Table of content
1 Lecture Week 1...................................................................................................................................... 3
1.1 Focus + introduction ...................................................................................................................... 3
1.2 Paper: Nichols & Wahlen (2004) - Testing the usefulness of accounting earnings....................... 4
1.3 Back to basic statistics: Regression (Also see canvas for more video’s) ..................................... 12
1.4 Recap of Week 1 (Including Seminar): ........................................................................................ 14
2 Seminar Week 1 .................................................................................................................................. 15
2.2 Paper: P.M. Dechow (1994) – Accounting earnings and cash flows as measures of firm
performance. The role of accounting accruals. ....................................................................................... 17
3 Lecture Week 2.................................................................................................................................... 25
3.1 Conservative accounting ............................................................................................................. 25
3.2 Paper week 2 – Lecture – Basu (1997), The conservatism principle and the asymmetric
timeliness of earnings ............................................................................................................................. 26
3.3 Small Recap of week 2: ................................................................................................................ 36
4 Seminar Week 2 .................................................................................................................................. 38
4.1 Recap of Basu paper (Lecture) in relation with Banker (Seminar paper).................................... 38
4.2 Paper Banker et. Al. (2017) – Implications of Impairment Decisions and Assets’ Cash-Flow
Horizons for Conservatism Research....................................................................................................... 39
4.3 Paper Glaum et al. (2018) – Goodwill Impairment: The effects of public enforcement and
monitoring by institutional investors ...................................................................................................... 45
5 Lecture Week 3.................................................................................................................................... 50
5.2 Intangible Assets: A case study (Ajax N.V.) ................................................................................. 52
5.3 Paper Lev Baruch (2019) – Ending the accounting-for-intangibles Status Quo .......................... 54
5.4 Non-GAAP Reporting ................................................................................................................... 59
5.5 Summary of learning objectives Week 3 ..................................................................................... 61
6 Seminar Week 3 .................................................................................................................................. 62
6.1 Paper He and Shan (2016) – International evidence on the matching between revenues and
expenses .................................................................................................................................................. 62
6.2 Paper Curtis et al. (2020) - Changes in the economics of R&D investments............................... 66
7 Lecture week 4 .................................................................................................................................... 70
7.1 User’s processing of accounting information.............................................................................. 70
7.2 Paper lecture 4 – R. Sloan (1996) – Do stock prices fully reflect information in accruals and cash
flows about future earnings? .................................................................................................................. 71
7.3 Theories on users’ information processing ................................................................................. 83
7.4 Summary of Learning Objectives – Week 4................................................................................. 84
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,8 Seminar week 4 ................................................................................................................................... 85
8.1 Bamber et al. (2010) - ‘Comprehensive Income: Who’s Afraid of Performance Reporting?’ ..... 85
8.2 Jung et al. (2018) - ‘Do Firms Strategically Disseminate? Evidence from Corporate Use of Social
Media’ 90
9 Lecture week 5 .................................................................................................................................... 93
9.1 Recap: Regression residuals ........................................................................................................ 93
9.2 Wallstreet Journal – Under Armour’s Subject to Federal Accounting Probes ............................ 93
9.3 Earnings management ................................................................................................................. 93
9.4 Paper Week 5 – Dechow & Dichev – The quality of accruals and earnings: The role of accrual
estimation errors ..................................................................................................................................... 94
9.5 Going back to Under Armour (background story to paper): ..................................................... 101
9.6 Paper week 5 – Stubben (2010) – Discretionary revenues as a measure of earnings
management ......................................................................................................................................... 101
10 Seminar week 5 ............................................................................................................................. 108
10.1 McVay (2006) - ‘Earnings Management Using Classification Shifting: An Examination of Core
Earnings and Special Items’ ................................................................................................................... 108
10.2 Amiram et al. (2015) - ‘Financial statement errors: evidence from the distributional properties
of financial statement numbers’ ........................................................................................................... 112
11 Lecture week 6 .............................................................................................................................. 116
11.1 Recap: interactions .................................................................................................................... 116
11.2 Landsman et al. (2012) - ‘The information content of annual earnings announcements and
mandatory adoption of IFRS’................................................................................................................. 119
12 Seminar week 6 ............................................................................................................................. 123
12.1 Paper 1: The information content of corporate social responsibility (CSR) disclosure in Europe:
an institutional perspective. .................................................................................................................. 123
12.2 Paper 2: Chen et al. (2018) - consequences of mandatory CSR disclosure on firm profitability
and social externalities: Evidence from China....................................................................................... 129
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,1 Lecture Week 1
1.1 Focus + introduction
This week’s lecture focusses on:
1) The paper by: Nichols and Wahlen (2004): Empirically Testing the usefulness of accounting and financial
reporting: earnings and stock returns.
2) Refreshing Regressions
1.1.1 Some examples that relate to this course topics:
Example (1): IFRS 15 – Consequences
IFRS 15 talks about new revenue recognition rules.
- There is no effect on the fundamental value or cash flow, but for some companies, the
change to IFRS affects how early the company can recognize revenues from contracts with
customers
Example: deferral of revenues as a liability on the balance sheet, instead of upfront
recognition – So, revenue is recognized later.
Questions relevant to this topic:
(1) Do accounting rules matter at all?
(2) How does this change affect investors? Can investors see through the effects of the accounting
change on reported profits?
(3) How does this change affect managers’ decisions and reporting strategies?
Example (2): IFRS 16 – Consequences
IFRS 16: new accounting rules for leases
• New rules require companies to recognize lease assets and liabilities on balance sheets
Previously, operating leases were held off-balance sheet, and its effects were
disclosed in the notes to the financial statements.
Questions relevant to this topic:
• Does recognition versus disclosure matter? Do investors and other stakeholders understand the
difference? Large badge of data of personal opinions can show the answer to these kinds of questions
• Does this change affect managers’ decision-making, and if so, why?
• Does the increase in liabilities on the balance sheet affect the cost of firms’ external financing?
1.1.2 Financial reporting topics
“Financial Accounting” is a very broad discipline and the academic literature is huge. Therefore, for this
course we primarily focus on:
(1) Financial reporting topics (what is actually reported on the statements)
(2) The consequences of accounting information for investors and managers (focus on the
numbers, economics of a company)
[Note that topics such as “contracting, regulation, auditing, debt markets, non-financial reporting, etc. are not included”]
The “user” focus of this course is in line with the focus of standard
setters, such as the IASB. In its revised conceptual framework, the
IASB explains that the objective of financial reporting is to provide
information that is “useful to users”. We need to find what is useful
for investors? They identify the Investor as a primary user.
Together, these concepts form the foundation for academic
research on financial accounting questions.
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,Fundamental papers: Papers that are used by a lot of researchers (a lot of “cited” papers) will be used in
this company
Importance of accounting earnings: CFO Perceptions – we focus on earnings as it is important for the
IASB and investors. The (four yellow points) are the most important.
1.2 Paper: Nichols & Wahlen (2004) - Testing the usefulness of accounting
earnings
This paper reviews research on how earnings numbers relate to stock returns. “How do earnings
numbers relate to stock returns?”
1.2.1 Introduction:
Example: On Monday, October 28, 2019, Philips reported earnings lower than last year in the same
quarter (a negative earnings change). The stock price drop of -1.79% makes sense, but can we also
explain this theoretically and empirically? Can we figure out, why is this happening? There are many
reasons it could drop. But we research what the impact of the announcement was on the stock price. Is
lower stock price due to lower earnings announcements?
This helps us understand reporting. Prior researches do provide many insights that help us understand
the relevance of financial reporting.
The paper of Nichols & Wahlen summarizes the intuition (“theory”, the theory is difficult, it suggest that
there is a mechanism that when you do one thing, another one flows out) and empirical evidence on
how accounting earnings information relates to firms’ stock returns, “particularly for the benefit of
students, practitioners, and others who may not yet have been exposed to this literature”
1. This paper represents a theoretical framework to link earnings and stock returns
2. After that, it replicates and extend three classic studies using newer data
a) Relation between earnings and returns: Ball and Brown (1968)
b) The role of earnings “persistence” in this relation
c) Market efficiency and the speed of stock market reactions to earnings news
We compare what accountants think in a firm (accounting measure of performance, earnings & net
income), and the change in book value of the firm.
Earnings = Net income = “Bottom-line” measure of accounting performance. Earnings is an “accrual
accounting measure of the firm’s profit or loss from business activities and events during a quarter or
annual period”. It is “an accounting measure of the change in the value of the firm to common equity
shareholders during a period”
Stock return is also a measure of performance, but more from the perspective of an investor in the
company (change in market value).
Stock return = relative change in the stock price of a firm = the change in the
market value of a firm over time + any dividends that are paid.
- Represents the stock market’s estimate of the firm’s bottom-line performance over the period
In this paper they discuss: how do these alternative bottom-lines relate, and why? If they do not move
together, what are the best measures? We have two performance measures (stock return & earnings). Do
they move together yes or no, and why exactly.
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,1.2.2 Flashback to the beginning: Ball and Brown (1968)
Why is this relation important? Why should we care about it? The relation between stock return and
earnings informs us about the relevance of accounting and financial reporting.
Ball and Brown (1968) were the first to empirically test this relation…
- They induced a significant shift in the accounting research paradigm (model) and changed….
… the way in which academics conducted research towards evidence-based research;
… academic’s beliefs about the relevance of accounting information
This paper focuses on a relatively simple question: “Do earnings capture information that investors
consider useful and ‘value relevant’? “ Why do we spend so much time looking back in accounting while
investors focus on forward-looking measures?
As explained 50 years later by Ball and Brown (2019), accounting research before 1968 “comprised
largely of a priori reasoning, occasionally backed by anecdotal evidence” (p. 411)
- Primary view from the literature: financial statements are completely meaningless!
- Much discussion on how to improve the usefulness of accounting information by changing
accounting systems
1.2.3 Discussion Nichols and Wahlen (2004)
Nichols & Wahlen state accounting was previously mainly focused on the theoretical analysis, rather
than empirical analysis of the usefulness of accounting information. This theoretical analysis does not
validate empirical evidence. How do we know whether theoretical or empirical is better?
Ball and Brown added that there was a lack of evidence. They found that economic analyses were
believed to provide the most important information. There was no empirical evidence to the question
“why do firms and auditors put so many resources into calculating net income and preparing balance
sheets if they’re meaningless? They said it is due to investor demand, so they decided to research it.
The 3 Key insights from the paper of Ball and Brown (1968) are:
1. Accounting information, as reflected in earnings, is useful: changes in earnings are empirically
related to stock returns.
2. But: accounting earnings information is not particularly timely in providing useful information;
much of the information (85 percent) has been anticipated by investors and pre-empted by
other sources of information. Most information is already reflected in the market value of a
company. The moment Philips comes out with news, 85% of the news was already known by
investors.
3. Stock market investors react rapidly to new information in earnings, but not their reaction is
not complete; evidence of “post-earnings announcement drift” (PEAD). Markets are deemed to
be efficient, however, we still see this is not fully the case. How do we know things are not
complete? We measure this.
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,1.2.4 The Framework - Ball and Brown (Point 2-A)
Paper Ball and Brown tell us that Accounting is useful. But why should earnings relate to stock returns?
Nichols and Wahlen (2004) use the framework of Beaver (1998) to illustrate the three links that form the
foundation of the relation between earnings and returns:
1. Current period earnings provides information to predict future periods’ earnings, which …
(when companies post earnings now, will help you predict the earnings number of next year or
next years on)
2. … provide information to develop expectations about dividends in future periods, which …
(if you know the earnings, you can predict to what extent you can earn on your investment)
3. … provide information to determine share value, which represents the present value of
expected future dividends.
(knowing what you could return, you can determine the share value of a company, determine the
market value is too high or too low)
A flashback to how we determine the value of a common share. In the long run, a common shareholder
cares about receiving a return on his/her investment.
- either a constant period payoff (dividend)
- and/or the ability to liquidate the investment at a higher price.
We can see this in the graph. Here we see the expected/required payoff structure
from buying a share. (the red part could be an increase in value, but also a dividend
payment. A dividend payout lowers the value of a share. Thus: the value of an equity
share can be seen as the present value of expected future dividends. This includes a “liquidating”
dividend at the end of the investment horizon or the end of the company’s life.
This is formalized by the Discounted Dividends Model (DDM), the
model looks at the following calculation:
Notice we need to know the dividends (expectations) for the upcoming years. So, to determine the value
of a share, we need to form expectations of the dividends to be paid out in future periods.
In practice, a more common way to express the value of a common share is to use a Discounted Cash
Flow (DCF) model:
We look at this because some companies are not paying out dividends.
In this calculation:
(1) FCFt = the expected “free cash flow” in the period “t”:
- FCF = Operating cash flow - Cash invested in operations
(2) Rwacc = the weighted average cost of capital (WACC)
(3) V0Debt = the value of the firm’s debt.
Similar models exist that express value in terms of expected future earnings. Thus, we can alternatively
value the share by forming expectations of future cash flows and earnings.
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,Nichols and Wahlen (2004, Figure 1) use this
understanding of valuation to derive the framework
underlying the relation between earnings and stock
returns. They try to find the connection between the
relation between current earnings and current share
price. We test this relation, if one goes up and the
other one does too then we find a relation. We need
to know why this relationship exists.
(On the right we see a total of 3 different links, the
better we understand the link, the better we are in
understanding how important value is to investors)
Link #1: The theory of link #1 assumes that earnings, and financial reporting more broadly, provides
information to investors about current, and expected future, profitability
1. Current period earnings summarize information about the wealth created by the company
during the period for shareholders
2. Current period earnings provides information useful for prediction
Nichols and Whalen state that financial reporting is
important to firms due to the useful information
which can be used by stake/shareholders to
understand the ability of future wealth.
Similarly, the IASB recognizes the importance of the
“predictive value of accounting numbers”. The
current earnings are predicting future earnings.
The IASB Conceptual framework states the
following: Information needs to be relevant so
investors can calculate the predictive value
Link #2: The theory of link #2 assumes that current and future earnings are informative about dividend
distributions.
(1) From practice and academic insights, we know this assumption is valid: dividends are typically
linked to earnings.
(2) Even if firms do not pay dividends, the firm could pay higher dividends it was more profitable.
Link #3: The theory of link #3 goes back to our valuation example and assumes that share prices equal
the present value of expected future dividends to the shareholders
Simply said, the framework explains that the information in earnings should relate to changes in stock
price because (mechanism of the story) earnings are informative about the future dividends/cash
flows/earnings the company is expected to generate. When something is informative, it is useful.
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,The Framework helps us to explain the following:
1. Why investors often use earnings-based valuation metrics, such as P/E multiples
2. Why do capital market participants and the media pay so much attention to earnings
3. Why analysts develop and publish their earnings forecasts
4. Why do companies often hold “conference calls” after their earnings announcements to
discuss the prospects for the next quarters
Furthermore, the framework helps us to create tests of how the relation between earnings and returns
might vary across different firms or accounting regimes. Why do stock prices move together with
earnings numbers? We test everything using a link between these points.
1.2.5 Earnings persistence (Point 2B of introduction)
Nichols and Wahlen state that earnings persistence is the likelihood of an earning level to recur in the
future (constant earnings, link 1). So, we want to predict what happens in future periods, we are using
the current earnings to determine this. For example interest rate on a savings account, this is received
every year = fully persistent
A prediction could be: more persistent earnings should have a stronger impact on
stock prices. For example, for firms with an 8% discount rate and persistent earnings
of €1 per year (fully paid as dividends), the 1 euro value should yield € 13,50.
But, what happens to the value if the company books an additional, one-time,
gain of €0.50? This one-time gain has zero persistence because it will not recur in
future periods (or “transitory”)
Because the transitory gain has no predictive future value for dividends/cash flows/ earnings, it should
only affect the valuation through the effect on current period earnings. So, Gains with no predictive
value have no strong effect on market values (we wanted to know how much current period earnings
affect the expected future earnings).
Again, the framework helps us understand why changes in earnings and changes in stock market
valuations should be related. It explains why stock prices react to news in earnings announcements
Understanding the persistence of earnings further helps us determine how strongly the stock price
should respond
- For example, the reduction in earnings for Philips was substantial, but the stock price went
down by less than 2%; but why? – because the impairment is just likely to be a “one-time” event.
This can be related to the link we just discussed.
Concluding, the major driver of the negative earnings change was an impairment charge
- Impairments are one-time, transitory, events
- Thus: impact on value should be limited (29% decrease in earnings, only a 1,60 decrease in
stock price)
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,1.2.6 Empirical research design
The remainder of the study investigates with data whether this previous example holds. How do we
know this is happening? What Nichols and Whalen (2004) did, is that they re-assessed the empirical
relation between earnings and returns. Do earnings reflect information that is deemed important by the
capital market (relevant and reliable)?
Why this relation might not hold:
1. Press reports, macro numbers or other announcements by the company may pre-empt the accounting
earnings number as a timely information source
2. GAAP / IFRS may provide an incomplete view: deferral of revenue or required expensing of R&D
3. Earnings management reduces the usefulness of earnings (“cash is king”). The “0,50 cents may flow out
of manipulation”
1.2.7 Empirical research design: earnings “surprise”
How do we know information is already expected, and how do we know whether the information is
“new = surprise”. Another reason for the limited drop-in Philips’ stock price was that the impairment was
already announced by the company, and (partly) reflected stock price.
- To better understand the stock market reaction to earnings, we should have a precise measure
of the “news” or “surprise” in the earnings number.
The Options to retrieving a precise measure of finding “news” or “surprises”:
1. Same quarter of last year (this is what the press referred to with Philips)
Used by Ball and Brown (1968) and Nichols and Wahlen (2004)
2. A comprehensive prediction model based on multiple signals
3. Forecasts of analysts made on or before the day of the earnings announcements
This is what many researchers use because it includes recent news (such as the
impairment announcement of Philips)
1.2.8 Empirical research design: “Event Study”
Event study: We have an event, and we want to measure exactly how much is accounting-related and
how much Is related to something else. Measurement of the timeline of share prices affects the event
timeline. If we measure for long period, we include a lot more information and short term we use a
precise short amount of information.
Economics measures the effects of an economic event on the value of a firm, this can be done
through an event study. This event causes the effect to be represented in the asset prices immediately.
Thus, the economic impact can be measured by prices that are observed in a short period. This can also
be used when we research earnings announcements
The effect of the event is typically estimated on the stock price of a company.
The Event window is the period around the event in which we are interested. In our case:
[-12,+6] for the months around the earnings announcement month
[-1,+1] for the three days around an earnings announcement day
- Time period 0 = event period
Cumulative abnormal stock returns: measure of the total stock price change over the event window
Cumulative means we sum up the “abnormal” returns (AR) for each of the days / months
> CAR[-1, +1] = ARday-1 + ARday0 + ARday+1
> Abnormal returns (AR) = Stock returns – Expected returns
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, 1.2.9 Empirical research design: “abnormal” returns
From finance theory, we know that stock returns vary with certain firm characteristics.
- Higher risk, higher expected return
- Smaller companies are typically riskier and earn higher returns
Nichols and Wahlen (2004): measure stock returns after adjusting for “expected” returns based on
company size: Abnormal Returns (AR) = Return – E[Return]
In this case, E[Return] is the average stock returns of companies that have a similar size
The Cumulative abnormal returns (CAR) are calculated by:
All previous points are related to the precise measurement of surprises.
1.2.10 Results of the study by Nichols and Wahlen (2004)
In Table 2, Nichols and Wahlen (2004) present the results of their replication of
Ball and Brown (1968).
So, they test: do companies with positive earnings surprise (i.e., positive
change in earnings) have higher returns than companies with a negative
surprise? And if so, by how much? If there is a difference, it means that
investors are reacting to the type of news (reaction to earnings).
Here they find:
- CAR [-12,0] (positive) = 0.192
- CAR [-12,0] (negative) = -0.164
- Difference = 0.356 = 35,6%
Graphical evidence from figure 2 (shown on the right)
Consistent with Ball and Brown (1968), earnings are “value
relevant” because:
(1) Price jump in announcement month 0 for good
news earnings, but no such effect is visible for bad
news earnings
(2) Prices move in the direction of earnings news
before the earnings announcement, reflecting most of
the price change. Earnings are not very “timely”
- When earnings are announced, most of the
effect in share price already happened.
Therefore you need to anticipate)
Furthermore, the results are weaker for changes in cash flows
(this can be related to Dechow 1994 in the tutorial). We miss a
lot of information if we only look at cash flow from operations.
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