Unequal Impact of Conservatism on Accrual Measures and Drivers: Implications for the Specification of Accrual Models

This study makes two main contributions to the literature. Firstly, it tests empirically the relative timeliness of accrual measures and earnings components used as explanatory variables in accrual models (“accrual drivers”) regarding the impact of conservatism. Secondly, taking into account the empirical evidence on such a timeliness, it discusses intuitively potential implications for the specification of (traditional) accrual models and the quality of discretionary accrual estimates. It concludes that common accrual models, as Jones (1991), are misspecified. They have a dependent variable (accruals) asymmetrically affected by conservatism, and one or more explanatory variables that are not affected, inducing a non-systematic measurement error in estimating discretionary accruals.accruals; accrual models; discretionary accruals; conservatism.

THE DETERMINANTS OF THE GOING PUBLIC DECISION: EVIDENCE FROM THE U.K.

Several theoretical papers have addressed the question of why firms raise public equity. However, direct empirical evidence on the characteristics of firms going public is scarce and limited to non-Anglo-Saxon contexts. Our research combines the analysis of ex ante and ex post characteristics of Initial Public Offering (IPO) companies to cast more light on the determinants of the going public decision in the UK. Some of our findings are consistent with prior empirical studies in other contexts: IPO probability depends positively on firm size and stock price levels. Results also suggest that a firm?s need to finance investments is not the main motive to go public, although this reason underlies the going public decision in a number of UK firms. Besides, contrary to the evidence shown by Pagano et al. (1998) for Italian IPOs, we find that UK firms do not go public to reduce debt since leverage is negatively related to the probability of going public. Finally, the relationship between profitability and the likelihood of an IPO for our whole IPO sample is negative and significant. Whether firms that go public have higher investment rates than other firms, as is the case of our survivor IPOs, the negative effect of profitability on the probability of going public may reflect the fact that these firms cannot yield sufficient internal funds to finance large investments. In fact, the relationship between profitability and the likelihood of an IPO becomes significantly positive for our acquired IPO group, where investment opportunities variables have no significant effect on the going public decision. This result is consistent with the portfolio rebalancing motive to go public.Initial Public Offerings, the Going Public Decision.

Piecewise Linear Accrual Models: do they really control for the asymmetric recognition of gains and losses?

The asymmetric recognition of gains and losses underlying conservative accounting is not taken into account by Jones (1991)-type accrual models. Recently, Moreira (2002) and Ball and Shivakumar (2005a) have proposed piecewise linear accrual models designed to control for this asymmetric impact. Our paper first discusses the sign of the expected measurement error in discretionary accruals (DAC) estimates when models do not control for the asymmetry underlying conservatism. We find that DAC in firms with bad news (BN) are expected to be understated, while those in good news (GN) firms will be overstated. Based on this original result we empirically test, using graphical and statistical tools, whether piecewise linear accrual models correct such a measurement error. The empirical evidence shows mixed results. For GN firms the estimates are corrected downwards, as expected; for BN firms, unexpectedly, part of the estimates is also corrected downwards. The reason for this unexpected result seems to lie in a non-linear relationship between accruals and the proxy for BN that the models are unable to control for. Thus, DAC estimates under piecewise linear models are not deemed to be of better quality than those of traditional accrual models.accrual models; piecewise linear accrual models; conservatism; earnings management

Earnings Management to Avoid Losses: a cost of debt explanation

In this paper we analyze firms’ earnings management behavior to avoid losses conditional on the (asymmetric) incentive underlying market (positive/negative) returns. Our intuition is that firms with negative returns in the period (bad news, BN) face a higher incentive to undertake earnings management, and that their ultimate intention is to hide from credit markets a signal (loss) that could be translated into a negative impact on their cost of debt. The empirical evidence supports this intuition. BN firms show higher earnings management pervasiveness than their counterparts with good news (GN), and the set with simultaneous BN and prior period positive earnings undertake more pervasive earnings manipulation than BN firms in general. Within this restricted set of firms, and consistent with a cost of debt explanation, we find that firms with larger needs of debt show a higher incidence of earnings management to avoid losses. The overall empirical evidence challenges the implicit assumption in Burgstahler and Dichev (1997) that the incentive to manage earnings is homogeneous to all firms, and suggests that the discontinuities around zero in the earnings distributions are driven, at least partly, by firms’ earnings management behavior.earnings management, earnings thresholds, earnings discontinuities, cost of debt

The determinants of the UK Big Firms Premium

Our study attempts to determine whether, and if so why, the large auditing firms are able to earn a premium on their audit work in the UK. We start by confirming the apparent existence of a Big Firm premium during the period 1985-2002. We examine industry specialisation, non audit service fee and monopoly pricing explanations for the premium. The results of our tests of industry specialisation are mixed. There is little evidence that this premium is associated with industry specialisation when specialists are defined at the national level. Significant premium are observed if specialisation is defined at the city level, particularly if the auditor is the industry leader. However, when appropriate allowance is made for endogeneity, by modelling both audit and non-audit fees in a simultaneous equations framework, the Big Firm premium disappears. We find evidence to suggest that non audit fees earned by auditors from their audit clients are positively related to the size of the audit size and vice versa. Finally, when the sample is stratified by the size of audit client, we find no systematic evidence of anti-competitive pricing

UK evidence of auditor brand name and industry specialisation

First draftThere is considerable empirical evidence that after controlling for factors known to affect the level of audit fees, the large international firms earn an audit fee premium. In this paper, we estimate a Big Six premium of 10% to 23% for a large sample of UK clients. Recent studies contend that the development of brand name and industry specialisation reputations is costly and the Big Six firms can expect a return from this investment. We find evidence consistent with brand name returns across most sub-samples of clients. However, the audit fees charged by the Big Six firms are not significantly higher than the fees charged by their non Big Six counterparts for the smallest quartile of clients. An explanation for this finding is that the demand for a firm with a brand name 'bottoms out' below a critical size because of the extra cost. The audit fees charged by the Big Six firms are not significantly higher for the sub-sample where industry specialisation is defined by the size of the non audit fee. An explanation for this result is that there may be an inter-relationship between the pricing of audit and non audit services. Unlike the prior literature, we find scant evidence of returns to industry specialisation. We believe that returns to specialisation are insignificant because the UK Big Six firms are large enough to be considered specialists across all markets

Real options models of the firm, capacity overhang, and the cross-section of stock returns

We use a stochastic frontier model to obtain a stock-level estimate of the difference between a firm's installed production capacity and its optimal capacity. We show that this "capacity overhang" estimate relates significantly negatively to the cross-section of stock returns, even when controlling for popular pricing factors. The negative relation persists among small and large stocks, stocks with more or less reversible investments, and in good and bad economic states. Capacity overhang helps explain momentum and profitability anomalies, but not value and investment anomalies. Our evidence supports real options models of the firm featuring valuable divestment options

"Post-Earnings Announcement Drift: Market Inefficiency or Research Design Biases?"

The predictability of abnormal returns based on information contained in past earnings announcements is a statistically and economically significant anomaly. Neither is it illusory, nor is it an artifact of the experimental design. It may be a result of market inefficiency. Our results cannot rule out this explanation. However, we find that the magnitude of the post-earnings announcement effect is correlated with factors that proxy for the ex ante probability of the firm surviving to be part of the earnings surprise sample, and with determinants of the bid-ask spread

Post-Earnings Announcement Drift?

The predictability of abnormal returns based on information contained in past earnings announcements is an anomaly that is statistically and economically significant. Neither is it illusory, nor is it an artifact of the experimental design. It may be a result of market inefficiency. Our results cannot rule out this explanation. However, we find that earnings change numbers are associated with the probability that firms leave the sample through acquisition, bankruptcy or for other reasons, or are not included in the sample in the first place. Moreover, we find that the magnitude of the post-earnings announcement effect is correlated with factors that proxy for the ex ante probability of the firm surviving to be part of the earnings surprise sample. It also appears to be related to determinants of the bid-ask spread