Earnings Numbers Research Articles

COVID-19, firm performance, and the value relevance of earnings

In the wake of the COVID-19 crisis, there has been a growing interest in investigating how stock markets behave during times of uncertainty and crisis. This is because it has been shown that stock prices seem to disconnect from fundamentals during moments of extreme uncertainty. Using earnings and returns data from publicly traded corporations for the twelve months beginning January 1, 2020, we assessed the performance of major industrial sectors during COVID-19. We also investigated the concurrent earnings/returns relation to discover whether earnings changes convey useful information during times of high uncertainty. Following prior literature along similar lines, we used firm-level earnings and returns data and estimated cross-sectional regressions to examine the earnings/returns relation. We found considerable variation in the earnings and returns data across and within the industrial sectors. Our results mostly showed a positive relationship between accounting income and concurrent stock returns, implying that accounting earnings numbers were value relevant during the pandemic. Positive earnings news (earnings increases) seemed to generate a greater market response than negative earnings news (earnings drops), leading to a shift in the overall stock market's outlook from negative to positive in the second half of 2020. These findings will help the decision-making of investors, creditors, policymakers, financial analysts, and other stakeholder groups.

Do High-Quality Auditors Improve Non-GAAP Reporting?

ABSTRACT Prior research finds that clients of high-quality auditors report higher-quality GAAP earnings. We extend this research to investigate whether auditor quality is associated with the quality of voluntarily disclosed non-GAAP earnings measures. Using a sample of Australian firms disclosing annual non-GAAP metrics, we find that clients of high-quality auditors are more likely to voluntarily disclose non-GAAP earnings numbers. However, clients of high-quality auditors make adjustments in calculating non-GAAP earnings (non-GAAP exclusions) that are less predictive of future earnings and less value relevant than those of other firms. These results indicate that their adjustments are of higher quality. We also find similar results for U.S. firms using a sample of quarterly non-GAAP earnings disclosures. Overall, our evidence indicates that commonly used indicators of audit quality for GAAP reporting are positively associated with the quality of voluntarily disclosed non-GAAP earnings measures. JEL Classifications: J33; M41.

PEAD.txt: Post-Earnings-Announcement Drift Using Text

AbstractWe construct a new numerical measure of earnings announcement surprises, standardized unexpected earnings call text (SUE.txt), that does not explicitly incorporate the reported earnings value. SUE.txt generates a text-based post-earnings-announcement drift (PEAD.txt) larger than the classic PEAD. The magnitude of PEAD.txt is considerable even in recent years when the classic PEAD is close to 0. We explore our text-based empirical model to show that the calls’ news content is about details behind the earnings number and the fundamentals of the firm.

Earnings management in times of natural disasters

Purpose The main purpose of this study is to examine the determinants of firms’ earnings management (EM) activities during natural disasters, specifically the 2011 floods in Thailand. The motivation for conducting this study is that although disasters stem from natural processes, such events affect firms’ actions, resulting in adverse economic and social outcomes. Design/methodology/approach Based on data from listed companies in Thailand and using a sample of 5,786 firm-year observations from 2008 to 2013, this study uses the differences-in-differences method to estimate the relation between earnings quality (EQ) and floods. Additionally, this study uses the same research design to observe how fast firms engage in EM, as reflected by the trends in EQ following the floods. Findings This study finds that firms engage in EM to increase their earnings numbers and misrepresent their performance after experiencing the 2011 floods in Thailand. The evidence is consistent with the hypothesis that natural disasters are related to EQ. In addition, this study finds that firms’ responses are observed only in the year after the floods (2012). Originality/value This study contributes to the literature on EM and quality in two ways. First, this study provides new evidence that during crisis situations such as natural disasters, firms strive to signal good news to capital markets, consistent with the market expectation hypothesis. Second, this study shows that natural disasters are as useful and equal as other exogenous shocks such as financial crises for economic research.

Quarterly earnings thresholds: Making the case for prior quarter earnings

AbstractWe provide evidence that the prior quarter earnings number is an important and informative benchmark that is relatively unexplored in the accounting literature. Our analyses suggest that managers appear to avoid negative earnings changes relative to the prior quarter. Moreover, we find that even after controlling for the information contained in other frequently used benchmarks (i.e., analysts’ forecasts and earnings from the same quarter of the prior year), changes over the prior quarter's earnings are associated with stock returns. We find that this result is stronger post‐Regulation FD and XBRL, perhaps as a result of the improved information environment. We also find that the informativeness of prior quarter earnings is greater for firms with less volatile earnings and that meeting‐or‐beating prior quarter earnings are associated with future performance.

Cluster analysis of share price: How firm characteristics relate to accounting metrics

The purpose of this paper is to improve our understanding of the relationship between share price and accounting information. Much of the literature utilizes the earnings number to reflect firm value. However, the revenue number seems more relevant for high tech firms (Xu, Cai, & Leung, 2007), and cash flow figures are more informative for internet companies (Romanova, Helms, & Takeda, 2012). We build on this notion that share price may map out to different accounting numbers for different firms. We collect 629 accounting metrics for 3,365 firms in the U.S. and estimate their correlation with the firms’ share price. We analyze these correlations and find that many firms exhibit a low correlation between share price and earnings. Other accounting numbers are important for these firms, including book value of net assets, retained earnings, stock options, gain or loss items, special or non recurring items, and dividend rates. We are curious to learn what causes firms to anchor onto different metrics, therefore perform a cluster analysis to group similar firms together along three key accounting metrics. We examine the composition of each cluster and find that capital structure, dividend patterns, the persistence of operations, age, and industry can influence which accounting number is correlated with firm value. We encourage other researchers to continue this exploration as there are many interesting questions to answer.

Rounding up performance measures in German firms: Earnings cosmetics or earnings management on a larger scale?

AbstractWe use Benford's Law to provide evidence that German firms round up both their net income and earnings per share. We use the introduction of the euro to show that round earnings numbers are likely the result of earnings management. The incentive to round up comes from stakeholders’ left‐digit bias when processing the information in financial statements. Since round numbers are natural benchmarks, stakeholders perceive the performance metrics directly below such thresholds as abnormally lower. However, rounding up is objectionable only if it involves large‐scale earnings management, but not in cases of negligible ‘earnings cosmetics’. Because the difference between the pre‐managed and reported earnings is unobservable, we investigate whether the prevalence of rounding up coincides with specific levels of several earnings characteristics and proxies for audit quality. If the rounding up is cosmetic, then it should occur independently of these characteristics. In contrast, if firms use earnings management on a larger scale, then it might not be possible to simultaneously round up and achieve other objectives of earnings management. Our evidence is in line with substantial earnings management.

Environmental Liability Provisions and Earnings Persistence of Oil Firms in Nigeria

The purpose of this study is to examine whether provision for environmental liability is associated with earnings persistence of oil firms in Nigeria. The study also examines whether changes in provision for environmental liability is associated with earnings quality. Data from four oil firms for the period 2012 to 2018 were analysed using ordinary least square regression with robust standard errors. Two hypotheses formulated for the study were tested by regressing future earnings on current earnings and other variables. Results showed that environmental liability provisions were not significantly related to earnings persistence. Changes in these provisions were also insignificantly related to earnings quality. The evidence supports institutional theory as basis for explaining the relationship between environmental liability provisions and earnings quality in Nigeria; indicating that the relationship is not driven by ethical considerations or stakeholder concern. There is need for a legal framework for environmental financial reporting in Nigeria to ensure that the environmental obligations of all polluting firms are adequately accounted for, and earnings numbers are ethically reported.

Audit firm tenure and perceived audit quality: evidence from CEO incentive contracts

PurposeThis paper aims to examine how compensation committees perceive audit quality as indicated by audit firm tenure. Using the contracting weight attached to earnings and cash flows in chief executive officer (CEO) compensation as proxy for the compensation committee’s perception of audit quality, the study examines whether compensation committees perceive performance metric informativeness as being affected by auditor tenure.Design/methodology/approachThe paper regresses CEO cash compensation on accounting-based performance metrics and on interactions between auditor tenure and accounting-based performance metrics while controlling for other factors previously shown to affect CEO pay. Auditor tenure is measured using continuous and dichotomous variables.FindingsAuditor tenure is associated with a reduced (positive) weight on earnings (operating cash flows), which suggests lower perceived audit quality as tenure lengthens consistent with the auditor closeness argument. This relation is asymmetric, i.e. the negative effect of longer auditor tenure on incentive contracting is more pronounced for positive earnings. The results are robust to using CEO total compensation as the compensation measure, as well as using level and change specifications.Research limitations/implicationsThe inability to control for audit partner tenure in assessing the effect of audit firm tenure on incentive contracting and the potential endogeneity between auditor tenure choice and incentive contracting are the main limitations of this study. Given the lack of information on US audit partner tenure, the study could not control for the audit partner tenure issue. However, the study has attempted to mitigate the endogeneity issue by using a Heckman selection model that includes in the first-stage a regression of auditor tenure on various firm, performance measure and CEO-related governance characteristics, based on existing models (Liet al., 2010).Practical implicationsCompensation committees view auditor tenure as an indicator of accounting quality in setting CEO pay. Further, long auditor tenure is perceived as detrimental to financial reporting integrity, particularly when earnings numbers suggest positive managerial performance and innovations.Originality/valueThis study provides empirical evidence that auditor tenure matters in setting executive pay. Further, this study shows evidence on the link between auditor tenure and audit quality from an internal user’s perspective. Prior studies have focused either on external users (investors, creditors) or on the preparer (using measures such as discretionary accruals or meet/beat analysts’ forecasts or forecast guidance).

Rule- vs. Principle-Based Accounting Standard and Earnings Characteristics : An Analysis Using ASC 606

We examine the effect of the adoption of the new revenue recognition standard (ASC 606) on earnings quality and the role of earnings in the debt market. We find that ASC 606, a transition from a rules-based to a principles-based accounting standard, decreases earnings predictability, which is demonstrated by increased absolute analyst forecast error and analyst forecast dispersion, and increases the use of discretion in preparing earnings numbers, which is demonstrated by increased discretionary accruals. In addition, the use of earnings-based covenants decreases in debt contracting, while the use of capital-based covenants increases, which indicates a decrease in the usefulness of earnings numbers in contracting. In terms of the stock market response, overall, the earnings response coefficient (ERC) does not change after the new rule. However, following the adoption, the ERC has increased for firms with high institutional holdings and decreased for firms with low institutional holdings. Our analysis supports the idea that this is due to monitoring from institutional investors curbing the use of discretionary accruals.

Pre-IPO cash flow volatility and aftermarket valuation

PurposeThe purpose of this paper is to examine how pre-IPO cash flow and earnings volatility influence both post-IPO pricing and valuation. This paper provides an empirical extension of Pástor and Veronesi’s (2003, 2005) argument that uncertainty surrounding a private firm’s expected profitability can impact how the firm is valued in the IPO aftermarket.Design/methodology/approachThis paper includes a sample of 695 IPOs between 1996 and 2011. Pre-IPO financial statement data are hand collected from the EDGAR database. Pre-IPO cash flow and earnings volatility is computed using the standard deviation of the firm’s three years of cash flows and earnings prior to the IPO. Tobin’s Q serves as a measure of post-IPO firm valuation. This paper includes two subsamples to account for the “hot” IPO market of the late 1990s.FindingsFirms with higher pre-IPO cash flow volatility are associated with higher post-IPO aftermarket valuations. This result holds for both the “hot” IPO and the later sub-sample. Pre-IPO earnings volatility does not influence aftermarket valuations, suggesting that only the uncertainty surrounding cash flows serves as a salient measure to IPO investors. Finally, IPO underpricing is associated with pre-IPO cash flow volatility, suggesting another channel in which IPO pricing is influenced.Research limitations/implicationsThe hand collection for this paper is laborious and is limited to yearly cash flow and earnings numbers. The paper documents that quarterly and yearly cash flow and earnings volatility measures are highly correlated for the select stocks that allow for such testing. Further, a broader sample that accounts for more international IPO issues might corroborate the findings in this paper.Practical implicationsThis study shows that investors both initially price and value IPO firms base on their pre-IPO cash flow volatility.Originality/valueThis is the first paper to examine the direct link between pre-IPO cash flow and earnings volatility on IPO aftermarket valuation and IPO pricing.

Value Irrelevance of the Reported Earnings Numbers and Informativeness of the Asset Price under the Conservative Accounting: Implications on Mark to Market Accounting

This paper presents an one-period model of an one-asset market allowing for the strategic interaction among rational traders and earnings fixated traders. Earnings fixated traders are functionally fixated on the reported earnings numbers in formulating their trading strategies without paying attention to the accounting procedures used to generate those numbers. This paper shows analytically that under the conservative accounting, the reported accounting earnings numbers are value-irrelevant and the informativeness of the asset price improves as the volatility of the reported earnings increases towards the volatility of the economic earnings of the asset. These results support the alternative accounting of mark to market.

Can Earnings Fixated Traders Hurt the Informativeness of the Asset Price in a Competitive Securities Market? Implications on Mark to Market Accounting

This paper examines the impact of earnings fixated traders on the asset price in a competitive securities market. In the market, there is a risky asset whose payoff is normally distributed. Earnings fixated traders underestimate the mean and variance of the asset payoff due to the fact that earnings fixated traders are functionally fixated on accounting earnings in formulating their trading strategies without paying attention to the accounting procedures used to generated those earnings numbers. This paper proves that the presence of earnings fixated traders does not affect the informativeness of the asset price. In addition, if the alternative accounting of mark-to-market replaces the conservative accounting, the results of this paper suggest that both the expected asset price and volatility of the asset price are higher but the informativeness of the asset price remains the same.

Accounting Conservatism and Asset Price

This paper presents a static model of a competitive securities market. In the market there are two assets: risk-free asset and risky asset. The payoff of the risk-free asset is one and the payoff of the risky asset is unknown. Rational traders correctly estimate the mean and variance of the risky asset payoff. Earnings fixated traders are functionally fixated on accounting earnings numbers. Due to the conservative accounting practices, earnings fixated traders underestimate the mean and variance of the risky asset payoff. Noise traders' demand for the risky asset is assumed to be random. This paper proves analytically that the presence of accounting conservatism decreases the asset price and the volatility of the asset price and it increases the expected return of the asset. In addition, this paper proves that the presence of accounting conservatism decreases the likelihood of the asset price lying on the right tail of its distribution and depending on the model parameter values, the presence of accounting conservatism may increase or decrease the likelihood of the asset price lying on the left tail of its distribution.

Key performance indicators as supplements to earnings: Incremental informativeness, demand factors, measurement issues, and properties of their forecasts

The documented decline in the information content of earnings numbers has paralleled the emergence of disclosures, mostly voluntary, of industry-specific key performance indicators (KPIs). We find that the incremental information content conveyed by KPI news is significant for many KPIs yet diminished when details about the computation of the KPI are absent or when the computation changes over time. Consistent with analysts responding to investor information demand, we find that analysts are more likely to produce forecasts for a KPI when that KPI has more information content and when earnings are less informative. We also analyze the properties of analysts’ KPI forecasts and find that KPI forecasts are more accurate than mechanical forecasts and their accuracy exceeds that of earnings forecasts. Our study contributes to the literature on the information content of KPIs as well as research on the properties of analysts’ forecasts. We provide evidence on whether and how to regulate voluntary disclosures.

The Prevalence and Validity of EBITDA as a Performance Measure

This study evaluates EBITDA as a financial performance measure and investigates the use of EBITDA in financial reporting. First, we take issue with recent comments that both the SEC and the IASB have levied against non-GAAP earnings numbers, and in particular EBITDA. While EBITDA allegedly provides an accurate reflection of the operations and abstracts from how assets are financed, we argue that (net) operating profit already provides this information without the necessity of making subjective adjustments. Also, our evidence suggests that EBITDA paints a rosy picture of the firm’s profitability and cash-generating ability. Next, using textual analysis, we investigate the prevalence of EBITDA in financial disclosures based on a large sample of 15,895 annual reports and 51,758 earnings releases from S&P 1500 firms between 2005 and 2016. We find that 14.8% of sample firms disclose and emphasize EBITDA numbers. EBITDA disclosures modestly increase over time and tend to be rather sticky in nature. In our cross-sectional analyses, we find that, consistent with our hypotheses, EBITDA-reporting firms are smaller, more leveraged, more capital-intensive, less profitable and have longer operating cycles than non-EBITDA reporting firms. They also exhibit higher forecast errors and a higher likelihood of missing the analyst forecast benchmark. Additional tests further underscore the opportunistic nature of EBITDA disclosures as we find that these firm characteristics are more strongly associated with the disclosure of adjusted EBITDA measures, and less strongly associated with the disclosure of EBITA and EBIT.

Does Mandatory Adoption of IFRS Enhance Earnings Quality? Evidence From Closer to Home

The global accounting convergence and the often discussed probable adoption of International Financial Reporting Standards (IFRS) by U.S. regulators is a timely topic. We contribute to the literature by examining a more recent mandatory IFRS adoption by Canada. Canadian GAAP (CGAAP) is often considered a close substitute for U.S. GAAP. One key feature of this setting is that two earnings numbers are available for fiscal year 2010 since Canadian firms were required to reconcile earnings under CGAAP with earnings under IFRS. We run a “horse race” of earnings quality between earnings under CGAAP and IFRS. We find that on average, relative to IFRS-earnings, earnings under CGAAP have greater association with next period cash flows and higher degree of persistence. Further, when the difference between earnings under CGAAP and IFRS is large, IFRS-earnings are less value-relevant and less persistent. These results strongly support the notion that higher earnings quality is associated with CGAAP. Finally, the results also indicate that differences between CGAAP and IFRS with regard to accounting for financial instruments and investments significantly impair the quality of IFRS-earnings. Our findings are potentially informative to any revival of policy debates on the possible adoption of IFRS by U.S. firms.

Detecting Cosmetic Earnings Management Using Benford’s Law: Evidence From Iran

Cosmetic earnings management (CEM) is a way of manipulating financial results through small upward rounding of reported earnings. As a result, there will be more than expected zeros and less than expected nines as second digit of earnings numbers. Previous studies showed that cosmetic earnings management has occurred before implementation of Sarbanes-Oxley Act in the U.S and there has been a tendency to exercise it worldwide. This paper investigates the occurrence of CEM in the companies listed in Tehran stock exchange (TSE) during 1999 to 2013 by comparing observed distribution of earning numbers with a standard distribution, called Benford’s law. The results show that CEM has not occurred in TSE for the period 1999 to 2009. We suggest users of financial statements to pay attention to earning numbers as a start point for further investigations.

How Disaggregated Forecasts Influence Investor Response to Subsequent Earnings Announcements

ABSTRACT Firms often issue disaggregated earnings forecasts, and prior research reveals benefits to doing so. However, we hypothesize and experimentally find that the benefits of disaggregated forecasts do not necessarily carry over to the time of actual earnings announcements. Rather, disaggregated forecasts create multiple points of possible comparison between the forecast and the subsequent earnings announcement. Thus, when firms disaggregate forecasts and subsequently release disaggregated actual earnings numbers, investors reward firms that beat those multiple benchmarks, but punish firms that miss those multiple benchmarks. Thus, we show that issuing a disaggregated earnings forecast to achieve the associated benefits can backfire after the announcement of actual earnings. Our results have implications for researchers and firm managers. Data Availability: Contact the authors.

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.