do stock prices fully reflect information in accruals and
TRANSCRIPT
Do Stock Prices Fully Reflect
Information in Accruals and
Cash Flows About Future
Earnings?
Hongwen CAO
September 25, 20181
Richard G. Sloan, 1996
The Accounting Review Vol. 71, No. 3, 289-315
Brief introduction to the paper, its author, and the topic of interest.
Background
Data: Main definitions, sample formation, and adjustment.
Methodology: Hypothesis testing.
Data and Methodology
Each hypothesis followed by its corresponding analysis.
Hypothesis and Empirical Analysis
Conclusion of the paper.
Personal comments to the paper.
Conclusion and Comments
Content
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Background
3
- About the authorβ 1996: Assistant Professor of Accounting at the
Wharton School of the University of Pennsylvania
β Current: Chaired Professor of Accounting at
University of California at Berkeley
- About the journalβ The Accounting Review: One of the leading
academic journals in accounting published by the
American Accounting Association (AAA)
- Why this topic
Importance
βCFO, as a measure of performance, is less subject to distortion
than is the net income figure⦠because the accrual system, which
produces the income number, relies on accruals, deferrals,
allocations and valuations, all of which involve higher degrees of
subjectivity than what enters the determination of CFO⦠Some
analysts believe that the higher the ratio of CFO to net income,
the higher the quality of that income.β
βBernstein, L. 1993. Financial Statement Analysis.
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Data and Methodology
β Definitions:
β Earnings: Operating income after depreciation,
excluding non-recurring items.
β Accruals:
Accruals=(ΞCA-ΞCash)-(ΞCL-ΞSTD-ΞTP)-Dep
β Cash from operations:
Cash=Earnings-Accruals
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β’ Sample formation
β’ Adjustments
6
Data and Methodology
β’ Stock: CRSP monthly stock returns file provides data on NYSE and AMEX firms.
β’ Financial statement data: Compustate annual industrial and research files.
β’ Final sample: 40,679 firm-year observations for 30 years from 1962 to 1991.
β’ All 3 variables are standardized by firm size for cross-sectional and temporal
comparison.
β’ Size-adjusted returns are computed by measuring the return in excess of that
on a value-weighted portfolio of firms having similar market values.
β’ Jensen alpha estimation: π ππ‘ β π ππ‘ = πΌπ + π½π π ππ‘βπ ππ‘+ πππ‘
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β’ Empirical Analysis:
7
β’ Linear and non-linear regression
β’ Studentβs t-test
β’ F test: Statistical test with an F-distribution under
the null hypothesis.
Left: Studentβs t-distribution; right: F-distribution
Data and Methodology
8
Hypothesis
and Empirical Test
Persistence of
current earningsEarning
expectations
Trading
strategy
Timing of abnormal
stock returns
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β’ Components of earnings
β’ Risk proxies
9
Descriptive Statistics
A strong negative relation
between accruals and cash flows.
-0.20
-0.10
0.00
0.10
0.20
0.30
1 3 5 7 9
Portfolio Accrual Ranking
Accruals Cash Flows Earnings
3.00
3.50
4.00
4.50
5.00
5.50
0.80
0.90
1.00
1.10
1.20
1.30
0 2 4 6 8 10 12
Portfolio Accrual Ranking
Portfolio beta Size
βU-shapedβ relation, with the
extreme portfolios containing
the smaller, more risky stocks.
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β’ Components of accruals
10
Descriptive Statistics
The majority of the variation
in accruals is attributable to
variation in the current asset
component.
ΞπΆπ΄ β ΞπΆππ β
π΄π£πππππ πππ‘ππ π΄π π ππ‘
ΞπΆπΏ β Ξπππ· β Ξππ
π΄π£πππππ πππ‘ππ π΄π π ππ‘
π·ππ
π΄π£πππππ πππ‘ππ π΄π π ππ‘- -
Current Asset Current Liability Depreciation
-0.20
-0.15
-0.10
-0.05
0.00
0.05
0.10
0.15
0.20
0.25
Portfolio Accrual Ranking
Earnings
Cash Flows
Accruals
Depreciation expense
Current Liability
Current Asset
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β’ H1:
11
Hypothesis 1
β’ The persistence of current
earnings performance is
decreasing in the magnitude
of the accrual component of
earnings and increasing in
the magnitude of the cash
flow component of earnings.
πΈπππππππ π‘+1= πΌ0 + πΌ1πΈπππππππ π‘ + ππ‘+1
πΈπππππππ π‘+1= πΎ0 + πΎ1π΄ππππ’πππ π‘+ πΎ2πΆππ β πΉπππ€π π‘ + ππ‘+1
Step 1
Current earnings performance
& future earnings performance
Step 2
Specification implied by H1
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Empirical AnalysisβTest of H1
βRobustness of
the result.
βMean reverting.
βOverstating πΌ1.
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Empirical AnalysisβTest of H1
βNo constraint on
persistence
coefficients.
βEquality of πΎ1 and
πΎ2 is rejected.
βStrong evidence to
support H1.
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β’ H2(i):
14
Hypothesis 2(i)
β’ The earnings expectations embedded in stock prices fail to
reflect fully the higher earnings persistence attributable to
the cash flow component of earnings and the lower earnings
persistence attributable to the accrual component of
earnings.
π¨πππππππ πππππππ+π= π· π¬ππππππππ+π β πΈπ β πΈπ
βπ¨ππππππππ β πΈπβπͺπππ ππππππ + ππ+π
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Empirical AnalysisβTest of H2(i)
β πΌ1: Result from Table 2;
πΌ1β: Regression result in
stock price equation.
β Stock prices correctly
reflect the implications
of current annual
earnings for future
annual earnings.
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Empirical AnalysisβTest of H2(i)
β πΎ1 & πΎ1β :The coefficient
on accruals is larger in
stock price regression.
β πΎ2 & πΎ2β: The coefficient
on CF is smaller in stock
price regression.
β Reject null hypothesis of
market efficiency.
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β’ H2(ii):
17
Hypothesis 2(ii)
β’ A trading strategy taking a long position in the stock
of firms reporting relatively low level of accruals
and a short position in the stock of firms reporting
relatively high levels of accruals generates positive
abnormal stock returns.
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Empirical AnalysisβTest of H2(ii)
β’ Decreasing trend for
abnormal return over
time.
β’ A hedge portfolio at
π‘ + 1 has a return of
10.4%βeconomic
significance.
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Empirical AnalysisβTest of H2(ii)
β’ 2 out of 30 years
have negative
return.
β’ Over 90% of
positive returns
rules out risk-based
explanation.
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Empirical AnalysisβTest of H2(ii)
β’ Further examination for the coefficient on the accrual
component.
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β’ H2(iii):
21
Hypothesis 2(iii)
β’ The abnormal stock returns predicted in H2(ii)
are clustered around future earnings
announcement dates.
Quarterly announcement3 days around the announcement are the announcement period
(total of 12 trading days per year), and the rest non-
announcement period (total of 242 trading days per year).
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Empirical AnalysisβTest of H2(iii)
β’ Percentage of return
in announcement
period.
β’ Announcement period
return decrease as
accrual component
increases.
β’ βBad newsβ earnings
announcement are
more likely to be
delayed.
Stock prices act as if investors fail to identify
correctly the different properties of accrual
and cash flow components of earnings.
Conclusion and Comments
Non-trivial trading cost
Limited trading quantities
Earnings management/manipulations
Research method
Practical strategy
Sample formation
Old paper
No benchmark
Parameters
End of presentation
Review of βDo Stock Prices Fully Reflect Information in Accruals and
Cash Flows about Future Earnings?β