Knowledge that Transforms

This paper investigates whether the accrual pricing anomaly documented by Sloan (1996. The Accounting Review 71(3), 289–316) for annual data holds for quarterly data and whether this form of market mispricing is distinct from the post-earnings announcement drift anomaly. We find that the market appears to overestimate the persistence of the accrual component of quarterly earnings and, therefore, tends to overprice accruals. Moreover, the accrual mispricing appears to be distinct from post-earnings announcement drift. A hedge portfolio trading strategy that exploits both forms of market mispricing generates abnormal returns in excess of those based on either unexpected earnings or accruals information alone.

Large clients create an economic dependence that may cause auditors to compromise their independence and report favorably to retain valuable clients. Economic dependence is measured as a client's size relative to the size of the office that contracts for the audit and issues the audit report. We find no evidence economic dependence causes Big Five auditors to report more favorably for larger clients in their offices. However, larger clients also pose greater litigation risk, and we do find that Big 5 auditors report more conservatively for larger clients, suggesting that reputation protection dominates auditor behavior.

This paper examines individual investors’ short- and long-term trading reactions to the 1986 Tax Reform Act's (TRA 86) capital gain tax rate increase. Consistent with a tax-induced trading model, we document a December 1986 change in year-end trading patterns. TRA 86 also had long-term effects on individual investors’ trading decisions. The results suggest that individual investors were less (more) willing to sell accrued gain (loss) stocks after TRA 86. Our ability to document predicted trading behavior is in part due to our trading metric, which captures individual investors’ selling activity better than the volume-based metrics used in prior research.

International differences in the demand for accounting income predictably affect the way it incorporates economic income (change in market value) over time. We characterize the `shareholder’ and `stakeholder’ corporate governance models of common and code law countries respectively as resolving information asymmetry by public disclosure and private communication. Also, code law directly links accounting income to current payouts (to employees, managers, shareholders and governments). Consequently, code law accounting income is less timely, particularly in incorporating economic losses. Regulation, taxation and litigation cause variation among common law countries. The results have implications for security analysts, standard-setters, regulators, and corporate governance.

It has generally been assumed that the potential commission revenue is an important determinant of a sell-side analyst's decision of what firms to cover and what information to publicly release. However, because stock volume has not been disaggregated on a brokerage-firm level, uncertainty remains regarding the economic importance of the relation between analyst coverage and brokerage-firm volume. Using a unique data set that identifies the broker(s) involved in each trade, I find that brokerage volume is significantly higher in covered stocks than in uncovered stocks. On average, brokers increase their market share in covered stocks by 3.8% relative to uncovered stocks.

This paper reexamines the determinants of the number of analysts following a firm using econometric models based on count distributions. We replicate Bhushan's (1989) analyst-following study to demonstrate the effects of using count-data econometrics, in lieu of OLS, in studying phenomena where the dependent variable ranges among nonnegative integers. In contrast with the original paper, our findings indicate the number of institutional investors is inversely related with analyst following. We also provide econometric evidence to support the preferred use of the negative binomial model in estimating cross-sectional, analyst-following regressions.

I examine two hypotheses of auditor resignation: litigation risk and clientele adjustment. I find resignation is positively related to increased client legal exposure, and to occurrence of clientele mismatch. The summary-measure approach allows me to distinguish clientele mismatch caused by changes in auditor (supply-side) characteristics vs. changes in client (demand-side) characteristics. Evidence suggests resignation is likely driven by supply-side changes. I also find investors react negatively to resignations, and the price drop varies cross-sectionally with litigation risk. Further, the tendency of dropped firms to engage small auditors is positively related to increased litigation risk, and to mismatch with large auditors.

Research in incentives has focused on performance measures and pay-performance sensitivities but has largely ignored the “performance standard”, which generates important incentives whenever plan participants can influence the standard-setting process. “Internally determined” standards are directly affected by management actions in the current or prior year, while “externally determined” standards are less easily affected. I show that companies choose external standards when prior performance is a noisy estimate of contemporaneous performance. In addition, companies using budget based and other internally determined performance standards have less-variable bonus payouts, and are more likely to smooth earnings, than companies using externally determined standards.

This paper documents changes in the patterns of earnings, cash flows and accruals over the last four decades. In the absence of a generally accepted definition of conservatism, a number of measures of reporting conservatism are identified and examined. These measures rely on the accumulation of nonoperating accruals, the timeliness of earnings with respect to bad and good news, characteristics of the earnings distribution and the market-to-book ratio. The patterns are consistent with an increase in conservative financial reporting over time. The findings have implications for accounting standard setting, regulation of financial information and financial statement analysis.

This study examines the effect of ongoing deregulation in the electric utility industry on the relation between market value, book value, and earnings. We predict that deregulation decreases (increases) the relative importance of book value (earnings) in explaining price. We test this prediction by examining changes in the value relevance of book value and earnings during the 1988–1996 time period for a sample of large, investor-owned electric utilities. We find that the regression coefficients and incremental explanatory power related to book value (earnings) have decreased (increased) over this time period. These results are generally robust in sensitivity analysis.