Monitoring Mechanism, Overvaluation, and Earnings Management

1. Monitoring Mechanism, Overvaluation, and Earnings Management Shing-yang Hu Department of Finance, National Taiwan University and Yueh-hsiang Lin Department of Finance, National Taipei College of Business

2. Motivation • Literature: When equity is overvalued, companies are more likely to • make more investments (Baker, Stein, and Wurgler, 2003; Polk and Sapienza, 2009; Stein, 1996), • conduct more mergers and acquisitions (e.g., Dong et al., 2006; Rhodes-Kropf, Robinson, and Viswanathan, 2005; Shleifer and Vishny, 2003), • offer more securities and pay more dividends (Baker and Wurgler, 2000, 2002, 2004), and • use more accruals (Chi and Gupta, 2009). • Jensen’s (2005): agency costs of overvalued equity set into motion a series of value-destroying forces that can undermine core firm value. • Researchers have yet to fully address whether any existing monitoring mechanisms can deter managers' value-destruction behaviors.

3. Objective • In this paper, we ask: Given overvaluation, can certain monitoring mechanisms can prevent managers from inflating the earnings? • Jensen (2005) argues that governance mechanisms (e.g. corporate control, equity-based incentive compensation) may not be effective to solve the agency problems associated with overvaluation. • Our empirical results: Yes! The first and the foremost contribution of our paper is to provide supporting evidence that monitoring is an effective tool to limit earnings management.

4. Hypothesis • Monitoring hypothesis: Given overvaluation, either external information intermediaries or internal corporate governance mechanisms could prevent managers from inflating the earnings. • Under constant external monitoring (e.g. analysts and rating agencies), inflated earnings through management are likely to be detected. • Under effective internal governance mechanisms, managers may be fired or suffer capital loss of shares or options holding if their management of earnings is revealed. • Managers will resist managing earnings even when faced with overvaluation.

5. Hypothesis • Market pressure hypothesis (drawn from Jensen (2005)): Managers may engage in earnings management to generate earnings reports that justify the firm’s overvalued market price. The pressure to justify the price is related to operating performance and dependence on equity financing. • When an overvalued company has poor operating performance, its managers face much greater pressure to improve performance and are more likely to engage in earnings management than managers of better performing companies. • When overvalued companies are highly dependent on the equity market, managers are more likely to engage in earnings management to support the market price to preserve their financing channel.

6. Relation between M/V and accruals • Sample: Non-financial firms listed on the NYSE, Amex, and Nasdaq included in the COMPUSTAT and CRSP databases from 1987 through 2005. • Proxy for earnings management: Total accruals (Ac) from items on the statement of cash flow: • Conventional discretionary accrual models: • Jones model: JA (regress Ac on change in sales and PPE) • Modified Jones model: MJA (regress Ac on change in sales minus change in AR and PPE) • CFO model (Dechow, Kothari, and Watts, 1998): CFOA (regress Ac on change in sales, PPE, and current CFO) • DD model (Dechow and Dichev, 2002): DD (regress Ac on change in sales, PPE, current and lagged CFO)

7. Relation between M/V and accruals • Follow Kothari, Leone, and Wasley (2005) to calculate ROA-firm-matched accruals. • Follow Rhodes–Kropf, Robinson, and Viswanathan (2005) procedure to estimate the following regression for each of the 12 Fama and French industries for each year t: • The estimated fundamental value (V) is the natural exponent of the fitted value. • M/V measures the discrepancy between market valuation and fundamental value and reflects the degree of overvaluation. • Classify sample observations into quartiles by M/V.

8. Relation between M/V and accruals • The differences of the mean discretionary accruals are significant at a 0.01 level, consistent with findings in Chi and Gupta (2009). • The significance diminishes after controlling for ROA, which is more consistent with the monitoring hypothesis than the market pressure hypothesis.

9. A closer look: The monitoringhypothesis • No relation between market overvaluation and future accruals for large firms or firms included in the S&P 1500 index, in the Investor Responsibility Research Center (IRRC) database or in the I/B/E/S database.

10. A closer look: The monitoringhypothesis • No relation between market overvaluation and future accruals for various groups of internal governance mechanism (proxied by Gompers et al.’s (2003) governance index) and groups of the degree of alignment between the governance system and shareholders’ interests (proxied by Bergstresser and Philippon’s (2006) incentive ratio)

11. A closer look: The market pressure hypothesis • Relation between market overvaluation and future accruals are more pronounced for poorer operating performances (proxied by ROA) and for more equity dependent (proxied by Kaplan and Zingales’ (1997) index).

12. Interaction between monitoring and market pressure • The market pressure hypothesis holds only when monitoring is weak, i.e. no significant difference in discretionary accruals between high and low overvalued companies for the lowest ROA quartile and the highest KZ index quartile

13. Regression Analysis • When examining the effect of overvaluation on earnings management it is important to control for ROA. • The effect of overvaluation is significant for non-S&P companies even when controlling for ROA. • Results of interaction terms are consistent with monitoring and market pressure hypotheses.

14. Robustness test • Results are similar for alternative discretionary accruals models constructed from items on the cash flow statement and for modified Jones discretionary accrual calculated from the balance sheet.

15. Robustness test • Following Roychowdhury (2006), we use three measures of real earnings management: • ABPRODA: Companies can produce inventory more than necessary to lower cost of goods sold and increase reported earnings. By producing more units, managers spread the fixed costs, causing the fixed costs (and thereby cost of goods sold) per unit to be lower. However, the firm will still incur much higher incremental holding costs, which cause annual producing costs to increase relative to sales, and cause a decline in cash flow from operations given sales levels. The higher the production cost is, the more extent of real earnings management is. Empirically, the abnormal productions costs, ABPRODA, are the residuals of the following cross-sectional regression within each two-digit SIC code industry and each year:

16. Robustness test • ABOCFA: Firms can accelerate the timing of sales by offering price discounts or lenient credit terms. Either way will cause a temporary increase in sales volume (which will disappear when the firm reverts to old prices). Thus, the earnings in the current year will increase as the additional sales are recorded with an assumption of positive margins. However, the current-year cash flow from operations will decrease; this lower levels of cash flow from operations proxy for higher levels of real earnings management. The second proxy for real earnings management, the abnormal cash flow from operations, ABOCFA, is negative one times the residuals (so that a higher ABOCFA means higher levels of real earnings management) of the following cross-sectional regression estimated for each two-digit SIC code industry and each year:

17. Robustness test • ABDISEXPA: Managers can increase reported earnings by reducing discretionary expenses such as R&D, advertising, selling, and general and administrative expenses. Therefore, a lower discretionary expense can reveal a higher level of real earnings management. The third proxy for real earnings management, the abnormal discretionary expenses, ABDISEXPA, is negative one times the residuals (so that higher levels of ABDISEXPA proxies for higher levels of real earnings management) of the following cross-sectional regression estimated for each two-digit SIC code industry and each year:

18. Robustness test • For highly monitored S&P companies, overvalued firms do not have high extent of real earnings management, supporting the monitoring hypothesis. On the other hand, there is weak evidence to support the market pressure hypothesis for non-S&P companies.

19. Robustness test • Estimate fundamental values through analysts’ forecasts(Frankel and Lee, 1998; Ohlson, 1990). • Using I/B/E/S sample, the qualitative results from two estimates of the fundamental values (regressions and analysts’ forecasts) are very similar.

20. Findings and Conclusions • Using U.S. data from 1987 to 2005, we test the market pressure hypothesis against the monitoring hypothesis. • Consistent with the monitoring hypothesis, we find no relation between market overvaluation and different measures of accruals and real earnings management in firms included in the S&P 1500 index. • For companies that are not in the S&P index and do not have any analysts following, there is a positive relation between market overvaluation and future accruals in poor-performing and equity-dependent firms. • Monitoring is found to be an important factor in the decision of whether or not to manage earnings by overvalued companies.