Ebook Earnings Management and Earnings Surprises: Stock Price Reactions to Earnings Components
The relationship between stock prices and company performance measured by accounting numbers has attracted much attention among accountants and financial economists. Many studies have examined stock price reactions to earnings announcements. Ball and Brown (1968), Beaver (1968), and Rendleman, Jones, and Latané (1982) report that stock returns are positively related to contemporaneous earnings surprises. This is a very robust result and subsequent work has confirmed the findings of the early studies in this area.
Other work has sought to determine if the composition of earnings contains information beyond that conveyed by the level of earnings alone. For example, Bowen, Burgstahler, and Daley (1987) and Wilson (1986, 1987) break earnings into accrual and cash (or funds) flow components. They show that innovations in both components are statistically significantly related to the abnormal stock returns of reporting firms.
Another line of research has focused on how firms may influence, or manage, reported earnings through their choices of accounting policies. Residual accruals are widely used to measure the thrust and extent of earnings management. Earnings are divided into cash flows and accruals. Most often only the current accruals, those related to working capital, are analyzed. The accruals are further decomposed into normal and abnormal components using Jones' (1991) time series regression model or, more commonly, some version of DeFond and Jiambalvo's (1994) cross-sectional regression model. The residuals from the regression, the abnormal accruals, are attributed to discretionary earnings management. The remainders of the accruals are the normal, nondiscretionary components.
There is a body of evidence that suggests that the information contained in accruals is not efficiently impounded in stock prices when it enters the public domain. Teoh, Welch, and Wong (1998a, 1998b), and DuCharme, Malatesta, and Sefcik (2001, 2004) find that abnormal working capital accruals around the time of stock issues, both IPOs and SEOs, are significantly negatively related to subsequent abnormal stock returns. Eckbo, Masulis, and Norli (2000) argue that these results are spurious, arising from inadequate controls for differences in risk between firms and the resulting mismeasurement of abnormal returns. DuCharme, Malatesta, and Sefcik (2001) show, however, that their results for IPOs hold even for risk-adjusted returns measured using the multi factor CAPM of Eckbo, Masulis, and Norli (2000).
In addition, Sloan (1996) and Xie (2001) report that accruals have significant power to predict subsequent stock returns in general. Buying stock in firms with low accruals and selling stock in firms with high accruals generates significantly positive abnormal returns relative to the Sharpe (1964) CAPM and the three-factor model of Fama and French (1993). How to interpret these provocative results remains debatable. Despite the results of DuCharme, et al. (2001), it is not possible to dismiss the central point raised by Eckbo, et al. (2000). We do not know the correct way to control for differences in risk and this is a crucial issue in the studies cited above, which attempt to measure abnormal returns over long holding periods.
In the current research we provide further evidence on the relation between stock returns and accounting information. Our study is closely related to those of Callen and Segal (2004), Subramanyam (1996), and DeFond and Park (2001). Callen and Segal (2004) examine the relation between stock returns, and news about cash flows, accruals, and expected returns within a variance decomposition framework similar to that developed by Vuolteenaho (2002). They conclude that news about accruals significantly affects stock returns. The measures of news used in the study, however are indirect, derived from estimated VAR models of the accounting numbers. Moreover, Callen and Segal (2004) do not distinguish between news about normal accruals and abnormal accruals.
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