Knowledge that Transforms

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.

This paper posits that stock market response to two accounting performance measures - sales growth and capital investment - is a function of firm life cycle stage. Firms are grouped into various life cycle portfolios using dividend payout, sales growth, and age. As predicted, the empirical results indicate a monotonic decline in the response coefficients of unexpected sales growth and unexpected capital investment from the growth to the stagnant stages. Additional analysis suggests that this relation is not driven by a firm size effect, risk differences, or measurement error in the proxies for performance measures.

The paper analytically evaluates alternative specifications of price-earnings regressions when prices lead earnings, i.e., reflect information about future earnings that is not reflected in the past time series of earnings. Because prices lead earnings, the specification using the earnings-level-deflated-by-price variable in a price-earnings regression is ‘better’, in terms of bias in the estimated earnings response coefficient and explanatory power, than specifications using earnings-change-deflated-by-price and earnings-deflated-by-lagged-earnings variables. An accurate proxy for unexpected earnings, however, outperforms the earnings-level- and earnings-change-deflated-by-price specifications.

The paper analyzes the contemporaneous association between market returns and earnings for long return intervals. The research design exploits two fundamental accounting attributes: (i) earnings aggregate over periods, and (ii) expanding the interval over which earnings are determined, is likely to reduce ‘measurement errors’ in (aggregate) earnings. These concepts lead to the level of (aggregate) earnings as a natural earnings variable for explaining security returns. We hypothesize that the longer the interval over which earnings are aggregated, the higher the cross-sectional correlation between earnings and returns. The empirical findings support this hypothesis.

This study distinguishes between the information in the Ou and Penman (1989a) Pr measure and that in analysts' forecasts of earnings. For cases where analysts' forecasts are available, trading on Pr produces abnormal returns only when the predictions of Pr and those of analysts' forecasts disagree. This is consistent with Pr capturing some information not impounded in market prices. However, abnormal returns to this trading strategy continue for up to 72 months after the release of the data necessary to compute Pr. This is consistent with Pr proxying for the effects of omitted risk factors.

This paper examines whether market participants implicitly assign different coefficients to pension cost components when determining security prices. The major findings are: (1) The pension cost components' coefficients generally differ from one another. As predicted, the transition asset amortization coefficient is lower than other pension coefficients, and is insignificantly different from zero. (2) Consistent with the market viewing pension-related income streams as less risky, the pension coefficients are generally larger than the nonpension coefficients. Additional specification tests permitting nonpension coefficients to vary with risk, tax-payer status, and industry membership, generally support the basic findings, although the significance levels are generally higher.

Previous research has generally estimated unexpected earnings as the change relative to the previous year, assuming that shocks to annual earnings are purely permanent. In the presence of transitory components of annual earnings, we predict that using earnings changes as a proxy for unexpected earnings causes earnings response coefficients to be understated and the estimation error to be negatively cross-sectionally correlated with persistence. The negative correlation causes the association between earnings response coefficients and persistence to be overstated. We use the IMA (1,1) model to capture transitory components of annual earnings and obtain results that are consistent with our predictions.

This study documents that the market's responsiveness to earnings announcements declines significantly after the issuance of qualified audit reports for a sample of ‘subject to’ qualifications and consistency qualifications. The results are consistent with a hypothesis that audit qualifications reduce the market's responsiveness to earnings announcements by altering the market's perception of earnings noise or the persistence of earnings, or both. Alternatively, a decline in earnings response coefficients may be observed because audit qualifications are more likely in firms that have undergone economic or structural changes and these changes, rather than the qualification per se, lead to decreased persistence or increased noise.

This study examines why firms settle their overfunded defined benefit pension plans. Under the new accounting standard (FASB Statement No. 88), companies ‘settling’ their overfunded pension plan can immediately recognize a portion of deffered pension gain as current earnings. Focusing on settlement transactions unaccompanied by asset reversions, we examine financial characteristics of settlement firms, including earnings, debt covenants, management incentive compensation, and firms' risk and financial structures. Our results suggest that firms undertake settlement to offset a decline in earnings and mitigate restrictive debt covenant constraints. However, a settlement firm's systematic risk (beta) does not change after settlement.