Earnings Quality

1. Earnings Quality Yanzhi Wang

2. Sloan (1996) • This paper aims to study the relation between earnings and earnings components (i.e, cash flows and accruals), and the impact of them on stock return. • Earnings measure in this paper excludes the non-recurring items and is adopted by the EBIT (Compustat Item 178). • Earnings=Cash flows + Accruals • Cash flow based accruals • Balance sheet based accruals

3. Earnings Persistence • Current earnings positively leads future earnings. Thus high current earnings is followed by high stock market return (Ou and Penman, 1989; Bernard and Thomas, 1989; 1990) • They use the mechanical prediction model or an autoregressive model to predict future earnings. • This links to the earnings momentum.

4. Earnings Fixation • Sloan (1996) turns to look at the earnings components rather than the earnings surprise. • Investors fixate on earnings, failing to distinguish fully between the different properties of the accrual and cash flow components of earnings.

5. Earnings Persistence and Earnings Components • CFO (cash flow from operations), as a measure of performance, is less subject to distortion than is the net income figure. This is so because the accrual system, which produces the income number, relies on accruals, deferrals, allocations and valuations, all of which involve higher degrees of subjectivity than what enters the determinations of CFO. • The higher the ratio of CFO to net income, the higher the quality of that income.

6. Hypotheses • H1: The persistence of current earnings performance is decreasing in the magnitude of the accrual component of earnings and increasing in the magnitude of the cash flow component of earnings. • H2(i): The earnings expectations embedded in stock prices fail to reflect fully the higher earnings persistence attributable to the cash flow component of earnings and the lower earnings persistence attributable to the accrual component of earnings.

7. Hypotheses • H2(ii):A trading strategy taking a long position in the stock of firms reporting relatively low levels of accruals and a short position in the stock of firms reporting relatively high levels of accruals generates positive abnormal stock return. • H2(iii):The abnormal stock returns predicted in H2(ii) are clustered around future earnings announcement dates.

8. Sample • The sample period covers the CRSP/Compustat data from 1962 to 1991. • Pre-1962 data suffer from a serious survivorship bias (Fama and French, 1992) • Compustat data availability, especially the accrual information • Require at least one year return information • The sample consists of 40,678 firm-year observations.

9. Accruals • Accruals=(ΔCA- ΔCash)-(ΔCL- ΔSTD- ΔTP)-Dep. • ΔCA=change in current assets (Compustat Item 4). • ΔCash=change in cash (Compustat Item 1) • ΔCL=change in current liability (Compustat Item 5) • ΔSTD=change in debt included in current liability (Compustat Item 34) • ΔTP=change in income taxes payable (Compustat Item 71) • Dep=depreciation and amortization expense (Compustat Item 14) • Earnings = EBIT/Average total assets • Accrual component=Accrual/Average total assets • Cash flow component=(EBIT-Accrual)/Average total assets

13. Figure 1

20. Chan, Chan, Jegadeesh, and Lakonishok (2006) • Can accounting information predict stock returns? • Accruals effect (Sloan, 1996) • High (low) accrual firms have low (high) future returns • Why do accruals predict returns? • Earnings manipulation hypothesis • Extrapolation hypothesis • Delayed reaction hypothesis

21. Definition of Accruals • Accruals = Earnings – Operating Cash flow • Accruals = Δ non-cash-CA – Δ non-cash-CL – Depreciation • Accruals are standardized by average total assets for comparability across firms • Δ CA = Δ AR + Δ INV + Δ OCA • AR: accounts receivable • INV: inventory • Δ CL = Δ AP + Δ OCL • AP: accounts payable • Accruals= (∆CA - ∆Cash) –(∆CL -∆STD - ∆TP) – DEP = (∆AR + ∆INV + ∆OCA) – (∆AP + ∆OCL) – DEP

22. How Large of Accruals and Components • Inter-quartile range of ΔAR and ΔInv are about 40% of earnings • Fairly large earnings shortfalls can be offset by not writing off obsolete inventory or bad debt

23. Portfolios Sorted by Accruals

24. Portfolios Sorted by Accruals • Average annual buy-and-hold return • AR=ΣiΠtrit - ΣjΠtrjt , rjis sample firm daily return, and rjis daily return for size/BM matching firms

25. High vs. Low Accrual Portfolios • High accruals firms are high sales growth firms • High accruals firms also report large earnings • High accruals firms experience strong returns one and two years before ranking • Low accruals firms earn higher returns in the three years following portfolio formation • The hedge portfolio (Low – High) return is largely due to low returns of high accrual firms

26. Returns and Components of Accruals

27. Inventory and Accounts Payable • Changes in inventory predict returns to the same extent as accruals • The sign of the correlation between Accounts Payable and futures returns not consistent with that between accruals and futures returns

28. What’s High Accruals? Manipulation? • Positive accruals imply cash flow less than earnings • Manipulation hypothesis • Large increases in accounts receivables indicate bogus sales • Large increases in inventory due to abnormal less write offs • Investors were fooled by earnings management

29. Other Hypotheses for High Accruals • Extrapolation hypothesis • Large sales growth will be accompanied by working capital increases, which cause high accruals • Investors extrapolate the current strong sales growth too far into the future • Delayed reaction hypothesis • High accruals may be due to deteriorating fundamentals • Unexpected slow down in current sales will result in unsold inventory • Competitive pressures may force firms to extend more credit terms • Investors overlook the early warning signals in accruals

30. Discretionary and Non-discretionary Accruals • Non-discretionary accruals: changes in working capital that are required to support sales growth • We model it to be proportional to sales growth • Discretionary accruals = Total accruals – non-discretionary accruals • Discretionary accruals • Abnormal accruals after control firm’s business condition • It’s subject to managers’ discretion • Proxy for the level of earnings manipulation

31. Measures of Discretionary Accruals • Jones (1991) model (applied inTeoh, Welch and Wong (1998)) to decompose accruals into DA and NDA. • Discretionary accruals=residuals of the following regression • CCJL (2006) approach • Iitis variable of inventory (or AR, accruals instead) • NDI is non-discretionary changes in inventory • DI is discretionary changes in inventory

32. Predictions • Manipulation hypothesis and delayed reaction hypothesis imply that only discretionary accruals predict future returns • Extrapolation hypothesis implies that only nondiscretionary accruals are related to future returns • Delayed reaction hypothesis may imply that accrual components (AR, INV, AP) should have similar return predictability

33. DA vs. NDA

34. Implications of DA and NDA • Discretionary component of accruals predict returns • Non-discretionary component of accruals do not predict returns • Evidence not consistent with extrapolation hypothesis

35. Earnings Components

36. Operating Performance • Accruals in the formation year significantly larger than earlier years. • Concurrent slow down of business? • Working capital build up in expectation of higher future sales? • Declining sales turnover and earnings growth for high accrual firms after portfolio formation • Extreme accruals years mark a turning point in the life cycle of firms

37. Conclusions • Accruals predict stock returns • Changes in inventory is the most important component, which may not be consistent with delayed reaction hypothesis • Only discretionary accruals, but not nondiscretionary accruals, can predict future returns, thus disputing extrapolation bias hypothesis • High accruals years mark a turning point in operating performance, suggesting evidence of manipulating earnings

38. Roychowdhury (2006) • Managers manipulate real activities to avoid reporting annual losses. • Three real earnings manipulation activities are examined: • Price discounts to temporarily increase sales • Overproduction to report lower cost of goods sold • Reduction of discretionary expenditures to improve reported margins. • Cross-sectional analysis reveals that these activities are less prevalent in the presence of sophisticated investors.

39. Real earnings manipulations • real activities manipulation as departures from normal operational practices, motivated by managers’ desire to mislead at least some stakeholders into believing certain financial reporting goals have been met in the normal course of operations. • What is main difference between real and accrual based earnings manipulation? • Real earnings manipulation differs from accruals manipulation, which does not involves in direct cash flow consequences.

40. Existing evidence on real activities manipulation • Bens et al. (2002, 2003) report that managers repurchase stock to avoid EPS dilution arising from employee stock option exercises, and employee stock option grants. • Dechow and Sloan (1991) find that CEOs reduce spending on R&D toward the end of their tenure to increase short-term earnings. • Bushee (1998) also find evidence consistent with reduction of R&D expenditures to meet earnings benchmarks.

41. Real earnings manipulation measures • Three manipulation methods and their effects on the abnormal levels of the three variables: • Sales manipulation, that is, accelerating the timing of sales and/or generating additional unsustainable sales through increased price discounts or more lenient credit terms. • Reduction of discretionary expenditures. • Overproduction, or increasing production to report lower COGS.

42. Sales manipulation • Sales manipulation as managers’ attempts to temporarily increase sales during the year by offering price discounts or more lenient credit terms. • The increased sales volumes as a result of the discounts are likely to disappear when the firm re-establishes the old prices. The cash inflow per sale, net of discounts, from these additional sales is lower as margins decline. • Retailers and automobile manufacturers often offer lower interest rates (zero-percent financing) toward the end of their fiscal years. • In general, sales management activities to lead to lower current-period CFO and higher production costs than what is normal given the sales level.

43. Reduction of discretionary expenditures • Discretionary expenditures such as R&D, advertising, and maintenance are generally expensed in the same period that they are incurred. • Hence firms can reduce reported expenses, and increase earnings, by reducing discretionary expenditures. This is most likely to occur when such expenditures do not generate immediate revenues and income. • Reducing such expenditures lowers cash outflows has a positive effect on abnormal CFO in the current period

44. Overproduction • To manage earnings upward, managers of manufacturing firms can produce more goods than necessary to meet expected demand. With higher production levels, fixed overhead costs are spread over a larger number of units, lowering fixed costs per unit. As long as the reduction in fixed costs per unit is not offset by any increase in marginal cost per unit, total cost per unit declines. • Nevertheless, the firm incurs production and holding costs on the over-produced items that are not recovered in the same period through sales. As a result, cash flows from operations are lower than normal given sales levels.

45. Measures • Abnormal CFO • Abnormal production cost • Abnormal discretionaly expenses

48. Interpretation • If firm-years that report profits just above zero undertake activities that adversely affect their CFO, then the abnormal CFO and abnormal discretionary expense for these firm-years should be negative compared to the rest of the sample. • Firm-years just right of zero have unusually high production costs as a percentage of sales levels.