Bottom-line Earnings Research Articles

The value relevance of EBITDA and book values: Evidence from the Johannesburg Stock Exchange

Orientation: This paper stems from Ohlson’s valuation framework, where residual income as a variable was substituted by the non-Generally Accepted Accounting Practices (GAAP) measure of earnings before interest, taxes, depreciation and amortisation (EBITDA).Research purpose: The primary purpose was to determine whether EBITDA, together with the book value of equity (BV), could be shown to be value relevant by means of an intrinsic equity evaluation model. Secondary hereto was to focus on the value relevance of the residual between EBITDA and traditional bottom-line earnings, namely interest, taxes, depreciation and amortisation (ITDA).Motivation for the study: The concern is that the current evidence value relevance of EBITDA offered in the literature has been premised on relative valuation approaches, meaning they are primarily anecdotal.Research approach/design and method: Cross-sectional ordinary least square regression analyses were applied from the top 100 largest companies listed on the JSE, from 1995 to 2017.Main findings: The results demonstrated that EBITDA, ITDA and BV accounted for significant variations in equity share prices when controlling for the confounding effects of scale, growth and the incidence of reported accounting losses.Practical/managerial implications: Ultimately, these findings should be seen to confirm the validity of EBITDA as an alternative input to bottom-line earnings in the valuation of equity shares.Contribution/value add: The study extends the debate by providing an alternative perspective based upon Ohlson’s residual income valuation framework, in respect of which there has currently been a paucity of evidence.

Revenue Classification Shifting: Does CEO Gender Matter?

Instead of managing bottom-line earnings, firms may use revenue classification shifting to inflate core earnings due to its less risky, less costly, but viable features. Female CEOs, being perceived more risk-averse and more ethical, may engage in either more or less revenue classification shifting than male CEOs. Using a sample of 36,427 US firm-year observations from 1993 to 2019, we find that female CEOs tend to engage in less revenue classification shifting than male CEOs when the monitoring environment is looser but increase revenue classification shifting when the monitoring environment becomes more stringent. Further analyses indicate that female CEOs may substitute revenue classification shifting for more costly earnings management tools under stricter monitoring. The results are robust to endogeneity tests, sample selection bias, and additional control variables, providing new evidence that female CEOs are more risk-averse.

Return Measures as a Link Between Financial Statements

SynopsisThe research problemI examine whether and how presenting a return measure (e.g., return on assets) on the face of the income statement influences non-professional investors’ judgments of a company as a potential investment.MotivationAccounting research suggests investors focus on bottom-line earnings to the exclusion of other financial information. To evaluate a firm’s economic performance, valuation models suggest investors should assess not only income, but also the resources employed by the firm to generate the income. Value is created when companies earn a sufficient return on resources employed in the business. Therefore, positive and/or growing accounting earnings do not necessarily indicate a firm is performing well. Return measures, such as return on assets, are ways to measure a company’s return on its economic resources.The test hypothesesH1: Reporting a return measure on the face of the income statement affects nonprofessional investors’ perceptions of investment attractiveness, and it does so by priming investors to evaluate the return on resources that the company earns.H2: Reporting a return measure on the face of the income statement affects nonprofessional investors’ perceptions of balance sheet relevance and acquisition of balance sheet information.Target populationStandard setters, financial statement preparers, and accounting researchers.Adopted methodologyIn an experiment, participants viewed an abbreviated annual report of a hypothetical company and provided judgments about the firm as a potential investment. I manipulated whether a return measure was reported on the income statement. I also manipulated the level of return; while net income and earnings per share were the same in all conditions, I manipulated balance sheet amounts such that return on assets was relatively high or low.AnalysesAnalyses included analysis of variance (ANOVA), analysis of covariance (ANCOVA), and conditional process analysis. Dependent measures included participants’ judgments about the company as a potential investment, perceived efficiency and effectiveness of the company’s management, perceived relevance of balance sheet information, and recall of financial statement information.FindingsResults supported my first prediction — reporting a return measure on the income statement affected non-professional investors’ perceptions of the company as a potential investment; further, these judgments were driven by perceptions of managerial efficiency and effectiveness in earning a return on the company’s resources. Results did not support my second prediction that reporting a return measure on the face of the income statement influences non-professional investors’ perception of balance sheet relevance or affects acquisition of balance sheet information.

On earnings and cash flows as predictors of future cash flows

Do accruals-based earnings provide better information about future operating cash flows than do operating cash flows themselves, as predicted by the Financial Accounting Standards Board's conceptual framework (FASB 1978)? While this is a foundational issue in accounting, because it addresses the information added by accrual accounting methods, testing it remains unsettled. We show that when comparing the predictive ability of operating cash flows with that of an equivalent earnings measure calculated on an accrual basis, earnings outperform operating cash flows. The result becomes more pronounced when allowance is made for cross-sectional differences in the relation between firms' earnings and future cash flows. In fact, even bottom line earnings then have similar explanatory power as operating cash flows.

Post-COVID-19: Rising from the Ashes

This article details how a predictive risk model, combined with financial and legal deal structure and negotiation processes, will produce high-quality projects and secure cash flow, and can result in significant performance improvement of both margin and bottom-line earnings for private equity portfolio companies. <b>TOPICS:</b>Financial crises and financial market history, performance measurement <b>Key Findings</b> ▪ Portfolio margin improvement: Evidence shows that by scaling predictive analytics and harnessing data, a team of operational risk professionals can improve portfolio margins to the point where &lt;1% operational losses on billion-dollar portfolios are achievable, resulting in direct portfolio margin improvement. ▪ Accelerated earnings: Private equity firms can quickly implement a five-part strategy for operational risk management focused on the sales and delivery life cycle to accelerate earnings and create compounding growth annually across their portfolio companies. ▪ 99%+ earnings capture: By pairing an intelligent risk-sensing model with active deal and project intervention at the critical moment, it is possible to capture more than 99% of the revenue each year and drive it directly back into the business, positively impacting the value creation cycle.

Dividend Policy and the COVID-19 Crisis

This paper examines dividend payment behavior of the S&P1500 firms during the COVID-19 crisis characterized by the stock market crash and a V-shaped stock price recovery propelled by technology stocks. We find that the great majority of firms either maintain or increase the level of dividend payment during the crisis period. Yet, the relationship between the dividend payout and bottom-line earnings available to common shareholders is significantly negative. This relationship holds even for dividend-increasing firms whose earnings streams should be relatively higher (or increasing) compared to other firms in the sample. We also find that forecast earnings of up to one year in the future are negatively associated with the current dividend level implying that the existing payout policies are unsustainable. Interestingly, we document similar patterns for stock repurchases.

Investor learning, earnings signals, and stock returns

Prior studies show that investor learning about earnings-based return predictors from academic research erodes return predictability. However, the signaling power of “bottom-line” earnings has declined over time, which complicates assessments of investor learning about profitability signals underlying earnings. We show that modified earnings variables with lower susceptibility to signal weakening exhibit rates of return attenuation that are 30-64% lower than rates for bottom-line earnings variables over our sample period. Notably, return gaps between bottom-line and less susceptible variables are widest in recent years, especially within non-overlapping samples and samples with weak bottom-line signals (e.g., special items, losses, fourth fiscal quarter). Our results hold after controlling for risk factors known to predict returns, they do not appear to be attributable to ex ante earnings volatility, and they are robust to alternative sample selection criteria, sub-period partitions, and portfolio holding windows. Overall, our results suggest that while investor learning is apparent in the data, learning efforts to date have been suboptimal at exploiting profitability signals within firms’ earnings streams.

Intra-industry information transfer effects of leading firms’ earnings narratives

We investigate whether there are information transfers related to the narratives accompanying earnings announcements in the same way there are for bottom-line earnings numbers. Our study is motivated by the conjecture that the narratives accompanying earnings press releases may contain industry-relevant information beyond that conveyed by the earnings number. If so, we expect earnings narratives to trigger distinct information transfer to industry-related peers. Our empirical tests confirm that, after controlling for the earnings information transfer, when industry leaders report positive earnings news and cite external causes, industry peers experience share price increases. Conversely, when industry leaders experience earnings disappointments and cite external causes, industry peers experience share price declines. We also find that the level of industry concentration plays a significant role in these relationships. These findings add to our understanding of the dynamics underlying co-movement of share prices within an industry. Additionally, these findings provide insights into another (previously undiscovered) means by which earnings narratives have relevance for investors.

The sharpest tool in the shed: IPO financial statement management of STEM vs. non-STEM firms

The valuation of STEM (science, technology, engineering, and math) firms has recently gained attention in the literature. Research has shown that, for valuation of STEM firms, accounting items such as sales growth and R&D expenditures matter more than bottom-line earnings. We examine whether, around the time of the IPO, STEM managers apply discretion over the accounting items most weighted by investors for their valuation. We find that investors tend to weigh sales growth and R&D more heavily than earnings in valuing STEM firms and that managers respond by managing those items rather than bottom-line earnings as in prior research. We find that future stock returns of STEM firms are negatively associated with sales management and not with abnormal accruals as for non-STEM firms. Our results illuminate the differential behavior of STEM managers and highlight the importance of a departure from the traditional IPO earnings management paradigm, which assumes that firms mainly manage their earnings.

IPO Valuation and Accounting Choices

The current literature presents conflicting evidence as to whether IPO firms manage earnings. Two major shortcomings of prior studies are their assumptions that: 1) investors primarily care about bottom-line earnings; and 2) all firms, regardless of their operating models, only manage earnings. We relax those assumptions by examining the application of discretion over various accounting items across different industry sectors. We find cross-sectional variation in the application of discretion over sales, R&D (R&D overinvestment), and other earnings items, with discretion being significantly associated with the relative importance of the items for IPO valuation. We further show that sales growth possesses the greatest value relevance, and the majority of IPO firms correspondingly manage sales. Lastly, we show that managed sales, and to a lesser degree managed other earnings items, are negatively associated with future stock returns. Overall, we provide robust evidence of use of discretion by IPO firms over various accounting items, depending on the firm’s operating model.

Management of pension discount rate and financial health

Purpose This study aims to examine the unexpected portion of the pension discount rate to determine if the pension discount rate is being used to manage earnings for both financially healthy and financially unhealthy firms as categorized based upon their Altman z-score for bankruptcy. Design/methodology/approach Regression analysis is conducted with the unexpected portion of the pension discount rate as the dependent variable and various metrics indicating potential firm strengths and weaknesses as the independent variables. Findings This study finds evidence that suggests managers for both groups of firms are using their choice of discount rate to manage bottom-line earnings. These findings highlight the patterns of various firm choice differences found between the two groups and the magnitude of the differences between the groups. Originality/value Three streams of literature are considered in this research: earnings management, defined pension plans and z-score bankruptcy. This study extends prior research by examining the unexpected portion of the pension discount rate based on the z-score determination of whether a firm is considered financially healthy or financially unhealthy. Our findings highlight the impact of various firm choice differences found between the two groups of firms.

Pension accruals and share prices: evidence from the amortization costs of transition amounts

This article investigates whether the market rationally evaluates the economic value of pension plans by focusing on the impacts of amortization costs of transition amounts on share prices. Because the amortization costs of transition amounts are cost attributed to the old deficits that appeared in the adoption year, they do not contain new additional information unless managers deliver private information through accountings choices. The data-set is from Japanese firms after the adoption of the postretirement accounting standard wherein recognition costs of transition amounts had a huge impact on the bottom-line earnings of sponsoring firms. We find that investors evaluate the amortization costs of transition amounts as though they hold new, value-relevant information. On the other hand, we do not have clear evidence that managers deliver private information through accounting discretions on the amortization of transition amounts.

Incremental Value Relevance of Disaggregated Book Values and Disaggregated Earnings: Evidence from Nigeria

The link between accounting information and firm value has attracted the attention of accounting and finance researchers since the seminar work of Ball and Brown (1968) and Beaver (1968). The association of accounting information with firm value is value relevance research. Value relevance is the degree to which accounting information captures information impounded in stock prices. Ohlson (1995) provided the conceptual linkage between accounting information and firm value. Since then, value relevance research has increased in volume and diversity. A trend in this line of enquiry is to determine if disaggregated accounting information is incrementally value relevant beyond bottom line accounting information. The objective of this paper was to ascertain if disaggregated accounting information has more value relevance compared to bottom line measures for firms listed on the Nigerian Stock Exchange Market. We specifically investigated the value relevance of disaggregated accounting information for Nigerian listed firms, using a sample of 940 firm-years from 1994 to 2013. The study contributes to the extant value relevance literature by employing a methodology that accounts for documented inefficiencies of the Nigerian capital market. Given the analysis conducted, findings indicate that disaggregated earnings are incrementally value relevant beyond bottom line earnings. Besides, disaggregated book value is found to be more value relevant compared to book value. In the light of these findings, both investors and analysts should shift emphasis from bottom line accounting information, like earnings and book value to disaggregated accounting numbers to improve the quality of investment decisions they make. Besides, regulatory authorities must improve on the corporate governance environment in order to mitigate incidences of window dressing, creative accounting and other corporate malfeasances

On the Contemporaneous Reporting of Income-Increasing and Income-Decreasing Special Items: Initial Evidence

Extant research finds that statement users typically discount special items in assessing a firm’s performance. Consequently, managers have been shown to highlight income-decreasing special items, in an effort to shift focus to “core” earnings, but strategically deploy and downplay income-increasing special items to boost bottom-line earnings. These dynamics suggest that the contemporaneous reporting of income-increasing and income-decreasing special items should be rare; however, this is not the case. We take a first step towards identifying the factors that guide this reporting practice. Using a novel dataset for a random sample of one hundred S&P 500 companies over twenty quarters, we analyze a set of potential drivers related to capital markets and contracting. Controlling for economic determinants, we find that the contemporaneous reporting of income-increasing and income-decreasing special items is linked both to efforts to avoid debt-covenant violations and to achieve earnings targets. Importantly, we find that the “equity-markets” effect manifests primarily for non-GAAP earnings. And, the “debt-markets” effect is driven by income-based covenants, not shielded from special items, and increases in covenant slack. As additional analysis, we confirm that the documented results generalize to a broad sample, based on machine-readable data, and the effect is most pronounced in settings where the use of alternative earning management methods is costly.

Detailed management earnings forecasts: do analysts listen?

We provide archival evidence on how a particular type of supplementary information affects the credibility of management earnings forecasts. Managers often provide detailed forecasts of specific income statement line items to shed light on how they plan to achieve their bottom-line earnings targets. We assess the effect of this forecast disaggregation on the credibility of management earnings forecasts. Based on a relatively large hand-collected sample of 900 management earnings forecasts, we find that disaggregation increases analysts’ sensitivity to the news in managers’ earnings guidance, suggesting that analysts find the guidance more credible. More importantly, we identify several factors that influence this relation. First, disaggregation plays a more important role when earnings are otherwise more difficult to forecast. Second, disaggregation is more important after Regulation Fair Disclosure prohibited selective disclosure, especially for firms that were more affected because they had previously provided more private guidance. Finally, in contrast to common assertions in the prior literature, we find that, in more recent years, disaggregation matters more for guidance that conveys bad news. Managers as well as researchers should be interested in evidence suggesting that financial analysts find disaggregation especially helpful in contexts where managers’ credibility is particularly important.

Detailed Management Earnings Forecasts: Do Analysts Listen?

We provide archival evidence on how a particular type of supplementary information affects the credibility of management earnings forecasts. Managers often provide detailed forecasts of specific income statement line items to shed light on how they plan to achieve their bottom-line earnings targets. We assess the effect of this forecast disaggregation on the credibility of management earnings forecasts. Based on a relatively large hand-collected sample of 900 management earnings forecasts, we find that disaggregation increases analysts’ sensitivity to the news in managers’ earnings guidance, suggesting that analysts find the guidance more credible. More importantly, we identify several factors that influence this relation. First, disaggregation plays a more important role when earnings are otherwise more difficult to forecast. Second, disaggregation is more important after Regulation Fair Disclosure prohibited selective disclosure, especially for firms that were more affected because they had previously provided more private guidance. Finally, in contrast to common assertions in the prior literature, we find that in more recent years, disaggregation matters more for guidance that conveys bad news. Managers as well as researchers should be interested in evidence suggesting that financial analysts find disaggregation especially helpful in contexts where managers’ credibility is particularly important.

Market Reactions to Accounting Policy Choices for Mergers and Acquisitions: Evidence for the Japanese Adoption of International Accounting Standards

The purpose of this paper is to explore, through M&As accounting policies, whether the Japanese adoption of IFRS is favorable for market participants. M&As are excellent prototypes for this study, because they have a substantial impact upon firms’ financial statements. Additionally, Japanese M&A accounting standards still maintain the amortization period within twenty years, which is practical in creating a sharp contrast comparison with the impairment approach outlined by the IFRS 3 and SFAS141/142. We focus on how the recognition and implementation of three different measurement rules, such as the pooling-of-interests, purchase with the amortization of goodwill, and purchase with the immediate expensing of goodwill, influence investors’ interpretations of earning numbers. First, we found that investors interpreted earning figures congruently despite the different accounting policies used. This phenomenon is consistent with the functional fixation hypothesis, which suggests that investors are bottom-line oriented. Second, we found that acquiring firms’ who choose to expense entire goodwill values within the current fiscal year in order to alleviate investors’ concerns that the M&A would negatively impact bottom-line earnings, and we have found that this is done successfully, convincing investors to regard the immediate write-off as an irrelevant item to the firm’s future earnings. The immediate write-off deserves our attention, because it yields the same future bottom-line earnings as firms who use the purchase with impairment method prescribed in IFRS 3 and SFAS 141/142.

The Persistence of Special Items

Prior research shows that negative special items are less persistent than core earnings. However, the allocation of special items to periodic earnings entails significant measurement error which may induce the observed lower persistence. In this paper, we control for this measurement error by aggregating core earnings and special items over periods of one to five years, and testing whether the differential persistence is robust to longer aggregation periods. We find lower persistence of special items only for firms with low core (pre-special items) profitability. For these firms, negative special items have no association with future bottom line earnings for all aggregation periods. In contrast, for high core profitability firms, negative special items exhibit significant persistence, and the persistence increases with the aggregation period. In particular, when earnings are aggregated over five years, we find no difference in the persistence of negative special items and core earnings.

The Value-relevance of Earnings and Book Value across Profit and Loss Firms: The Case of R&amp;D Spending

We examine the effect of omitting research and development (R&D) expenditures, which is an important value-relevant item embedded in earnings for estimating the Ohlson (1995) valuation model for loss firms. Consistent with the analytical insight, we find that R&D expenditures are positively (negatively) associated with stock prices for loss (profit) firms. For high R&D intensity loss firms, the empirical specification with disaggregated earnings leads to about 45 percent improvement in explanatory power: the adjusted R2 for the disaggregated and bottom-line earnings model are about 32% and 22%, respectively. We find that the coefficient on book value of equity decreases when earnings are disaggregated, which suggests that book value of equity is value-relevant partly due to its correlation with R&D expenditures. In other words, the evidence suggests that book value of equity provides information on expected future earnings rather than abandonment values for loss firms engaged in R&D activity. These findings have implications for empirical research design in studies of value-relevance of accounting information and studies of earnings process.

Earnings Management Using Classification Shifting: An Examination of Core Earnings and Special Items

This paper examines the classification of items within the income statement as an earnings management tool. Evidence is consistent with managers opportunistically shifting expenses from core expenses (cost of goods sold and selling, general, and administrative expenses) to special items. This vertical movement of expenses does not change bottom-line earnings, but overstates “core” earnings. In addition, it appears that managers use this earnings management tool to meet the analyst forecast earnings benchmark, as special items tend to be excluded from both pro forma and analyst earnings definitions.