The pricing of earnings and cash flows in the presence of abnormal and normal accruals

C S Agnes Cheng ^a and Katherine Schipper ^b
a University of Houston
^b Financial Accounting Standards Board

Abstract

This paper proposes a framework to assess the effects of abnormal and normal accruals on the valuation relevance of earnings and cash flows. We use this framework to investigate the relative weights placed by investors on earnings and cash flows, as a function of estimated normal and abnormal accruals. Assuming that the construct capitalised by investors is (unobservable) economic earnings, and that normal accruals capture the noise in cash flows as a measure of economic earnings, while abnormal accruals capture the noise in reported earnings as a measure of economic earnings, we predict that normal accruals (abnormal accruals) reduce the valuation weights placed by investors on cash flows (earnings). We find that abnormal accruals estimated using a modified version of the Jones (1991) model are associated with lower valuation weights placed on earnings. Results for the cash flow prediction are mixed, in that the valuation weight placed on cash flows in the presence of high magnitudes of normal accruals is lower when abnormal accruals are negative, but not when abnormal accruals are positive. © City University of Hong Kong.

JEL classification: M410

Keywords : value-relevance; normal and abnormal accruals; earnings; cash flows; operations

Evidence on auditor risk-management strategies before and after The Private Securities Litigation Reform Act of 1995

Jere R. Francis ^a and Jagan Krishnan ^b
a University of Missouri-Columbia
^b Temple University

Abstract

This study provides evidence that auditors adopted risk-management policies in the early 1990s in order to reduce their exposure to legal liability. Specifically, there is evidence that their clienteles became less risky and evidence of more conservative auditor reporting policies by non-Big Six auditors (but not by Big Six auditors). The auditor's legal exposure was reduced under The Private Securities Litigation Reform Act of 1995 , and there is evidence that risk-management policies were relaxed after 1994, resulting in riskier clienteles and less conservative reporting strategies for both Big Six and non-Big Six auditors. The study is important in documenting that alternative legal liability regimes can affect auditor incentives and behaviour. © City University of Hong Kong.

JEL classification: M41

Keywords : going concern reports; client screening; litigation risk; auditors' legal liability

When does insider selling support a "strong inference" of fraud?

Paul A. Griffin ^a and Joseph A. Grundfest ^b
a University of California
^b Stanford University

Abstract

Plaintiffs in securities fraud class action lawsuits often allege that sales by insiders support a "strong inference" of fraudulent intent. This study examines insider transaction activity for a sample of 842 companies sued in lawsuits alleging a violation of Section 10(b) of the Securities Exchange Act of 1934 to ascertain whether net insider selling during the litigation class period is unusual in amount and timing relative to net insider selling at other times and at other firms.

We find that class period net insider selling for the litigation sample significantly exceeds net insider selling before and after the class period and exceeds net insider selling around the same dates for a sample matched on industry. The more pronounced differences are for firms with a greater asymmetry of information between insiders and outsiders, namely, smaller firms and firms with lower analyst coverage. We also document a significant, positive association between net insider sales and short interest, particularly for smaller firms and for firms with lower analyst coverage and find that the level of insider transaction activity immediately prior to a corrective disclosure is not elevated to a statistically significant degree once we control for short interest and other information variables.

These results augment the financial literature by providing evidence of information-based selling by insiders around a disclosure event that leads to securities litigation. From a legal perspective, these results support the view that plaintiffs self select issuers whose patterns of class period insider selling diverge from historical or industry norms. The study is unable to distinguish whether the elevated class period insider selling is the result of insiders' use of material non-public information or insiders' (and short traders') legal use of costly public information. © City University of Hong Kong.

JEL classification: G41, K22 and K41

Keywords : securities fraud ; class action litigation; insider selling

The value relevance of equity accounting in Australia during the pre-recognition regulatory period

Irene Tutticci
The University of Queensland

Abstract

For a period of 26 years, Australian reporting requirements for equity accounting were out of step with international accounting practice, requiring equity accounting to be reported in a note to the accounts and the cost method to be employed in the statutory financial statements. This paper utilises the uniqueness of the Australian regulatory setting to investigate whether equity accounting has greater value relevance than the cost method and whether it provides information incremental to the cost method during the "note disclosure period". The results of both the valuation and returns models provide evidence that equity accounting has value relevance that is incremental to the cost method. Direct comparison of the two methods of accounting provides less conclusive evidence. Equity accounting is found to have statistically greater value relevance than the cost method for the valuation models, but not for the returns models. Differential reporting practices during the period of this study allow an extension of the study to consider two related issues. The first issue looks at the use of supplementary financial statements to report equity accounting as a signal by management of the relevance and/or reliability of equity accounted values. The results indicate that supplementary financial statements do not convey additional relevance or reliability to the market for equity accounted figures. The second extension of the study considers the effect of market value disclosure on the value relevance of equity accounting for companies with investments in publicly traded associates . The results indicate that although market value has incremental value relevance to the cost method, equity accounting has incremental value relevance to market value. © City University of Hong Kong.

JEL classification: M41and G14

Keywords : equity accounting ; cost method; value relevance

The impact of uncertainty and ambiguity when implementing the Balanced Scorecard

Michael Alles ^a and Mahendra Gupta ^b
a Rutgers, The State University of New Jersey
^b Washington University

Abstract

The Balanced Scorecard is now a widely used control tool which provides managers with previously unavailable insights into the factors that drive profits. However, the lack of obvious and objective metrics for many of the non-financial variables in the Balanced Scorecard means that it remains unclear how the Balanced Scorecard should be implemented, what its usefulness will be and how it should be incorporated into performance evaluation. In this paper, we explore how the information provided by the Balanced Scorecard changes the perceptions of managers and workers about how effort input is translated into output and profit. Within a principal/agent setting, we show that even when the Balanced Scorecard is not explicitly linked to compensation, it can have an implicit effect since the scorecard increases the information content of the metrics that are used by managers when determining pay-for-performance compensation, and managers cannot credibly commit to ignore that information. We identify circumstances where this effect reduces risk, enabling lower cost contracts to be written between the firm and the worker. However, the top-down approach inherent in a Balanced Scorecard implementation may also result in increased ambiguity and perceived risk in worker compensation, a possibility that is not recognised in the Balanced Scorecard literature. This phenomenon, by contrast, can undermine the benefits of implementing the Balanced Scorecard. © City University of Hong Kong.

JEL classification: M41 and M52

Keywords : Balanced Scorecard ; pay for performance