Knowledge that Transforms

This paper examines cross-sectional differences in the optimistic behavior of financial analysts. Specifically, we investigate whether the predictive accuracy of past information (e.g., time-series of earnings, past returns, etc.) is associated with the magnitude of the bias in analysts' earnings fore- casts. We posit that there is higher demand for non-public information for firms whose earnings are difficult to accurately predict than for firms whose earnings can be accurately forecasted using public information. Assuming that optimism facilitates access to management's non-public information, we hypothesize that analysts will issue more optimistic forecasts for low predictability firms than for high predictability firms. Our results support this hypothesis.

This paper provides evidence that firms with high disclosure quality ratings from financial analysis enjoy a lower effective interest cost of issuing debt. This findings is consistent with the argument that a policy of timely and detailed disclosures reduces lenders' and underwriters' perception of default risk for the disclosing firm, reducing its constant of debt. The results also indicate that the relative importance of disclosures is greater in situations where there is greater market uncertainty about the firm as reflected by the variance of stock returns. Since debt financial is an important source of external financing for publicly traded firms, the results have important implications on our understanding of the motives and consequences of corporate disclosures.

[This paper examines cross-sectional differences in the optimistic behavior of financial analysts. Specifically, we investigate whether the predictive accuracy of past information (e.g., time-series of earnings, past returns, etc.) is associated with the magnitude of the bias in analysts' earnings forecasts. We posit that there is higher demand for non-public information for firms whose earnings are difficult to accurately predict than for firms whose earnings can be accurately forecasted using public information. Assuming that optimism facilitates access to management's non-public information, we hypothesize that analysts will issue more optimistic forecasts for low predictability firms than for high predictability firms. Our results support this hypothesis.]

[This paper provides evidence that firms with high disclosure quality ratings from financial analysts enjoy a lower effective interest cost of issuing debt. This finding is consistent with the argument that a policy of timely and detailed disclosures reduces lenders' and underwriters' perception of default risk for the disclosing firm, reducing its cost of debt. The results also indicate that the relative importance of disclosures is greater in situations where there is greater market uncertainty about the firm as reflected by the variance of stock returns. Since debt financing is an important source of external financing for publicly traded firms, the results have important implications on our understanding of the motives and consequences of corporate disclosures.]

[This study investigates the role of alternative earnings components in the CEO cash compensation function. We find that cash compensation is significantly positively related to above the line earnings, as long as results are positive. Compensation is shielded from the effects of above the line losses. Similarly, nonrecurring transactions that increase income flow through to compensation, but nonrecurring losses do not. This effect is noted for gains and losses that arise both from extraordinary transactions, discontinued operations and nonrecurring items that do not qualify for below the line presentation. Thus, the data tell a remarkably consistent story: gains flow through to compensation, but losses do not. The classification of the gain or loss on the income statement is of relatively little importance.]

[This study tests the competitive equilibrium predictions of a multi-period model of audit pricing and independence in two sets of laboratory markets: a control set consisting of human subjects in the role of auditors contracting with robot clients, and a treatment set in which both auditors and clients are human subjects. The results in all the control-set markets and some of the treatment markets support the predictions of "lowball" pricing and that heterogeneous beliefs among auditors regarding the treatment of a client-reporting issue is a necessary condition for independence impairment. By contrast, several treatment-set markets exhibit cooperative behavior between auditors and clients to achieve jointly beneficial outcomes. This behavior deviates from the price-independence relationship predicted in the competitive equilibrium, exhibiting instead a price-independence relationship that is characterized by an absence of lowballing and frequent independence impairment, even when auditors have homogeneous beliefs.]

[This study provides evidence on the relevance and reliability of option pricing-based value estimates for bonds and their components, i.e., conversion, call, put and sinking fund features. Findings reveal component value estimates represent large fractions of bond par value, and a fundamental components approach to account for corporate debt results in key financial statement amounts significantly different from those presently recognized. Component value estimates and financial statement amounts vary significantly with component estimation order. Thus, bond value estimates potentially meet the FASB's relevance criterion. However, estimate variation across component estimation orders and comparisons of estimates to available benchmarks indicate bond value estimates lack reliability.]

[This study evaluates the relation between security returns and funds-based earnings components. We document that proxies for market expectations of the components that are based on measures of historical serial-and cross-dependencies are substantially more accurate than random-walk proxies. Moreover, we detect significantly higher valuations of the operating cash flow component of earnings, relative to current accruals, when market expectations are represented using the dependency-based predictions. Such differential valuation is not detectable for random-walk representations. Contrary to results in Ali (1994), we find incremental information in unexpected cash flows over the whole spectrum (moderate and extreme) of unexpected cash flow realizations.]

[We examine whether the application of fundamental analysis can yield significant abnormal returns. Using a collection of signals that reflect traditional rules of fundamental analysis related to contemporaneous changes in inventories, accounts receivables, gross margins, selling expenses, capital expenditures, effective tax rates, inventory methods, audit qualifications, and labor force sales productivity, we form portfolios that earn an average 12-month cumulative size-adjusted abnormal return of 13.2 percent. We find evidence that the fundamental signals provide information about future returns that is associated with future earnings news. Moreover, a significant portion of the abnormal returns is generated around subsequent earnings announcements. These findings are consistent with the underlying focus of fundamental analysis on the prediction of earnings. Significant abnormal returns to the fundamental strategy are not earned after the end of one year of return cumulation, indicating little support for the idea that the signals capture information about multiple-year-ahead earnings not immediately impounded in price or about long-term shifts in firm risk. Additional analysis on a holdout sample suggests that the strategy continues to generate abnormal returns in a period subsequent to the introduction of the fundamental signals in the literature, and contextual analyses indicate that the strategy performs better for certain types of firms (e.g., firms with prior bad news).]

[This paper presents a model that relates properties of the analysts' information environment to the properties of their forecasts. First, we express forecast dispersion and error in the mean forecast in terms of analyst uncertainty and consensus (that is, the degree to which analysts share a common belief). Second, we reverse the relations to show how uncertainty and consensus can be measured by combining forecast dispersion, error in the mean forecast, and the number of forecasts. Third, we show that the quality of common and private information available to analysts can be measured using these same observable variables. The relations we present are intuitive and easily applied in empirical studies.]