Firm Earnings Research Articles

Market Reactions to Corporate Restructurings

This article examines the stock price reactions to restructuring announcements by the DJIA 30 corporations over the period 1988–1995 by employing the event study methodology and cross-sectional regression analyses. Corporate restructurings, historically regarded as highly unusual accounting events, became increasingly common after 1987. One probable cause is the discretionary power managers enjoy due to the flexibility allowed by the Accounting Principles and Financial Accounting Standards Boards. Our general findings are that, contrary to contemporary press comments, restructurings, especially those impose a charge against the firm's earnings, are typically associated with negative excess returns. This evidence seems to be consistent with the notion that restructurings reveal unfavorable information of the firm's future performance. Furthermore, the larger the size of the restructuring amount announced in the Wall Street Journal, the more negative the stock price reaction is.

Determinants of the Dollar Value of Default Risk: A Put Option Perspective

This study uses the option valuation framework to identify andinvestigate the factors affecting the cross-sectional difference inindividual corporate bonds' default risk. The dollar value of defaultrisk (DVDR) is measured by subtracting the observed trading price of arisky corporate bond from a Cox-Ingersoll-Ross model value of acorresponding pseudo-default-free bond. From an option pricingperspective, DVDR can be modeled as the value of a put option on thefirm's risky assets. The DVDR of an individual investment-grade corporatebond is hypothesized to be related to the bond rating, time to maturity ofthe bond, size of the issuing firm, volatility of firm value, and dividendyield of the issuing firm. In the case of the first four factors, theempirical results are consistent with the predictions from a put optionperspective. There is a mixed relationship between DVDR and dividendyield, however, which provides a weaker support for the prediction of theoption valuation model. Such a mixed relationship documents the importantrole that dividend payments play in signaling a firm's future earnings andreducing overall agency costs. ["In particular, the formula can be usedto derive the discount that should be applied to a corporate bond becauseof the possibility of default." (Black and Scholes (1973), Journal of Political Economy, Abstract, p. 637.)]

Unraveling the Determinants and Consequences of an Innovation-Supportive Organizational Culture

The current research identifies constructs that are supportive of an innovative culture in small to medium-sized enterprises. A sample of 429 employees in 23 small to medium-sized manufacturing firms was used to identify constructs associated with an innovative culture. Supervisory support and reward system support are both positively related to an innovative culture. Perceived work overload is negatively related. Companies with cultures supportive of innovation tend to be smaller, have fewer formalized human resource practices, and less munificent resources. There is no direct relationship between an innovative culture and firm performance; however, when the competitive environment is changing rapidly firm earnings are enhanced by an innovative culture.

Technology-Risk-Related Peso Problems in Stock Returns

In the empirical testing of many asset pricing models it is assumed that realised returns are an unbiased estimate of expected returns over the period of study. In this paper it is argued that the occurrence of negative jumps in a firm's future earnings and, consequently, in its stock price, is positively related to the level of network externalities in the firm's product market. If the ex post frequency of these negative jumps in a sample does not equal the ex ante assessed probability of occurrence, the sample is subject to a peso problem. The hypothesis is tested for by regressing the skewness coefficient of a firm's realised stock return distribution on the firm's R&D intensity, i.e. the ratio of the firm's research and development expenditure to its net sales. The empirical results support the technology-related peso problem hypothesis. In samples subject to such a peso problem, the returns are biased up and the variances are biased down.

The Market Performance of Tracking Stocks

Tracking stocks have been a popular form of equity restructuring in recent years. AT&T, Disney, General Motors, Sprint, US West, and many others have issued tracking stocks. While the positive announcement returns of tracking stocks are well documented, an examination of their post-issue market performance is lacking. This paper examines the post-issue returns and the subsequent restructuring events through December 2000 by using a comprehensive sample of tracking stocks. We document three key results. First, we find that tracking stocks earn significantly negative buy-and-hold excess returns during a three-year period following the issue date. We also find significantly negative returns surrounding the earnings announcements during this period. This evidence contrasts with the post-issue returns of spinoffs, which are known to be positive, and of carveouts, which are known to be insignificant. Second, contrary to a common justification given to adopt tracking stocks, we find that they do not increase the transparency of firm earnings. Third, we find large positive announcement-period returns to events resulting in the elimination of tracking stock structure.

Board structure and the informativeness of earnings

This study draws on prior research on corporate governance and examines whether the informativeness of earnings, proxied by the earnings–returns relationship, varies with the fraction of outside directors serving on the board and board size. The results suggest that earnings of firms with the smallest boards in the sample (with a minimum of five board members) are perceived as being more informative by market participants. By contrast, there is no evidence that board composition mitigates the earnings–returns relation. Policy implications are discussed.

Open Market Stock Repurchase Signalling

This paper presents a signalling model of open market repurchases that simulates the effects of a repurchase on the insiders' utility. If insiders refrain from tendering, then they are exposed to more risk. If insiders are risk averse, then the market can draw several inferences regarding the insiders' expectations of their firm's future earnings: 1) firms that repurchase more have higher earnings; 2) holding the repurchase proportion constant, riskier firms have higher earnings; and 3) holding proportion constant, firms where insiders have a greater ownership stake have higher earnings. We test the model's implications with a sample of over 700 U.S. repurchases and find support for all three.

The Effect of the External Accountant's Review on the Timing of Adjustments to Quarterly Earnings

Publicly listed companies must have their quarterly financial data reviewed by an external accountant. A company can have such data reviewed at the end of each quarter (timely review) or in conjunction with the year-end audit (retrospective review). The costs and benefits of each review choice have been debated for decades. The Securities and Exchange Commission (SEC) consistently has indicated a preference for reviews, while many companies have argued that there is no evidence that reviews provide incremental benefits. In January 1999, the Big Five accounting firms jointly announced to the SEC that they will require timely interim reviews of the financial statements of each public client, as a condition of acceptance of the company as a client. In February 1999 the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees, created by the New York Stock Exchange and the National Association of Securities Dealers, recommended that the SEC require reviews prior to firms' filings of Forms 10-Q. Our paper assesses whether the timing of the external accountant's review of quarterly financial data (timely versus retrospective) is associated with differences in the timing of recognition of adjustments to quarterly earnings (recognition during the first three quarters versus the fourth quarter). Our results support earlier claims that a disproportionately large number of adjustments are recorded in the fourth quarter. The results also show that, as claimed but not previously documented, the frequency and proportion of adjustments recorded during the first three quarters are greater for companies with reviews, while the frequency and proportion of fourth quarter adjustments are smaller. Controlling for the total of adjustments recorded during the year, the number of adjustments made during the first three quarters is positively related to having a review, and to company size. Under reasonable assumptions, delay in recording adjustments should result in delayed resolution of uncertainty concerning the amounts of annual earnings, and of earnings of the late quarters in the fiscal year. We investigate the effect of deferred adjustments on uncertainty about the amounts of quarterly and annual earnings, using non-directional earnings prediction errors as proxies for uncertainty. Using results from tests referred to above, we divide the sample into high-deferral and low-deferral firms. Results indicate that high-deferral firms generate more uncertainty about third and fourth quarter earnings than do low-deferral firms. Contrary to our expectations, high-deferral firms do not have less uncertainty surrounding their first and second quarter earnings. The delay in resolving uncertainty over the third and fourth quarter earnings of high-deferral firms appears to cause increased uncertainty about their annual earnings for the entire fiscal year, relative to low-deferral firms.

Profit tax and tariff under international oligopoly

A simple model of international duopoly is developed to examine the effects of tariff and corporate profit tax. It is shown that in an export-cum-on-site-production regime, a tariff continues to be an effective instrument for shifting net profit away from foreign to domestic firms. A corporate profit tax, on the other hand, could lower the domestic output and employment and decrease the net earnings of both domestic and foreign firms. Thus when the host government's ability to raise tariff is limited, it should seriously consider a corporate tax cut policy to achieve the dual purpose of creating more jobs and increasing corporate earning at home.

Operational flexibility and market valuation of earnings

This paper examines the association between the stock returns and accounting earnings of firms that have different levels of operational flexibility. Operational flexibility is a firm’s ability to respond profitably to environmental fluctuations by shifting factors of production within a multinational network of subsidiaries. The geographic breadth and depth of a firm’s multinational network are used as indicators of operational flexibility. We find a significantly greater coefficient relating stock returns and accounting earnings for multinational firms that operate in many countries, but limit their concentration in any one foreign country, than for other multinational firms or domestic firms. This coefficient is significantly smaller for multinational firms whose foreign subsidiaries are highly concentrated in a few countries. When all multinational firms are pooled together, we find their earnings-returns association does not differ from that of domestic firms. Copyright © 1999 John Wiley & Sons, Ltd.

The Effect of the External Accountant's Review on the Timing of Adjustments to Quarterly Earnings

Publicly listed companies must have their quarterly financial data reviewed by an external accountant. A company can have such data reviewed at the end of each quarter (timely review) or in conjunction with the year-end audit (retrospective review). The costs and benefits of each review choice have been debated for decades. The Securities and Exchange Commission (SEC) consistently has indicated a preference for reviews, while many companies have argued that there is no evidence that reviews provide incremental benefits. In January 1999, the Big Five accounting firms jointly announced to the SEC that they will require timely interim reviews of the financial statements of each public client, as a condition of acceptance of the company as a client. In February 1999 the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees, created by the New York Stock Exchange and the National Association of Securities Dealers, recommended that the SEC require reviews prior to firms' filings of Forms 10-Q. Our paper assesses whether the timing of the external accountant's review of quarterly financial data (timely versus retrospective) is associated with differences in the timing of recognition of adjustments to quarterly earnings (recognition during the first three quarters versus the fourth quarter). Our results support earlier claims that a disproportionately large number of adjustments are recorded in the fourth quarter. The results also show that, as claimed but not previously documented, the frequency and proportion of adjustments recorded during the first three quarters are greater for companies with reviews, while the frequency and proportion of fourth quarter adjustments are smaller. Controlling for the total of adjustments recorded during the year, the number of adjustments made during the first three quarters is positively related to having a review, and to company size. Under reasonable assumptions, delay in recording adjustments should result in delayed resolution of uncertainty concerning the amounts of annual earnings, and of earnings of the late quarters in the fiscal year. We investigate the effect of deferred adjustments on uncertainty about the amounts of quarterly and annual earnings, using non-directional earnings prediction errors as proxies for uncertainty. Using results from tests referred to above, we divide the sample into high-deferral and low-deferral firms. Results indicate that high-deferral firms generate more uncertainty about third and fourth quarter earnings than do low-deferral firms. Contrary to our expectations, high-deferral firms do not have less uncertainty surrounding their first and second quarter earnings. The delay in resolving uncertainty over the third and fourth quarter earnings of high-deferral firms appears to cause increased uncertainty about their annual earnings for the entire fiscal year, relative to low-deferral firms.

Analysts' Interpretation and Investors' Valuation of Tax Carryforwards*

AbstractWe examine how financial analysts and equity investors incorporate information on deferred taxes from carryforwards into earnings forecasts and share prices. We focus on carryforwards because, in providing this information each period, management must use their private information about the firm's profitability prospects. Thus, accounting measurement of tax carryforwards is another way of providing a management earnings forecast. In analyzing the role of carryforwards in valuation, we distinguish between two conflicting effects. First, deferred taxes from carryforwards represent future tax savings; hence, they should be valued positively as assets. In contrast, the existence of tax carryforwards may signal a higher likelihood of future losses, which would have a negative effect on expected earnings and share prices. We find that analysts consider earnings of firms with carryforwards to be less persistent because of the increased likelihood of future losses. We also find that analysts tend to be less precise and more optimistic (biased) in forecasting earnings of firms with carryforwards. This higher optimism and lower precision are more pronounced just after firms adopt Statement of Financial Accounting Standards (SPAS) 109 and are almost entirely corrected over time. An analysis of investors' valuation indicates a strong positive relation between deferred taxes from carryforwards and share prices, suggesting that these carryforwards are valued as assets. Also, earnings and book values of equity are valued less in firms that have carryforwards than in firms without carryforwards. Finally, the valuation allowance required under SFAS 109 assists equity investors in valuing a firm's earnings and net assets. The combined findings on analysts' interpretation and investors' valuation suggest that analysts fail to fully capture the implication of carryforwards on future earnings within their forecasting horizon.

The impact of anti-takeover charter amendments on expectations of future earnings and takeover activity

In this study, additional evidence of the impact of anti-takeover amendments on firm earnings and subsequent takeover activity is presented. It is found that analysts' projections of financial performance measures do not appear to be altered by the adoption of anti-takeover amendments. Additionally, it is found that the anti-takeover charter amendments do not impact either takeover activity or takeover premiums following their adoption. Thus, anti-takeover amendments appear to have few, if any, consequences to shareholders. Copyright © 1999 John Wiley & Sons, Ltd.

Real Options and the Informativeness of Segment Disclosures

This paper examines the informativeness of segment disclosures using a real-options framework. I study the relation between firm value and segment earnings when managers have options to adapt poorly-performing segments and to expand segments with investment opportunities. The segment adaptation option implies that segment losses should be less informative than segment profits about firm value. The segment expansion option implies that earnings will be capitalized at a higher rate for segments with higher investment opportunities. My empirical results are consistent with the hypotheses. This framework and supporting empirical evidence provide a direct link between the valuation and managerial-monitoring roles of segment disclosures.

Equity Valuation and Negative Earnings: The Role of Book Value of Equity

This study provides an explanation for the anomalous significantly negative price-earnings relation using the simple earnings capitalization model for firms that report losses. We hypothesize and find that including book value of equity in the valuation specification eliminates the negative relation. This suggests that the simple earnings capitalization model is misspecified and the negative coefficient on earnings for loss firms is a manifestation of that misspecification. Furthermore, we provide evidence on three competing explanations for the role that book value of equity plays in valuing loss firms. Specifically, we investigate whether the importance of book value in cross-sectional valuation models stems from its role as (1) a control for scale differences (Barth and Kallapur 1996), (2) a proxy for expected future normal earnings (Ohlson 1995; Penman 1992), or (3) a proxy for loss firms' abandonment option (Berger et al. 1996; Barth et al. 1996; Burgstahler and Dichev 1997). Our results do not support the conjecture that the importance of book value in cross-sectional valuation stems primarily from its role as a control for scale differences. Rather, the results are consistent with book value serving as a value-relevant proxy for expected future normal earnings for loss firms in general, and as a proxy for abandonment option for loss firms most likely to cease operations and liquidate.

Discussion of Intangible Assets and Stock Prices in the Pre-SEC Era

Ely and Waymire examine the stock market's valuation of firms' reported intangible assets in the pre-SEC era. Their methodology is based on regressions of equity market value against accounting earnings and book value, plus additional terms related to the disclosure of intangible assets and auditor identity. The authors classify 405 firms with required stock price and accounting data in 1927 into three groups: firms that disclosed material amounts of intangible assets (MD firms), firms that disclosed immaterial or nominal amounts of intangibles (ND firms, whose reported intangible assets are less than $100), and firms with no separate disclosure of intangibles (Ambiguous Disclosers or AD firms). 1 Their primary findings are that for 143 MD firms, tangible book value is positively associated with price (7 = .254, t(y) = 2.59), while intangible book value is negatively associated with price (y = -.278, t(y) = -1.82). When an interaction term, earnings*intangible book value, is included, the coefficient and t-statistic on tangible book value are unchanged and the coefficient on intangible book value becomes positive but loses significance (y = .154, t(y) = 1.12). The coefficient on the interaction term is negative (7 = -.065, t(y) = -4.06), indicating that the market discounts a firm's earnings as a decreasing function of its capitalized intangibles. For all regressions, the coefficient on earnings alone is reliably positive. When a dummy variable for top auditor (defined as either Price Waterhouse, the

Lead indicator models and UK analysts' earnings forecasts

This study examines the predictive ability of models which adjust random walk forecasts of corporate earnings, to incorporate past changes in economic lead indicators. The results suggest that changes in the broad money supply measure M4 contain predictive ability, beyond equivalent changes in other lead indicators or an individual firm's earnings. When forecasts from the broad-money model are compared with forecasts generated by financial analysts a size effect is evident: the superiority of analysts' forecasts is apparent much earlier for large firms than for small firms. This result is consistent with studies suggesting a size-related differential in the collection and dissemination of information by market participants.

Are Financial Analysts' Forecasts of Corporate Profits Rational?

This paper develops generalized method‐of‐moments tests for the rationality of earnings per share forecasts made by individual stock analysts. We fail to reject the hypothesis of rationality as long as we take into account two complications: (1) the correlation in a given period of analysts' forecast errors in predicting earnings for firms in the same industry and (2) discretionary asset write‐downs, which affect earnings but are intentionally ignored by analysts when they make earnings forecasts. Our results challenge earlier work by De Bondt and Thaler and by Abarbanell and Bernard that found irrationality in analysts' forecasts.

Individual-Firm Style Loadings, Unrecorded Economic Assets, and Systematic Risk

This study estimates individual-firm style loadings for classification of individual securities into growth (glamour) and value groups. Style loadings are similar to betas, measuring the comovement of a firm's return with the return on a particular style index. The study examines this classification by comparing the extent of unrecorded economic assets for growth and value firms. The study also examines the systematic-risk characteristics associated with this classification. Using Ohlson's (1995) valuation model, this study estimates the persistence of abnormal earnings for individual firms using time-series analysis. Growth firms are shown to have higher levels of abnormal earnings persistence than value firms, probably due to their greater levels of unrecorded economic assets than value firms. Indeed, the study finds that growth firms have greater levels of R&D and advertising intensity than value firms. The study also shows that growth and value firms differ in their systematic risk. Possibly due to the greater uncertainty associated with unrecorded economic assets, the systematic risks of growth firms are larger than those of value firms.

THE EFFECT OF SELF‐TENDER OFFERS ON EARNINGS EXPECTATIONS

AbstractWe examine financial analysts' earnings revisions after self‐tender offers. Consistent with the assertions of earlier studies that self‐tender offers signal future performance, financial analysts significantly increase their forecasts of earnings for firms that announce self‐tender offers. However, the revisions differ based on the method chosen to repurchase shares. For Dutch auction offers, analysts significantly revise their estimates of short‐term earnings only. For fixed‐price tender offers, analysts increase both short‐term and long‐term earnings estimates. Also, long‐term earnings revisions are significantly related to announcement‐period abnormal returns for fixed‐price tender offers, which suggests that fixed‐price self‐tender offers convey more positive information about future earnings than do Dutch auction offers.