Market valuation and earnings manipulation

1. Market valuation and earnings manipulation Shing-yang Hu and Yueh-hsiang Lin

2. Motivation • How firms are priced? What determines firm value or return (the difference of the value)? • Market valuation has its impact: • Subrahmanyam and Titman (2001): stock prices can affect fundamentals. A higher stock price may signal that the firm has a good product, and induce consumers to adopt its product. • Literature of behavior corporate finance: managers’ corporate decisions such as investment, financing, dividend, M&A may be responses of market valuation.

3. Motivation • Scandals in early 2000s: Enron, WorldCom, eToy…,etc. • A lesson to be learned: trying to maintain a higher market valuation, managers may take action such as earnings manipulation that will reduce long-term firm value. • Paul Volcker (the former Federal Reserve Chairman): • “Optimistic visions of a new economic era set the stage for an explosion in financial values…. It was an environment in which incentives for business management to keep reported revenues and earnings growing to meet expectations were amplified.”

4. Motivation • Jensen (2005): agency costs of overvalued equity: • “Overvalued Equity=Managerial Heroin. It feels great at the beginning. But lead to massive pain in the end.” • “Managers use overvalued equity to make acquisitions to satisfy growth expectation….” • “Managers use access to cheap debt and equity capital to engage in excessive internal spending & unprofitable risky greenfield investments….” • “Finally, they turn to manipulation and even fraud to satisfy the market’s demands….” • “Equity-based incentive compensation cannot solve the problem. High equity or option holdings are like throwing gasoline on a fire.”

5. Objective • There is no study so far to empirically examine the relation between market valuation and future earnings manipulation. • We fill a gap in the literature by providing evidence of the relation. • We ask: • Does the relation exist? • Why does it exist? • Can good governance mechanism alleviate this problem?

6. Hypotheses • Manipulation hypothesis:Managers of firms with a higher valuation will manipulate future earnings more (have larger future accruals) to meet investors’ expectations. • Based on the assumption that keeping higher expected growth rates of cash flows needs larger reported earnings. • Expected growth hypothesis: Managers of firms with a higher valuation expect future performance better and increases accruals accordingly. • For example, managers may build up inventory to meet growing demand.

7. Findings • In our sample (all non-financial companies listed on the NYSE, Amex, and Nasdaq in the period of 1988-2004), averagely, there is a positive relation between market valuation and future accruals. • The manipulation hypothesis is more pronounced only in firms with limited attention or poorer performance. • For firms with more attention or better performance, the evidence does not support the manipulation hypothesis. • Higher valuation firms that issue equities are especially aggressive in accounting accruals. • Can good governance alleviate the incentive to manipulate earnings by higher valuation companies? Yes. • No evidence that high valuation companies with a stronger governance system or equity-based compensations will manipulate more.

8. Methodology • Measure of market valuation: • Market-to-book ratio of equity • Price-to-earnings ratio or the price-to-cash flow ratio? • May be inappropriate. • For example, if earnings and accruals are positively correlated and accruals are autocorrelated, a higher price to earnings ratio will be correlated with a higher future accrual due to its definition.

9. Methodology • Measures of earnings manipulation: total accrual • Calculated from items of the balance sheet (BS) • Calculated from items of the cash flows statements (CF) • Collins and Hribar (2002) argue that accruals from the BS may be biased due to the reasons such as M&A. Therefore, here we only present results on accruals from the CF. • The data on the CF is only available from 1987, and the number of firms reported in 1987 is limited so we choose to start the sample from 1988.

10. Methodology • To detect the effect of the normal business requirements on the total accruals, we use two conventional discretionary accrual models: • Jones model: JA • Modified Jones model: MJA

11. Manipulation or expected growth hypothesis? • One-way grouping method: For each fiscal year t we divide the sample into quartiles based on the market-to-book ratio of equity (M/B). • Test the difference in mean and median of accruals for year t+1 between the highest and lowest M/B quartiles using t and the Wilcoxon statistics. • Under the two hypotheses, the differences should be positive. • If valuation proxies for expected growth, after controlling performance, the differences should be less pronounced. • Follow Kothari, Leone, and Wasley (2005) to calculate ROA-matched accruals to distinguish the two hypotheses.

12. Manipulation or expected growth hypothesis? • The differences in mean and median of accruals between the highest and lowest quartiles are significantly positive. • The differences in ROA-matched accruals between the highest and lowest quartiles are still significantly positive. • Consistent with the manipulation hypothesis.

13. A closer look at the Manipulation Hypothesis • What characteristics of firms will have larger differences in ROA-matched accruals between the highest and lowest M/B quartiles? • Manipulation Hypothesis (MH) 1: The difference is larger for firms that less attention from investment communities. • When attention is low, the information environment will be poor so that investors are not able to differentiate a true earning from a fake one. • Two-way independent sorting based on M/B and attention, in which we use three measures to proxy for attention: the inclusion in the S&P 1500, the tracking by the Investor Responsibility Research Center (IRRC), and market capitalization.

14. Tests of H1 • The differences are significantly positive only for less attention firms. • Results are consistent with MH 1.

15. Manipulation Hypothesis (MH) 2 • Manipulation Hypothesis (MH) 2: The difference is larger for firms with poorer operating performance. • A high valuation company face much more pressure to improve its operating performance when it is poor than it is good. • Two-way independent sorting based on M/B and ROA. • Results are consistent with MH 2.

16. Manipulation Hypothesis (MH) 3 • Manipulation Hypothesis (MH) 3: The difference is larger for firms that have equity offerings. • Given the earnings manipulation, the stock price will be higher and the SEO will be more attractive. • Two-way independent sorting based on M/B and the amount of the sale of equities (SEO). • Results are consistent with MH 3.

17. Manipulation Hypothesis (MH) 4 • Manipulation Hypothesis (MH) 4: The difference is smaller for firms with a good governance system. • In a good governance system the manipulation is more likely to be found out, and managers may be replaced. • Use two measures to proxy for the alignment of the governance mechanism: • Governance Index (GI) introduced by Gompers, Ishii, and Metrick (2003) from the IRRC database. • Incentive ratio (IR) used in Bergstresser and Philippon (2003) from the CEOs’ company stock and option holdings in the ExecuComp database. • Regress the discretionary accruals on the valuation*GI and valuation*IR as well as the aforementioned variables.

18. Tests of H4 • Negative V*GI: The better the governance is, the smaller the impact of valuation on accruals. • Negative V*IR: The stronger equity-based compensation is, the smaller the impact of valuation on accruals. • Consistent with MH4 statistically but the magnitude is so small that the effect is weak economically (compared with coefficients on V). • Most of the four hypotheses are supported.

19. Conclusions • We provide the evidence of the relation between market valuation and future earnings manipulation. • In the U.S. companies, the relation occurs only in firms with limited attention or poorer performance. • For firms with more attention or better performance, there is no significant relation.