Securities market weightings of complementary earnings predictors: Biased expectations or omitted risk measures?

Pieter T. Elgers ^a and May H. Lo ^b
a University of Massachusetts, Amherst
^b Western New England College

Abstract

Previous studies report delayed securities returns associated with analysts' earnings forecasts, prior earnings, and prior securities returns. Although this evidence typically has been attributed to biases in investors' expectations of earnings, omitted risk factors constitute an equally plausible potential explanation of the delayed returns. For this reason, our paper evaluates whether the earnings expectations implicit in securities prices weight the information in analysts' forecasts, prior-year earnings, and prior securities returns in a manner consistent with their historical relations to earnings. We find that securities prices reflect a significant over-reliance on historical earnings and a substantial under-reliance on both analysts' forecasts and prior-year securities returns. Composite earnings forecasts that are based on the historical relations of realised earnings to analysts' forecasts, prior year earnings and prior year returns have significantly lower forecast errors than do composite earnings forecasts that are based upon inferred investor weightings of these same information variables. Moreover, significant size-adjusted returns are achieved with hedge portfolios based upon errors in investor earnings expectations that are predicted from differences in the historical and investor weights of these complementary information variables. A disproportionate part of these delayed returns occur in earnings announcement months. Overall, these findings lend credibility to the interpretation that biases in investors' earnings expectations, rather than omitted risk factors, underlie at least a portion of the delayed securities returns. © City University of Hong Kong.

JEL classifications: M41 and G15

Keywords : earnings expectations; market mis-pricing; omitted risk factors

On the factors influencing the return-earnings relation

Reza Espahbodi
Indiana University South Bend

Abstract

This study extends prior research attempting to identify factors influencing the return-earnings relation. It examines all firm-specific characteristics known to significantly influence the relation between earnings and return to reduce the likelihood of an omitted variable problem. More importantly, the study uses the recursive partitioning technique to avoid the subjectivity in specifying the earnings response regression model and the problems resulting from the OLS regression assumptions. The recursive partitioning analysis indicates that five factors ¡V exchange listing, incidence of loss, earnings predictability, earnings persistence and book value per share ¡V affect the return-earnings relation. When included in the earnings response regression, these factors explain a large percentage of the cross-sectional variations in return. Sensitivity tests are performed for alternate return windows and measure of unexpected earnings. © City University of Hong Kong.

JEL classifications: C14, C51, G14, M41

Keywords : stock return; earnings response coefficient; analysts' forecasts; recursive partitioning

Contingent rents and auditors' independence: Appearance vs fact

Nicholas Dopuch ^a , Ronald King ^a and Rachel Schwartz ^b
a Washington University
^b University of Illinois at Urbana Champaign

Abstract

A common theme in discussions of auditors' independence is the concern that provision of non-audit services may compromise auditors' independence. We use a simple model to show that although the latter argument applies in some cases, it is false in others. Specifically, we show that the presence of contingent economic rents is not sufficient for auditors to compromise their independence, nor is the lack of contingent rents sufficient to imply auditors' independence. We also show that contingent rents could increase audit quality and strengthen independence when the risk of misstatements is less than 50 per cent. Our paper provides definitions of independence in appearance and independence in fact. Although the issue of independence relates to the dual notion of appearance and fact, regulations generally focus on appearance. In contrast, the literature on auditors' independence has focused on independence in fact. We bridge the gap by formalising a definition of independence in fact, and a definition of independence in appearance. © City University of Hong Kong.

JEL classifications: M42 and N22

Keywords : auditors' independence; audit quality; securities regulation

Commentary on ¡§Contingent rents and auditors' independence: Appearance vs fact¡¨

Dan A. Simunic ^a and Michael T. Stein ^b
a University of British Columbia
^b University of Oregon

Abstract

Our objective in this Commentary is to assess the relevance of the Dopuch, King, and Schwartz (DKS) paper to the policy debate on non-audit services and auditor independence. To do this, we discuss the strengths and limitations of the authors' formal analysis, and examine the connections among the derived analytical results, available empirical evidence, and current audit practice. Finally, we comment on what we believe a reader can "take away" from the paper with respect to this policy debate. Overall, while we consider the DKS paper to be a useful contribution to the research literature in this area, our goal is to provide the reader with a balanced view of the important issues addressed by DKS. © City University of Hong Kong.

Board structure, political influence and firm performance ¡V An empirical study on publicly listed firms in China

Dongping Han ^a , Fusheng Wang a and Heng Yue ^b
a Harbin Institution of Technology
^b Tulane University

Abstract

The board of directors is the cornerstone of any effective corporate governance system. A well-structured board can effectively monitor and motivate management of a company for the benefit of the company's shareholders. This paper investigates the relationship between board structure and firm performance using a sample of 490 publicly listed firms in China. The characteristics of board structure we examined include: board size, inside/outside/independent directors, CEO/Chair duality, stock holdings of directors, rewards to directors and aged directors. We find significant relationship between firm performance and three characteristics: the rewards to director, the stock holdings of directors and the existence of independent directors. We also find political influences on the effectiveness of boards. When state ownership is more than 50% (state-dominating), rewards and stock holdings of directors are useful. When state ownership is less than 50% (non-state-dominating), the existence of independent directors comes into effect. In addition, our analyses indicate that state ownership affects firm performance. State ownership is positively related to firm performance in state-dominating groups while negatively related to firm performance in non-state-ownership groups. © City University of Hong Kong.

JEL classification: G34, G3

Keywords : corporate governance; board structure; political influence; firm performance; empirical study