable implications of our analytical results.

Market Underreactions to Earnings Surprises: An Analytical Measure and Empirical Evidence

We show that strategic informed trading that arises from information asymmetry (i.e., the difference in the precision of information) between the liquidity demander and the liquidity provider results in underreaction to earnings announcements. The price impact of a trade increases with the precision of the information used exclusively by the liquidity demander, but decreases with the precision of the information used by the liquidity demander and provider. The post-earnings announcement drift increases with both the price impact of a trade and the squared correlation coefficient between order imbalance and earnings surprise. We discuss several testable implications of our analytical results.

Strategic Informed Trading and the Market Reaction to Earnings Announcements

We show that strategic informed trading that arises from information asymmetry (i.e., the difference in the precision of information) between the liquidity demander and the liquidity provider results in underreaction to earnings announcements. The price impact of a trade increases with the precision of the information used exclusively by the liquidity demander, but decreases with the precision of the information used by the liquidity demander and provider. The post-earnings announcement drift increases with both the price impact of a trade and the squared correlation coefficient between order imbalance and earnings surprise. We discuss several testable implications of our analytical results.