Dissecting Earnings Recognition Timeliness

1. Dissecting Earnings RecognitionTimeliness Ryan Ball Chicago Booth School of Business&Peter Easton Center for Accounting Research and Education 10th London Business School Accounting Symposium 16/17 June, 2011

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 a regression of earnings on daily returns • facilitates identification of twofundamentally different elements of financial accounting • current sales element – i.e., matching, manifested in recognition of expenses in the same period as the related benefits (i.e., sales revenue) accrue • seen in decline in gross margin/daily return coefficient over 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 period expense/daily return coefficient

3. Elements of Earnings Recognition Timeliness • current sales element • a manifestation of the matching principle • expenses are recognized in the same period as the related benefits (i.e., sales revenue) are recognized • price/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 earnings • value change at end of year has no time to be recognized in earnings

4. Elements of Earnings Recognition Timeliness • expectations element • 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 we should care • expect the period expenses/return relation to be • positive when returns are positive (e.g., advertising, R&D) • negative when returns are negative (e.g., write-downs, big baths) • find empirically • positive correlation when returns are positive • no correlation when returns are negative • reason • current sales element ispositively related to returns • i.e., worse (more negative) returns, lower expenses • expectationselementis negatively related 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 revenue of the current period and directly related (matched) expenses • value change reflecting changes in expectations regarding sales in future periods recognized in expenses of 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 Sales Element 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 = net income/daily return coefficient on the first day (τ=0) of the current fiscal year t = net income/daily return coefficient on the last day (τ=252) of the current fiscal year t

10. Net Income Daily Return Coefficient Estimates Figure 1 Full sample of observations current sales element = (0.139-0.057) / 2 = 0.029 (4.59) 0.139 (12.51) 0.082 (8.63) ERT = 0.029 + 0.082 = 0.111 (13.37) expectations element Beg. of Fiscal Year Number of trading days relative to first day of the fiscal year, τ End of Fiscal Year

11. 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?

12. Net Income Daily Return Coefficient Estimates Figure 2 Sample partitioned by sign of annual return 0.262 (22.34) NEGATIVE RETURN current sales element -0.005 (-0.84) 0.253 (21.69) expectations element current sales element 0.025 (3.01) 0.069 (5.13) 0.020 (2.61) POSITIVE RETURN Beg. of Fiscal Year End of Fiscal Year Number of trading days relative to first day of the fiscal year, τ

13. Isolating the Current Sales and Expectations Elements Net Income = Gross Margin – Period Expenses • Gross Margin = Sales Revenue – Cost of Sales • Tends to capture value change associated with sales of the current fiscal year (i.e., the current sales element) • Period Expenses • Capture both elements • Two opposing forces (i.e., a netting effect) when returns are negative: • Expenses related to sales of the current period will be positivelyrelated to returns (i.e., bad news/negative returns, lower expenses) • Other expenses (e.g., assets write-downs) negatively related to returns

14. 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

15. 9/11/2001 InVision Technologies

16. 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

17. Gross Margin Daily Return Coefficient Estimates Figure 3 Sample partitioned by sign of annual return 0.382 (10.67) current sales element 0.159 (4.49) 0.354 (7.02) current sales element 0.161 (4.81) 0.064 (0.091) 0.032 (1.12) Beg. of Fiscal Year End of Fiscal Year Number of trading days relative to first day of the fiscal year, τ

18. Components of Period Expenses • Related to sales of the year (Currentsales element) • Related to expectations of change in profitability in future years (Expectations element) • If annual returns are negative • Current sales element ispositively related to returns • i.e., worse (more negative) returns, lower expenses • Expectations elementis (e.g., assets write-downs) negatively related to returns • i.e., worse (more negative) returns, greater expenses

19. Period Expense Daily Return Coefficient Estimates Figure 4 Sample partitioned by sign of annual return current sales element 0.137 (4.93) POSITIVE RETURN 0.285 (6.79) 0.129 (4.61) 0.012 (1.27) expectations element current sales element 0.164 (6.32) NEGATIVE RETURN -0.198 (-2.86) Beg. of Fiscal Year Number of trading days relative to first day of the fiscal year, τ End of Fiscal Year

20. Control for Quarterly Earnings Announcements • Allow coefficient to incrementally change around each of the four quarterly earnings announcement dates:

21. Net Income/Daily Returns Coefficient Estimates Figure 5 Sample partitioned by sign of annual return 0.249 (17.98) 0.267 (18.61) 0.242 (17.05) 0.242 (17.05) 0.061 (4.67) 0.055 (3.38) 0.081 (3.55) 0.023 (2.83) Number of trading days relative to first day of the fiscal year, τ Beg. of Fiscal Year End of Fiscal Year

22. Control for Change in Variance • Net income/daily returns coefficient function of covariance and variance: • Our interest is in examining changes in the covariance of net income and daily returns, not changes in the variance of returns. • where:

23. Standard Deviation of Daily Returns within Fiscal Year Figure 6 Sample partitioned by sign of annual return Number of trading days relative to first day of the fiscal year, τ Beg. of Fiscal Year End of Fiscal Year

24. Summary • method based on regression of net income and components of net income on daily returns • used to identify two elements of ERT • current saleselement • expectations element • the net income/daily 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 expectations element • much of the difference between the net income/daily return coefficient for negative annual return observations vis-à-vis positive annual return observations is due to the expectations element

25. Summary • we break earnings into 2 components • gross margin • period expenses • the gross margin/daily 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 • there is no expectations element • there is no difference between the gross margin/daily return coefficient for negative annual return observations vis-à-vis positive annual return observations

26. Summary • the period expense/daily return coefficient • declines 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 expectations element • is negative at the end of the year for the bad news sample • this expectations element reflects a negative association between returns and period 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 • negative expectations element