James A. Ohlson, Pervin K. Shroff, Changes versus Levels in Earnings As Explanatory Variables for Returns: Some Theoretical Considerations, Journal of Accounting Research, Vol. 30, No. 2 (Autumn, 1992), pp. 210-226

Preferred Stocks, Foreign Tax Credits, Tax Reform Act, Tax burden

Examining 128 tender offer bids made from 1980 through 1987, we categorize outside directors as either independent of or having some affiliation with managers, and find that bidding firms on which independent outside directors hold at least 50% of the seats have significantly higher announcement-date abnormal returns than other bidders. However, the relationship between bidding firms' abnormal stock returns and the proportion of board seats held by independent outside directors is nonlinear, suggesting it is possible to have too many independent outside directors. All results are lost if the traditional inside-outside board classification method is used.

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.

An increase in margin requirements in the First Section of the Tokyo Stock Exchange is followed by a decline in margin borrowing, trading volume, the proportion of trading performed through margin accounts, the growth in stock prices, and the conditional volatility of daily returns. The nonmarginable Second Section stocks show a smaller change in volatility and only a delayed weak price response. The hypothesis that margin requirements restrict the behavior of destabilizing speculators can explain these correlations but cannot explain the observation that individuals, the most active users of margin funds, appear to be good market timers.

We analyze taxpayer choices of return preparation services. We distinguish between two types of nonpaid preparers, six types of paid third parties, and self-preparation. Among other things, we find significant differences in the factors which explain the demand for paid third parties who are and are not able to represent clients before the IRS. Among these factors are increases in IRS audit rates and the frequency of IRS penalties.

[We undertake a comprehensive investigation of price and volume co-movement using daily New York Stock Exchange data from 1928 to 1987. We adjust the data to take into account well-known calendar effects and long-run trends. To describe the process, we use a seminonparametric estimate of the joint density of current price change and volume conditional on past price changes and volume. Four empirical regularities are found: (i) positive correlation between conditional volatility and volume; (ii) large price movements are followed by high volume; (iii) conditioning on lagged volume substantially attenuates the "leverage" effect; and (iv) after conditioning on lagged volume, there is a positive risk-return relation.]

The paper analyzes lead-lag relationships for six major stock market indexes: New York S&P 500, Tokyo Nikkei, London FT–30, Hong Kong Hang Seng, Singapore Straits Times, and Australia All Ordinaries, for time periods before, during, and after the October 1987 market crash. Unidirectional and bidirectional causality tests are conducted by means of the Granger methodology. Practically no lead-lag relationships are found for the pre-crash and post-crash periods. However, important feedback relationships and unidirectional causality are detected for the month of the crash. There is also an increase in contemporaneous causality during and after the month of the crash. In general, our findings suggest that the October 1987 market crash probably was an international crisis of the equity markets and that it might have begun simultaneously in all the national stock markets.

[Much of the research in positive accounting theory deals with whether managers choose accounting methods that reduce or minimize certain costs faced by firms, such as the cost of violating bond covenant restrictions, political costs, and the tax cost associated with the use of the FIFO rather than the LIFO inventory method. However, this research ignores some more fundamental costs associated with the legal form under which the firm chooses to operate, a much larger issue that precedes the choice of accounting methods. This article examines this larger issue by focusing on the trade-off that exists between tax costs and transaction costs in the choice of organizational form. Scholes and Wolfson (1986, 1989) assert that an organization's form is chosen to minimize both tax costs and transaction costs. Under this theory, if the corporate form has a greater tax cost than that of an alternative form, the partnership, the corporate form would not be chosen unless the transaction costs of the partnership form exceed those of the corporate form. Fama and Jensen (1983b, 327) examine costs of alternative organizational forms and state that "the form of organization that survives in an activity is the one that delivers the product demanded by customers at the lowest price while covering costs." Although Fama and Jensen specifically excluded tax costs from their analysis, Scholes and Wolfson argue that both relative tax costs and relative transaction costs are important determinants of organizational form choice, and that changes in relative tax costs will result in changes in form. They also make the following predictions about the effect of the 1986 Tax Reform Act: corporations will be replaced as an organizational form by partnerships for new ventures financed with equity; many existing corporations will convert to partnership form; absent this conversion, many corporations will add debt to their capital structure. These predictions lead directly to two questions. First, how do tax laws affect the choice of business entity? Second, what happens when these tax laws change? These two general questions are investigated here through two more specific research questions. The first is, What are the incremental tax costs and transaction costs of alternative organizational forms (corporations and master limited partnerships) available to large, publicly traded firms? The second is, How will managers of existing corporations respond to a tax law change (the 1981 Economic Recovery Tax Act) that causes the tax cost of the corporate form to increase relative to that of the partnership form? The results of empirical tests of four hypotheses developed to investigate these research questions indicate that, for the period 1978-85, the corporate form resulted in a significantly greater average tax cost than the partnership form, and this incremental tax cost increased significantly after the 1981 Economic Recovery Tax Act (ERTA). Partnerships are found to have a significantly lower return on assets and sales than a matched sample of corporations. Responses of managers to increasing tax costs of the corporate form after 1981 are predicted to be (1) increasing long-term debt, (2) increasing non-dividend distributions, and (3) decreasing dividend payout ratios. Empirical results for both univariate and multivariate tests are consistent with these predictions. These results make a significant contribution to accounting research for two reasons. First, they demonstrate a relationship between changes in relative tax costs of alternative (competing) organizational forms and changes in such fundamental elements of capital structure as debt levels, non-dividend distributions, and dividend payout ratios. Previous research on the relationship between taxes and capital structure (e.g., Bradley et al. 1984; DeAngelo and Masulis 1980; MacKie-Mason 1990; Titman and Wessles 1988) has not considered the effect of the tax cost of alternative organizational forms. Second, the results provide empirical support for predictions by Scholes and Wolfson (1986, 1989) and Petruzzi (1988) regarding responses of corporations to increases in relative tax costs (i.e., Scholes and Wolfson predict increasing long-term debt; Petruzzi predicts increasing non-dividend distributions).]