Dissecting Earnings Recognition Timeliness

1. Dissecting Earnings RecognitionTimeliness Ryan Ball Chicago Booth School of Business&Peter Easton Center for Accounting Research and Education Workshop Arizona State University 2 March 2012

2. Summary • ERT is the portion of price change that is recognized in earnings of the period in which the price change occurs • Dissection • via regressions of • earnings on daily returns • sales revenue on daily returns • expenses on daily returns • facilitates identification of two fundamentally different elements of financial accounting • current sales element – matching, manifested in recognition of expenses in the same period as the related benefits (i.e., sales revenue) accrue • seen in decline in sales revenue/return and expenses/return coefficients • over the year • expectations element– recognition of changes in expectations regarding • earnings of future periods in expenses in the current fiscal year • seen in non-zero end-of-year expenses/return coefficient

3. Elements of Earnings Recognition Timeliness • current saleselement • a manifestation of the matching principle • expenses are recognized in the same period as the related benefits (i.e., sales revenue) are recognized • price (market value) change reflects • changes in sales in the current period, changes in the expenses related to these sales, and the extent to which these changes are expected to persist into the future • the matching principle leads to recognition of these sales and matched expenses within the period • value change at beginning of year has the whole year to be recognized in sales and matched expenses • value change at end of year has no time to be recognized in sales and matched expenses

4. Elements of Earnings Recognition Timeliness • expectationselement • value change reflects: • changes in expectations about future earnings, with no implications for sales (and related expenses) of the current period • leads to recognition of expenses in earnings in the current period • expenses reflect • management’s attempts to affect future earnings (e.g., research and development and advertising) • accounting for the associated expenditures • GAAP, requiring recognition of expenses as a result of changes in the value of the recognized assets of the firm (e.g., restructuring charges and write-downs)

5. Illustration of why all this matters • expect the expenses/return relation to be • positive when returns are positive (e.g., advertising, R&D) • negativewhen returns are negative (e.g., write-downs, big baths) • find empirically • positive correlation when returns are positive • nocorrelation when returns are negative • reason • current sales element isnegativelyrelated to returns • i.e., worse (more negative) returns, lower expenses • expectationselementis positivelyrelated to returns • i.e., worse (more negative) returns, greater expenses

6. Earnings Recognition Timeliness change in price in current period change in price recognized in current earnings (i.e., change in book value) change in price recognized in future earnings • b is the change in price in the current fiscal period that is recognized in earnings of the current fiscal period • earnings are more ‘timely’ when bis higher

7. Dissecting ERT change in price in current period change in price recognized in current earnings change in price recognized in future earnings current sales element expectations element • value change recognized in sales revenueof the current period and directly related (matched) expenses • value change reflecting changes in expectations regarding sales in future periods recognized in expensesof the current period • no implication for sales and associated expenses in the current period KEY: distinguishable via the timing of recognition in earnings withinthe fiscal period

8. Current SalesElement and Expectations Element KEY: distinguishable via the timing of recognition in earnings withinthe fiscal period = number of trading days relative to the first day of the current fiscal year

9. KEY: distinguishable via the timing of recognition in earnings withinthe fiscal period = number of trading days relative to the first day of the current fiscal year = earnings/return coefficient at the beginning(τ=0) of the current fiscal year t = earnings/return coefficient at the end (τ=252) of the current fiscal year t

10. Derivation of the Regression Expand the summation term to show 252 separate explanatory variables: For each of the 252 beta coefficients (i.e., β0, β1, •••, β251), substitute the expression from the coefficient constraint: Rearrange and group similar terms: Rearrange and group similar terms:

11. Control for Expected Earnings and Expected Returns • Expected earnings • Lagged earnings • Lagged sales revenue • Expected returns • Log of market capitalization • Log of price per share • Book to market ratio • Leverage • Year and industry fixed effects

12. Net Income Daily Return Coefficient EstimatesTable 2 current sales element =(0.099-0.038)/2 = 0.030 (4.53) βτ 0.099 (9.36) expectations element = 0.038 (3.36) Number of trading days relative to first day of the fiscal year, τ

13. Asymmetric Timely Loss Recognition • extant descriptions of asymmetric timely loss recognition highlight asymmetry in the expectations element; not asymmetry in the current sales element • Basu [1997] specification captures total asymmetry (i.e., asymmetry in both elements): “Good news” (RETjt≥ 0) “Bad news” (RETjt< 0) • Is asymmetry across “good” and “bad” news partitions partially driven by the current sales element?

14. Earnings/Return Coefficient Estimates Table 2 Sample partitioned by sign of annual return NEGATIVE RETURN 0.182 (16.92) 0.166 (15.01) expectations element 0.011 (1.40) βτ 0.008 (1.45) current sales element 0.023 (3.93) POSITIVE RETURN 0.057 (5.07) Number of trading days relative to first day of the fiscal year, τ

15. Isolating the Current Sales and ExpectationsElements Earnings = Sales revenue – Expenses Expenses • two elements • Current Sales: portion of expenses matched to sales • Expectations: related to changes in expectations about revenues and expenses in future periods When annual returns are negative: • two opposing forces (i.e., a netting effect): • Expenses related to sales of the current period will be negatively related to returns (i.e., worse (more negative) returns, lower expenses ) • Other expenses (e.g., assets write-downs) positively related to returns (i.e., worse (more negative) returns, greater expenses)

16. 9/11/2001 United Airlines 9/10/01 Date 1/1/01 4/2/01 7/1/01 9/28/01 12/31/01 Share Price $38.94 $32.90 $35.15 $30.82 $17.10 $13.50 -$25.34

17. 9/11/2001 InVision Technologies

18. 9/11/2001 InVision Technologies 9/10/01 Date 1/1/01 4/2/01 7/1/01 9/28/01 12/31/01 Share Price $1.44 $3.00 $3.85 $3.11 $9.93 $29.79 $28.35

19. Sales Revenue and Expenses/Return Coefficient Estimates Table 3 Sample partitioned by sign of annual return 0.248 (5.06) • 0.138 (5.53) 0.150 (4.74) 0.262 (6.32) • 0.127 (2.76) 0.028 (1.42) -0.017 (-1.32) -0.103 (-3.79) 0.039 (1.08) -0.080 (-1.67) -0.087 (-3.27) -0.191 (-4.77) Number of trading days relative to first day of the fiscal year, τ

20. Dissection of Earnings Recognition Timeliness

21. Dissection of Earnings Recognition Timeliness $1 less negative price change associated with $0.150 higher sales revenue $1 more positive price change associated with $0.138 higher sales revenue

22. Dissection of Earnings Recognition Timeliness $0.047 contribution margin $0.051 contribution margin

23. Dissection of Earnings Recognition Timeliness Significant expectations element No expectations element

24. Dissection of Earnings Recognition Timeliness No explanatory power for returns!!! Significant because of matched expenses

25. Dissection of Earnings Recognition Timeliness Basu [1997]

26. Coefficient Estimates on Earnings Announcement Days • Add variables to capture: • Earnings announcement effects • News about current year earnings released after year end (3)

27. Table 4Dissection of the Earnings/Return Coefficient

28. Table 4Dissection of the Earnings/Return Coefficient Controlling for Earnings Announcement Effects

29. Two Year Sales Revenue and ExpensesCoefficient Estimates

30. Dissecting Earnings Recognition Timeliness(Two Year Sales Revenue and Expenses)

31. Table 5Dissection of the Sales/Return and Expenses/Return Coefficients for Small Firms

32. Comparison of Large and Small Firms

33. Figure 1Dissection of the Sales/Return and Expenses/Return Coefficients for Small Firms for a Sub-sample Observations With Positive Annual Returns

34. Figure 2Dissection of the Sales/Return and Expenses/Return Coefficients for Small Firms for a Sub-sample Observations With Negative Annual Returns

35. Summary • method based on regression of earnings and components of earnings on intra-year returns • used to identify two elements of ERT • current saleselement • expectations element • the earnings return coefficient • declines from the beginning of year to the end • captures the current sales element • is non-zero at the end of the year • captures the expectationselement • much of the difference between the earnings return coefficient for negative annual return observations vis-à-vis positive annual return observations is due to the expectationselement

36. Summary • we break earnings into 2 components • sales revenue • expenses • the sales revenue return coefficient • declines from the beginning of year to the end • captures the current sales element • is zero at the end of the year • there is no expectationselement

37. Summary • the expenses return coefficient • increases (i.e., becomes less negative) from the beginning of year to the end • captures the current sales element • is zero at the end of the year for the good news sample • there is no expectationselement • is positive at the end of the year for the bad news sample • thisexpectations element reflects a negative association between returns and expenses (e.g., write downs) • the sum of the two elements of ERT for the bad news sample is not significantly different from zero – it represents the aggregate effect of a • positive current sales element • negativeexpectations element