Academic Research in Accounting

1. Academic Research in Accounting Victoria Dickinson, PhD, CPA

3. Functional Areas Financial Accounting and Reporting Managerial Accounting Auditing Taxation Systems Educational Methods

4. Financial Accounting Market-Based Research Managerial Choice Accounting Information Constituencies Standard Setting/Regulation

5. Market-Based Research Market Efficiency Valuation Models Information Content of Earnings, Cash Flows, and Accruals Fundamental Analysis/Anomalies Earnings-Returns Responsiveness Earnings Quality and Other Signals Cost of Capital

6. Market Efficiency Fama (1970) defines an efficient market as one in which �security prices fully reflect all available information�. (CRSP) Important implications for accounting research If markets are efficient, then gains from fundamental analysis are severely limited. In other words, accounting doesn�t add value since it is not a timely source of information. Conversely, if security prices react to new accounting information, then accounting information is useful.

7. Market Efficiency (Continued) Two types of tests: short- and long-horizon event studies and cross-sectional tests of return predictabilities (anomalies research) Event studies � examine the stock market reaction around a specified event (or date in time) Examples: Bernard and Thomas (1989, 1990), Ball and Bartov (1996) Cross-sectional tests of returns predictability � examines whether the cross section of returns on portfolios formed periodically using a specific trading rule generates abnormal returns. Examples: Sloan (1996), Collins and Hribar (2000)

8. Market Efficiency (Continued) Challenges: Finding appropriate model of risk CAPM, Fama French 3-Factor model (beta, size, and book-to-market) Finding appropriate model of expected performance (Compustat) Random walk, analysts� forecasts, statistical time-series

9. Valuation Models Firm-value is defined as the present value of expected future net cash flows, discounted at the appropriate risk-adjusted rate of return. Financial Accounting Standard Board�s (FASB) conceptual framework states financial statements (F/S) should help investors and creditors in �assessing the amounts, timing, and uncertainty of future cash flows.� (FASB, 1978) Relation between current performance and future cash flows Relation between current performance and security prices (Easton 1985)

10. Valuation Models Finance field: Dividend-Discounting model Discounted cash flows

11. Valuation Models Accounting-Based Valuation Made significant strides through late 1990s Residual income model (Feltham and Ohlson 1995) Transformation of the dividend-discounting model, but express value directly in terms of current and future accounting numbers, book values, and earnings.

12. Valuation Models Value can be aligned with earnings, book values, or some combination (Burgstahler and Dichev 1997) Earnings � growth firm Book values � distressed firm Combination (residual income) � well-performing RI model performs only slightly better than earnings capitalization (Dechow et al, 1999)

14. Information Content of Earnings, Cash Flows, and Accruals Advances in market efficiency challenged the notion that accounting variables had �information content� for the securities markets Accounting Earnings = Cash Flows + Accounting Accruals Which component is informative? (Dechow 1994, Sloan 1996)

15. Information Content of Earnings, Cash Flows, and Accruals Conducted as event studies or association studies Event study: Does an event (i.e., earnings announcement) convey new information to market participants as reflected in changes in the level or variability of security prices or trading volume over a short period of time surrounding the event? Association study: Tests for positive correlation between an accounting performance measures (e.g., earnings or cash flows from operations) and stock returns, both measured over relatively long, contemporaneous time periods, e.g., one year Does not assume accounting reports are only source of information to market No causal connection is inferred

16. Information Content of Earnings, Cash Flows, and Accruals Evidence: Accounting matters Earnings surprise correlated with stock returns (Ball and Brown 1968) Return volatility and trading volume (evidence of information flow to market) increase during earnings announcements (Beaver 1968) Accounting information is not timely (stock prices lead earnings) (Beaver et al. 1980) Earnings are not informative about future stock prices (or maybe markets are inefficient), but stock prices are informative about future earnings Market response to earnings news is asymmetric (good news gets incorporated into price faster than bad news) (Bernard and Thomas 1989, 1990) Earnings is more highly correlated with stock returns than is cash flows (Wilson 1986, 1987; Dechow 1994)

17. Fundamental Analysis/Anomalies Primary focus of fundamental analysis (FA) is identification of mispriced securities (Graham & Dodd�s 1934 Security Analysis) FA entails the use of information in current and past F/S, in conjunction with industry and macroeconomic data to arrive at firm�s intrinsic value. Examples: Ou and Penman (1989), Lev and Thiagarajan (1993), Abarbanell and Bushee (1997, 1998), Piotroski (2000)

18. Earnings-Returns Responsiveness Earnings response coefficients (ERC) � the coefficient from a regression of returns on earnings Represent a mapping of earnings� time-series properties and discount rates into changes in equity market values Represents the present value of the revisions of expected future earnings

19. Earnings-Returns Responsiveness Prior literature has idenfied four determinants of ERCs (Kormendi and Lipe 1987; Easton and Zmijewski 1989; and Collins and Kothari 1989) Persistence (+), growth (+), beta (-), and interest rates (-) Relate ERCs to economic determinants such as competition, technology, innovation, effectiveness of corporate governance, compensation, etc.

20. Earnings Quality and Other Signals Deficient GAAP � low quality earnings Exhibit only weak correlation with security returns (R-squared of 1 to 5 percent) R&D, conservative accounting, nonfinancial information (Baruch Lev) Bias the ERC downward May be noise rather than deficiency Permanent versus transitory; operating versus nonoperating Dechow-Dichev (2002) measure Correlates earnings with past, present, and future cash flows

21. Cost of Capital Implied cost of capital models Gebhardt, Lee & Swaminathan (2001) and Claus & Thomas (2001) Assume g Calculate implicit ?E given current prices

22. Cost of Capital � Equity Risk Premia Residual Income: Claus & Thomas 3.4% Easton, Taylor, Shroff & Sougiannis (2002) 4.8% Gebhardt, Lee & Swaminathan 1.7% Historical Averages: Fama & French 5.0%

23. Managerial Choice Positive Accounting Theory (Contracting) Voluntary Disclosure Conservatism and Accounting Earnings (Financial Statement) Management Corporate Governance Managerial Ownership/Insider Trading

24. Positive Accounting Theory (Contracting) Positive accounting theory (PAT) (Watts and Zimmerman 1978) predicts that the use of accounting numbers in compensation and debt contracts and in the political process affects a firm�s accounting choices.

25. Voluntary Disclosure Recognition versus Disclosure (probably not voluntary) Management Forecasts � guide expectations of markets (investors, analysts, etc.) (First Call) Bad News � usually disclosed immediately (Skinner 1994) Mitigate threat of litigation Good news � may save for earnings surprise (Soffer et al 2000) Proprietary cost of disclosure Timing may be motivated by insider trading (Noe 1999) Pro Forma Earnings (Doyle et al 2003)

26. Conservatism and Accounting Would F/S be more informative about current economic income (i.e., change in market value) if GAAP were changed to permit managers to capitalize R&D outlays? Asymmetric accounting treatment Immediate recognition of losses while deferring gains Choice that results in lower net income and/or assets Example: Basu 1997

27. Earnings (Financial Statement) Management Schipper (1989) defines earnings management as �purposeful intervention in the external reporting process with the intent of obtaining some private gain to managers or shareholders.� (Smoothing) Can be income-increasing or decreasing (cookie jar reserves) (Healy 1985)

28. Earnings (Financial Statement) Management Use models of discretionary accruals to proxy for earnings management No good model of discretionary accruals (Jones 1991, Dechow et al 1995) Correlated with performance and growth Survivorship Bias Biased by M&A and non-transitory items (Collins and Hribar 2000) Overcome by newer models like performance-matched accruals

29. Corporate Governance Do differences in corporate governance structures affect the degree of information asymmetry in capital markets and, in turn, influence the timing and strength of the relation between security returns and earnings information? No good measure Shareholder rights (Gompers et al 2003) Board characteristics (Klein 1998)

30. Managerial Ownership/Insider Trading Does managerial ownership affect the informativeness of accounting numbers because of the separation of corporate ownership and control? Warfield, Wild and Wild (1995) show managerial ownership is positively associated with earnings' explanatory power for returns and inversely related to the magnitude of accounting accrual adjustments.

31. Accounting Information Constituencies Analysts (Sell-Side) Use wider information set than just accounting numbers to forecast future performance Common expectations model for future earnings More accurate than time-series models (Brown et al 1987) Consensus: Mean versus dispersion (I/B/E/S) Sequence of revisions (herding) (Trueman 1994)

32. Analysts (Sell-Side) Drawback �previously thought that optimism in analysts� forecasts due to compensation contracts (McNichols and O�Brien 1997) Analysts are learning from evidence of past biases (Clement 1999) Incentives have changed Quality of analyst forecast data has improved Fewer selection and survivor biases

33. Standard Setting/Regulation FASB, IASB, SEC, Sarbanes Oxley Issues: Multi-purpose financial reporting Informational Perspective versus Stewardship Research Questions- Do F/S numbers prepared according to a new standard convey new information to the markets? Are F/S numbers prepared under new standard more highly associated with contemporaneous stock returns and prices? What are economic consequences of the issuance of a new standard? Facilitates comparison across standard regimes (IFRS versus local GAAP)

34. Fringe Research Like Mine Forecasting future operating performance interacted with industrial organization framework Life Cycle Barriers to Entry and Competitive Factors Supply-Chain management Publication Prospects Conferences (Trail Mix and Timing) Journals (Who is my peer?)

35. Conclusion No shortage of topics Who is your audience? Bring outside discipline into accounting Bring accounting to outside discipline Competitive publishing arena (3 to 5 A journals) Contribution, contribution, contribution

36. References Abarbanell, J. S. and B. J. Bushee (1997). "Fundamental analysis, future earnings, and stock prices." Journal of Accounting Research 35: 1-24. Abarbanell, J. S. (1998). "Abnormal returns to a fundamental analysis strategy." The Accounting Review 73: 19-45. Ball, R. J. and P. D. Brown (1968). "An empirical evaluation of accounting income numbers." Journal of Accounting Research(Autumn): 159 178. Ball, R. J. and E. Bartov (1996). "How naive is the stock market's use of earnings information?" Journal of Accounting and Economics 21(June): 319-337. Basu, S. (1997). "The conservatism principle and the asymmetric timeliness of earnings." Journal of Accounting and Economics 24: 3-37. Beaver, W. H. (1968). "The information content of annual earnings announcements." Journal of Accounting Research 6(Empirical research in accounting: Selected studies): 67 92. Beaver, W. H., R. A. Lambert, et al. (1980). "The information content of security prices." Journal of Accounting and Economics 2(March): 3-28. Bernard, V. L. and J. K. Thomas (1989). "Post-earnings announcement drift: Delayed price response or risk premium?" Journal of Accounting Research(Supplement): 1-48. Bernard, V. L. and J. K. Thomas (1990). "Evidence that stock prices do not fully reflect the implications of current earnings for future earnings." Journal of Accounting and Economics 13(December): 305-340. Brown, L. D., G. D. Richardson, et al. (1987). "An information interpretation of financial analyst superiority in forecasting earnings." Journal of Accounting Research 25(Spring): 49-67. Burgstahler, D. C. and I. D. Dichev (1997). "Earnings, adaptation and equity value." The Accounting Review 72(April): 187-215.

37. References Claus, J. and J. K. Thomas (2001). "Equity premia as low as three percent? Evidence from analysts' earnings forecasts for domestic and international stock markets." Journal of Finance 56(October): 1629-1666. Clement, M. B. (1999). "Analyst forecast accuracy: Do ability, resources, and portfolio complexity matter?" Journal of Accounting and Economics 27(June): 285-303. Collins, D. W. and S. P. Kothari (1989). "An analysis of intertemporal and cross-sectional determinants of earnings response coefficients." Journal of Accounting and Economics 11(July): 143-182. Collins, D. W. and S. P. Hribar (2000). "Earnings-based and accrual-based market anomalies: One effect or two?" Journal of Accounting and Economics 29: 101-123. Dechow, P. M. (1994). "Accounting earnings and cash flows as measures of firm performance: The role of accounting accruals." Journal of Accounting and Economics 18: 3-42. Dechow, P. M., A. P. Hutton, et al. (1999). "An empirical assessment of the residual income valuation model." Journal of Accounting and Economics 26(January): 1-34. Dechow, P. M. and I. D. Dichev (2002). "The quality of accruals and earnings: The role of accrual estimation errors." The Accounting Review(January): 35-59. Doyle, J. T., R. J. Lundholm, et al. (2003). "The predictive value of expenses excluded from 'pro forma' earnings." Review of Accounting Studies 8: 145-174. Easton, P. D. (1985). "Accounting earnings and security valuation: Empirical evidence of the fundamental links." Journal of Accounting Research 23(Supplement): 54-77. Easton, P. D. and M. E. Zmijewski (1989). "Cross-sectional variation in the stock market response to the announcement of accounting earnings." Journal of Accounting and Economics 12(July): 117-142. Easton, P. D., G. K. Taylor, et al. (2002). "Using forecasts of earnings to simultaneously estimate growth and the rate of return on equity investment." Journal of Accounting Research 40(June): 657-676. Fama, E. F. (1970). "Efficient capital markets: A review of theory and empirical work." Journal of Finance 25(May): 383-417.

38. References Gebhardt, W., C. M. C. Lee, et al. (2001). "Toward an implied cost of capital." Journal of Accounting Research 39: 135-176. Gompers, P. A., J. L. Ishii, et al. (2003). "Corporate governance and equity prices." Quarterly Journal of Economics 118: 107-155. Graham, B. and D. Dodd (1934). Security Analysis. New York, McGraw-Hill. Healy, P. M. (1985). "The impact of bonus schemes on the selection on accounting decisions." Journal of Accounting and Economics 7(April): 85-107. Klein, A. (1998). "Firm performance and board committee structure." Journal of Law and Economics 41: 275-303. Kormendi, R. C. and R. C. Lipe (1987). "Earnings innovations, earnings persistence, and stock returns." Journal of Business 60(July): 323-345. Lev, B. I. and S. R. Thiagarajan (1993). "Fundamental information analysis." Journal of Accounting Research 31(Autumn): 109-215. McNichols, M. F. and P. C. O'Brien (1997). "Self selection and analyst coverage." Journal of Accounting Research 35(Autumn): 167-199. Noe, C. F. (1999). "Voluntary disclosures and insider transactions." Journal of Accounting and Economics 27: 305-326. Ohlson, J. A. (1995). "Earnings, book values, and dividends in equity valuation." Contemporary Accounting Research 11(Spring): 661-687. Ou, J. A. and S. H. Penman (1989). "Financial statement analysis and the prediction of stock returns." Journal of Accounting and Economics 14: 295-329. Ou, J. A. and S. H. Penman (1989). "Accounting measurement, price-earnings ratios, and the information content of security prices." Journal of Accounting Research 27(Supplement): 111-44.

39. References Piotroski, J. D. (2000). "Value investing: The use of historical financial statement information to separate winners from losers." Journal of Accounting Research 38: 1-41. Schipper, K. (1989). "Commentary on earnings management." Accounting Horizons(December): 91-102. Skinner, D. J. (1994). "Why firms voluntarily disclose bad news." Journal of Accounting Research 32(Spring): 38-60. Sloan, R. G. (1996). "Do stock prices fully reflect information in accruals and cash flows about future earnings?" The Accounting Review 71(July): 289-315. Soffer, L. C., S. R. Thiagarajan, et al. (2000). "Earnings preannouncement strategies." Review of Accounting Studies 5: 5-26. Trueman, B. (1994). "Analyst forecasts and herding behavior." Review of Financial Studies 7: 97-124. Warfield, T. D., J. J. Wild, et al. (1995). "Managerial ownership, accounting choices, and informativeness of earnings." Journal of Accounting and Economics 20: 61-91. Watts, R. L. and J. L. Zimmerman (1978). "Towards a positive theory of the determination of accounting standards." The Accounting Review(January): 112-134. Wilson, G. P. (1986). "The relative information content of accrual and cash flows: Combined evidence at the earnings announcement and annual release date." Journal of Accounting Research(Supplement): 165-200. Wilson, G. P. (1987). "The incremental information content of the accrual and funds components of earnings after controlling for earnings." The Accounting Review 62(April): 293-322.