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The Credibility of Stock Repurchase Signals
Chao Chen Min-Ming Wen
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Information HypothesisAsymmetric information” or “signaling sto
ry”: A signal that the firm’s stock price is signi
ficantly undervalued Vermalen (1981, JFE) Dann and DeAngelo (1983, JFE) document tha
t stock Ikenberry, Lakonishok and Vermalen (1995, JF
E)
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Alternative Observations
• Bartov (1991, JAE) Jagannathan and Stephenes (2003, FM)
• Grullon and Michaely (2003, JF)
• Huang, Liano, and Pan (2003) • Zhou and Lin (2004) • Kahle (2002, JFE)
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Credibility of Repurchase Signals Stock repurchase signals are cheap to make,
because firms do not need to follow up on their announcements. (The Wall Street Journal and Fortune)
Billett and Xue (2003), false signal with the subsequent seasoned equity offerings
Kim, Schremper, and Varaiya (2004), the least stringent regulation on execution and disclosure of repurchase
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Research Questions Do firms really do what they announced? Can it be a false repurchase signal sent by
managers who intend to benefit from it due to their employee stock options ready for exercise or other self motivated activities?
Is there any link between stock repurchase and earnings management?
Do firms with earnings management have a higher probability of leaving repurchase program incomplete?
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Measures of Credibility and Earnings Management This study uses whether a firm
completed its repurchase program as a measure of the credibility of repurchase announcement.
Following Teoh, Welch and Wong (1998a, b), we use discretionary accruals as a measure of earnings management
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Completed v.s Incompleted Completed repurchase program-- if the share
s that the board wants to repurchase under the authorization have been repurchased.
Incompleted repurchase: (i) Temporarily suspended by the board(ii) the repurchase authorization is withdrawn by the board
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Incomplete Repurchase A typical repurchase program lasts for three
years (Stephens and Weisbach 1998) Incompleted status means that up to Jan
uary 2003, firms that had announced repurchase programs between 1995 and 2000 did not complete the repurchase.
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Hypothesis 1: Earnings management neutral hypothesis Based on the information hypothesis, if a
firm announces its intention to repurchase stock, the firm should be neutral on earnings management.
Thus, the discretionary current accruals before and after the announcement of stock repurchase will be indifferent.
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Implications A rejection of the null hypothesis: (i) is in favor of the existence of earnings
management prior to the announcement of stock repurchases(ii) indicates that stock repurchase firms shift future earnings prior to the announcement.(iii) ROA will be negatively correlated with pre-stock repurchase discretionary current accruals
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Hypothesis 2: Managerial entrenchment hypothesis If top managers decide to leave the stock
repurchase program incomplete, the negative effect of earnings management prior to repurchase announcements on future earnings changes will be more severe.
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Implication Following hypothesis 2 and the rejection
of hypothesis 1 => if a firm has a greater incentive of mani
pulating earnings, the credibility of stock repurchase can be lower so that the probability of leaving the repurchase program incomplete is higher.
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Data and Sample The Securities Data Corporation’s (SDC)
Worldwide Merge and Acquisition database Firms made the repurchase initial
authorization between 1995 and 2000. COMPUSTAT data up to 2002 Non-financial firms
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Data and Sample Panel A of Table 1 presents the number of fir
ms initialized repurchase programs in each sample year and the frequency and percentage of completed v.s. incompleted repurchase.
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Table 1 Completed(i) Incomplete(ii) Total
Frequency Percent Frequency Percent 1995 75 44.4% 94 55.6% 169
1996 128 53.8% 110 46.2% 238
1997 124 46.4% 143 53.6% 267
1998 136 31.0% 303 69.0% 439
1999 83 29.1% 202 70.9% 285
2000 53 21.4% 195 78.6% 248
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Methodology (1) Earnings management model Following Teoh, Welch, and Wong (1998a, J
F, 1998b, JFE) methodologies.(2) Logistic Model
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Methodology Cross-sectional regression of the change in return on
asset (∆ROA) in year 1 and year 2 on variables in year –1:
∆ROAi, t+j=α1+δ1 DCAi, t-1 +δ2 NDCA i, t-1 +δ3 (OCF/TA) i, t-1 + δ4 (MV/TA) i, t-1 + e i, t+j
∆ROAi, t+j (j=1 or 2) = α1+ δ1TotalCAi, t-1 + δ3
(OCF/TA) i, t-1 + δ4 (MV/TA) i, t-1 + e i, t+j
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Empirical resultsI. Testing earnings management hypothesisTable 2
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Table 2 Year -2 -1 0 1 2 Observation NI 1521 1625 1646 1540 1213 DCA 1454 1574 1599 1500 1177 NDCA 1493 1609 1486 1534 1208 OCF 1519 1625 1635 1540 1213 Mean NI 6.562a 6.716 a 5.479 a 3.712 a 3.754 a DCA 0.581 0.946b 1.101a -0.207 -0.528b NDCA 3.267a 2.796a 0.839a 0.899a 1.040a
OCF 11.198 a 10.458 a 10.108 a 10.155 a 9.923 a Median NI 6.980a 7.192 a 6.409 a 5.166 a 4.825 a DCA 0.199 0.355a 0.353a -0.101 -0.498a
NDCA 0.950a 1.059a 0.660a 0.511a 0.509a
OCF 10.543 a 11.254 a 10.676 a 10.419 a 10.337 a
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Implications of Table 2 DCA > 0 if t =-1, 0; DCA < 0 if t =1,2 Consistent with Bartov (1991), Jagannathan
and Stephenes (2003), and Grullon and Michaely (2004)
Results of Table 2 suggest the possibility that earnings management exists among the firms intended to buyback their shares.
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Regression results: Table 3 Panel A:
Intercept DCA NDCA OCF MV R2 ADJ-
R2 N F
∆ROAi,t+1
-0.01
(-1.35) -0.04
(-1.21) -0.11a
(-3.09) -0.07a
(-3.40) -0.04a
(-6.14) 0.036 0.033 1301 12.05 a
∆ROAi,t+2
0.01 (0.41)
-0.16a
(-2.92) -0.23a
(-3.93) -0.15a
(-5.43) -0.03
(-1.43) 0.040 0.036 1018 10.48 a
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Results Table 3 Non-discretionary current accruals, operating
cash flows, and size have a significantly negative effect on the changes of returns on asset one year after repurchase.
Discretionary current accruals inversely and significantly affects the post-repurchase performance of firms.
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Results: Complete v.s. Incomplete Results of imposing equation (5) on the
completed and incompleted groups
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Empirical Results Comparisons of post-stock repurchase an
nouncement ROA of completed and incompleted groups
Table 4A: the descriptive statistics of firm size and repurchase contents (number of shares and the percentage of targeted shares) of completed and incompleted firms
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Table 4 Panel A Descriptive Statistics of Repurchase Shares and Percentage of
Targeted Repurchase Shares
Group Shares(i) Percent(ii)
Total assets (iii)
Mean Completed 3400386 6.37 2694.86 Incomplete 3584094 7.86 2222.50
Standard Deviation Shares Percent Total assets Completed 6854995 5.32 10973.93
Incomplete 8093569 6.52 11093.14
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Table 4 Pane B Regression Results Intercept DCA NDCA OCF MV ADJ-
R2 N F
Completed ∆ROAi,t+1
0.03a -0.04 -0.35a -0.18a -0.03 0.07 492 10.78 a (3.08) (-0.84) (-4.45) (-4.16) (-1.29)
∆ROAi,t+2 0.03b -0.11 -0.25a -0.27a -0.08a 0.08 428 10.37 a (2.37) (-1.36) (-2.65) (-4.79) (-2.75)
Incomplete
∆ROAi,t+1 -0.02a -0.08c -0.04 -0.05b -0.03a 0.03 809 7.35 a
(-3.13) (-1.75) (-1.10) (-1.99) (-5.13) ∆ROAi,t+2
-0.01 -0.20a -0.19b -0.16a -0.01 0.02 590 4.35 a (-0.90) (-2.82) (-2.32) (-3.05) (-0.38)
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Results: Table 4B(1) Incomplete firms: significant negative effects of earnings management prior to repurchase announcements on both ∆ROAi,t+1 and ∆ROAi,t+2
(2) Completed firms: discretionary current accruals prior to repurchase announcements have insignificant negative effects on both ∆ROAi,t+1 and ∆ROAi,t+2.
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Table 5
Comparison of ROA of the complete and incomplete repurchase groups
(i) ∆ ROA Group = ROA (Complete) – ROA (Incomplete) (ii) % ∆ in ROA = [ROA(t+i) – ROA(t+i-1)]/ROA(t+i-1), i = -1, 0, 1, 2.
Median Mean (t-2) (t-1) t0 t+1 t+2 (t-2) (t-1) t0 t+1 t+2 ROA (Complete)
0.0871 0.0949 0.0880 0.0727 0.0660 0.1025 0.1130 0.0923 0.0826 0.0694
% ∆ in ROA(ii)
8.96% -7.27% -17.39% -9.22%
10.24% -18.32% -10.51% -15.98%
ROA (Incomplete)
0.0806 0.0827 0.0680 0.0501 0.0396 0.0968 0.0606 0.0664 0.0416 0.0351
%∆ in ROA 2.61% -17.78% -26.32% -20.96% -37.40% 9.57% -37.35% -15.63% ROAGroup
(i) 0.65%a 1.22%a 2.00%a 2.26%a 2.64%a
0.57% (0.13)
5.24%a
(2.77) 2.59%a
(2.88) 4.10%a
(4.75) 3.43%a
(3.18)
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Methodology-- Logistic model To link the probability of leaving a
repurchase program incomplete and the incentives of earnings management
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Logit Model Logit (p) = log (p/1+p) = α + ß’ x p -- the probability of leaving a repurchase progra
m incomplete and defined as Pr (Y = 1 | x ), Y =1 if the repurchase program is incompleted, Y = 0, otherwise
x is a vector of explanatory variables(i) pre-stock repurchase discretionary current accruals, (ii) the number of shares firms intended to buyback, (iii) firm size, (iv) debt ratio, (v) whether the firm disclose the funding source of repurchase.
p = e ßX/(1+eßx).
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Table 6 Logistic Regression Model
Variables Parameters Estimate
Chi-Square
Intercept 0.020 0.006 DCA(t-2) -0.176 0.451 DCA(t-1) 19.381c 2.993 DCAt -1.881 1.087 DCA(t+1) 16.134 0.611 NDCA(t-1) 2.152 0.035 OCF(t-1) 0.215 0.271 PercentShare 0.052a 17.774 DE(t-1) 0.014 0.113 lnTA(t-1) -0.041 1.375 Dummy 0.470a 14.456
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Empirical Results: Logistic regression model
(1) firms with higher pre-stock repurchase discretionary accruals tends to have significantly higher probability leaving the repurchase program incomplete.
(2) Higher discretionary accruals prior to the stock repurchase suggest a greater incentive of managing earnings.
(3) A linkage between the probability of conducting earnings management and the probability of leaving repurchase program incomplete.
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ConclusionsThe earnings management
inversely and significantly affects the post-repurchase performance of firms with incomplete repurchase programs.
Stock repurchase may be a false signal and the firm’s value may actually be overvalued
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Conclusions firms with higher pre-stock repurchase
discretionary accruals tend to have significantly higher probability leaving the repurchase program incomplete.
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Methodology Current accrual (CA) model :
CAi,t = [ARi,t + INVi,t + OCAi,t ] - [APi,t + TPi,t + OCLi,t ] (1)
Discretionary and nondiscretionary accruals for a given year,
= a0 ∙ + a1∙ + εi,t (2)
1,
,
ti
ti
TACA
1,
1
tiTA1,
,
ti
ti
TASales
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Methodology CAi,t = the current accruals of firm i at year t, ARi,t = accounts receivables, INVi,t = inventory, OCAi,t = other current assets, APi,t = account payable, TPi,t = tax payable, and OCLi,t = other current liabilities. Salesi,t = the change in sales from the previous y
ear (t-1) for firm i. TA = Total Assets
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Methodology Nondiscretionary current accruals (NDCA) :NDCAi,t = ∙ + ∙ (3)
ARi,t = the change in account receivable in year t for firm i.
and are the coefficients estimates from equation (2)
^
0a1,
1
tiTA
^
1a1,
,,
ti
titi
TAARSales
^
0a^
1a
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Methodology The scaled discretionary current accruals (DCA) :DCAi,t = - NDCAi,t (4)
DCAi,t is used for the proxy of earning management
1,
,
ti
ti
TACA
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Equations for Accruals
Total Accruals = Changes in Net Operating Assets (NOA) =(NOAt – NOAt-1)/NOAt-1
NOA = Operating Assets (OA) – Operating Liabilities (OL) OA = Current Operating Assets + Non-current OA (NCO
A) OL = Current Operating Liabilities (COL) + Non-COL (NC
OL) COA = Current Assets (CA) – Cash and Short Term Inves
tments (STI) NCOA = Total Assets (TA) – CA – Investments and Adva
nces COL = CL – Debt in Current Liabilities NCOL = TL – Current Liabilities – Long-term debt SG = sales growth = (Salest – Salest-1) - 1