Knowledge that Transforms

We examine the profitability of a trading strategy which is based on a logit model designed to predict the sign of subsequent twelve-month excess returns from accounting ratios. Over the 1978–1988 period, the average annual excess return produced by the trading strategy ranges between 4.3% and 9.5%, depending on the specific measure of excess return and weighting scheme involved. However, our implementation of the Ou and Penman (1989) trading strategy in the 1978–1988 period, which is based on a logit model that predicts subsequent unexpected earnings- per-share from accounting ratios, does not earn excess returns.

This paper examines the response of managers of property-casualty insures to the differential costs and benefits of understanding the liability for outstanding claim losses. The primary hypothesis is that the incentive to underestimate the liability is a decreasing function of the insurer's actual financial position. Empirical tests suggest that managers of financially weak insurers bias downward their estimates of claim loss reserves relative to other insurers after controlling for exogenous economic factors. Evidence also reveals that managers of insurers ‘close’ to receiving regulatory attention understate reserve estimates to an even larger degree.

This study examines whether annual financial statements filed with the Securities and Exchange Commission are timely sources of information for investors. We examine a summary measure, the probability of bankruptcy, through which the release of financial statements might communicate information to investors. The results indicate that a significant association exists between revisions in the probability of bankruptcy due to nonearnings data and security returns over the fiscal year, but that investors have largely revised their estimates of the probability of bankruptcy prior to the release of the full financial statements.

This study seeks to identify economic and financial characteristics that distinguish three groups of companies classified by response to the U.K.'s mandatory CCA standard (SSAP 16) as loyal compliers, early defectors and hard-line noncompliers. Three major explanatory variables emerge – leverage, firm size, and the fixed assets to total assets ratio. Overall results suggest that a major motivation for compliance was lower income reporting, especially as an argument for continuing recognition of CCA for tax and regulatory purposes. The belief that noncompliance was largely motivated by preparation costs is discounted.

Stock return over a period reflects the market's revision in expectation of future earnings. Accounting earnings over the same period, however, have limited ability to reflect such revised expectations. Therefore, returns anticipate earnings changes and the earnings response coefficient from a regression of returns on contemporaneous earnings changes is biased toward zero. We reduce this bias by including leading-period returns in price-earnings regressions. The resulting estimated earnings response coefficient magnitudes suggest that the capital market, on average, views earnings changes to be largely permanent. This is consistent with the random walk time series property of annual earnings.

This study separates trading volume into buyer- and seller-initiated activities and examines the directional volume reaction in small and large trades to different types of earnings news. ‘Good’ (‘bad’) news triggers brief, but intense, buying (selling) in the large trades. However, a persistent period of unusually high buying activity is observed in the small trades irrespective of the news. This anomalous proclivity of small traders to buy is robust across firm size, trading volume, and different earnings expectation models. Several explanations are discussed, although the behavior does not seem fully explained by existing theories.

This paper evaluates the relative performance of IBES consensus financial analyst forecasts and forecasts based upon the anticipatory behaviour of security prices, according to two criteria: (a) the accuracy of earnings growth predictions and (b) the contemporaneous association between unexpected earnings and security returns during the forecast year. Results are presented for firms in differing size groups, measured here by market capitalization. The results indicate that neither forecast source is superior to the other in terms of either criterion. There is, however, significant complementarity of financial analyst and price-based forecasts.

We consider a principal-agent model to examine the effectiveness of responsibility centers, in particular cost or profit centers. We show that rather than contracting with each agent directly, the principal can create equally powerful incentives by setting up a responsibility center structure. The principal contracts with only the ‘manager’ of the center and delegates contracting with other agents and coordinating their activities. The principal then must monitor some measure of financial performance such as the center's cost of profit. We also find that responsibility centers dominate direct contracting with the agents when communication is limited.

This study examines the effect of the book income adjustment provision in the 1986 alternative minimum tax (AMT) on financial accounting practices. A model is developed to identify firms that are more susceptible to the book income adjustment. The changes in financial accounting practices for firms affected by the AMT are then examined. Our results indicate that firms that are likely to be affected by the book income adjustment shift timing and permanent differences across years to reduce the impact of the AMT.

This review explores systematic explanations for the anomalous evidence in the relation between accounting earnings and stock prices. The anomaly is that estimated future abnormal returns are predicted by public information about future earnings, contained in (1) current earnings and (2) current financial statement ratios. The current-earnings anomaly appears due to either market inefficiency or substantial costs of investors acquiring and processing information, the choice depending on one's priors concerning these costs and one's definition of market ‘efficiency’. The financial-statement-information anomaly appears due to accounting ratios proxying for stocks' expected returns. Anomaly seems likely to be a permanent state.