Earnings Measurement, Determination, Management, and Usefulness: An Empirical Approach

EARNINGS MEASUREMENT, DETERMINATION, MANAGEMENT, AND USEFULNESS An Empirical Approach

Ahmed Riahi-Belkaoui

QUORUM BOOKS Westport, Connecticut • London

Library of Congress Cataloging-in-Publication Data Riahi-Belkaoui, Ahmed, 1943Earnings measurement, determination, management, and usefulness : an empirical approach / Ahmed Riahi-Belkaoui. p. cm. Includes bibliographical references and index. ISBN 1-56720-330-2 (alk. paper) 1. Financial statements. 2. Corporations—Accounting. 3. Accounting. I. Title. HF5681.B2R424 1999 657'.3—dc21 99-27826 British Library Cataloguing in Publication Data is available. Copyright © 1999 by Ahmed Riahi-Belkaoui All rights reserved. No portion of this book may be reproduced, by any process or technique, without the express written consent of the publisher. Library of Congress Catalog Card Number: 99-27826 ISBN: 1-56720-330-2 First published in 1999 Quorum Books, 88 Post Road West, Westport, CT 06881 An imprint of Greenwood Publishing Group, Inc. www.quorumbooks.com Printed in the United States of America

The paper used in this book complies with the Permanent Paper Standard issued by the National Information Standards Organization (Z39.48-1984). 10

9 8 7 6 5 4 3 2 1

To my family, here and there

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Contents List of Exhibits Introduction

ix xiii

1

The Income Statement

2

Earnings Measurement and Price Level Changes

23

3

Earnings Determination following Wealth Measurement

49

4

Contextual Accruals and Cash Flow Based Valuation Models: Impact of Multinationality and Reputation

59

5

Multinationality and Earnings Management

71

6

Earnings Management and Reputation Building

81

7

The Smoothing of Income Numbers: Some Empirical Evidence on Systematic Differences between Core and Periphery Industrial Sectors

89

The Relevance of Earnings Levels versus Earnings Changes as an Explanatory Variable for Returns

105

Accrual Accounting and Cash Accounting: Relative Merits of Derived Accounting Indicator Numbers

113

Cash Flow, Earnings, and Corporate Control

129

8 9 10

1

viii

11 12 13

Contents

The Information Content of Value Added, Earnings, and Cash Flow: U.S. Evidence

145

Earnings-Returns Relation versus Net-Value-Added-Returns Relation: The Case for a Nonlinear Specification

155

Accrual Accounting, Modified Cash Basis of Accounting, and Loan Decision: An Experiment in Functional Fixation

169

Index

181

List of Exhibits 1.1 1.2 2.1 2.2 2.3 2.4 2.5 2.6 2.7

2.8

Karabatsos Corporation: Single-Step Income Statements for the Year Ended December 31, 1991 Karabatsos Corporation: Multiple-Step Income Statements for the Year Ended December 31, 1991 DeCooning Company: Income Statements for the Year Ended December 31, 19X6 DeCooning Company: Balance Sheet for the Year Ended December 31, 19X6 DeCooning Company: Timing-Error Analysis for the Year Ended December 31, 19X6 DeCooning Company: General Price-Level Income Statements for the Year Ended December 31, 19X6 DeCooning Company: General Price-Level Balance Sheets for the Year Ended December 31, 19X6 DeCooning Company: General Price-Level Gain or Loss for the Year Ended December 31, 19X6 Statement of Income from Continuing Operations Adjusted for Changing Prices for the Year Ended December 31, 19X6 (in thousands of average 19X5 dollars) Five-Year Comparison of Selected Supplemental Financial Data Adjusted for Changing Prices (in thousands of average 19X5 dollars)

13 14 29 30 33 35 36 37 43

44

List of Exhibits

X

2.9

Statement of Income from Continuing Operations Adjusted for Changing Prices for the Year Ended December 31, 19X6 (in thousands of average 19X5 dollars)

45

3.1 3.2

Summary Statistics for Variables of Earnings Policy Model Correlation Matrix

52 53

3.3

Earnings and Net Value Added (^-statistics in parentheses)

54

4.1

Selected Statistics Related to a Common Factor Analysis of Three Measures of Multinationality for Forbes' The Most International 100 U.S. Firms for the 1987-1990 Period

63

4.2

Selected Statistics Related to a Common Factor Analysis of Measures of Reputation

65

4.3

Descriptive Statistics and Correlations

66

4.4

Regression Results of Linear Models

67

5.1

Selected Statistics Related to a Common Factor Analysis of Three Measures of Multinationality for Forbes3 The Most International 100 U.S. Firms for the 1987-1990 Period Descriptive Statistics Pearson Correlation Coefficients Results of Regression Estimation—Model (1)

76

5.2 5.3 5.4

77 78 78

Results of Regression Estimation—Model (2) Selected Statistics Related to a Common Factor Analysis of Measures of Reputation Summary Statistics for Empirical Variables

79 85

6.3 7.1 7.2

Explaining Corporate Reputation Overall Summary of Results Smoothing of Operating Income with Operating Expenses (Time Expectation Model No. 1)

87 96 97

7.3

Smoothing of Operating Income with Operating Expenses ("Market" Income Expectation Model)

97

7.4

Smoothing of Operating Income with Operating Expenses (Time Expectation Model No. 2)

98

7.5

Smoothing of Ordinary Income with Operating Expenses (Time Expectation Model No. 1)

98

7.6

Smoothing of Operating Income with Operating Expenses ("Market" Income Expectation Model)

99

7.7

Smoothing of Operating Income with Operating Expenses (Time Expectation Model No. 2) Smoothing of Ordinary Income with Operating Expenses (Time Expectation Model No. 1)

99

5.5 6.1 6.2

7.8

86

100

List of Exhibits

xi

7.9

Smoothing of Ordinary Income with Operating Expenses ("Market" Income Expectation Model)

100

7.10

Smoothing of Ordinary Income with Operating Expenses (Time Expectation Model No. 2)

101

7.11

Smoothing of Operating Income with Operating Expenses (Time Expectation Model No. 1)

101

7.12

Smoothing of Ordinary Incorne with Ordinary and Operating Expenses ("Market" Inconie Expectation Model)

102

7.13

Smoothing of Operating Income with Ordinary and Operating Expenses (Time Expectation Model No. 2)

102

8.1

Explanatory Power of Current and Future Annual Levels of Earnings for Current Annual Returns

108

8.2

Explanatory Power of Current and Future Annual Changes in the Levels of Earnings for Current Annual Returns

109

8.3

Explanatory Power of Model A and Model B CrossSectional References

110

9.1

CEP, EPSP, and CFP's Means, Standard Deviations, and Coefficients of Variation for the Sample Companies, 19591977

118

9.2

Rank Correlations of All the Sample Companies' CEPs with CEPs in Subsequent Years

122

9.3

Rank Correlations of All the Sample Companies' CFPs with CFPs in Subsequent Years

123

9.4

Rank Correlations of All the Sample Companies' EPSPs with EPSPs in Subsequent Years Frequent Distribution of Sample by Year of Takeover Resolution—Sample Period 1977-1989

124

10.2

Sample Frequency of Takeover Classified by Form of Payment, Hostile or Friendly Offer, and Number of Bidders for the Target

134

10.3

Comparison of Target Firm and Industry Earnings to Total Assets (E/TA) and Cash Flow to Total Assets (CF/TA) Ratios

137

10.4

Regression Results of Target Firm Abnormal Returns on D(E/TA) and D(CF/TA)

138

10.5

Regression Results of CAR(T) on D(E/TA) and D(CF/TA) with Control Variables related to Target Firm and Merger Characteristics

139

11.1

Regression Results on Single Return Effects

147

11.2

Regression Results on Combined Return Effects

148

10.1

133

List of Exhibits

xn 11.3

Tests for Relative Information Content for Net Income, Cash Flows, and Value Added

148

11.4

Incremental Comparisons

149

12.1 12.2 13.1

Linear Regression Results Nonlinear Regression Univariate Analysis of Various Tables

160 162 177

Introduction

This book is about earnings in general and the measurement, determination, management, and usefulness of earnings in particular. The interest in earnings and its related issues of measurement, determination, management, and usefulness stems from a) the crucial importance of earnings as the shareholder's share in the wealth provided by the firm, b) the reliance of investors and users on earnings and transformation of earnings for resource allocation decision, and c) the direct association between the efficiency of the capital markets and the timely provision of earnings data. Accordingly, the nature of earnings is examined in Chapter 1. The measurement aspect of earnings is the subject of Chapter 2. The determination of earnings is covered in Chapter 3. Earnings management and income smoothing are covered in Chapters 4 to 7. Finally, the usefulness of earnings is covered in Chapter 8 to 13. Each of these chapters identifies the nature of the issue surrounding the concept of earnings and presents empirical evidence that can be used for decision making and/or public policy. The contents of the chapters is as follows: Chapter 1, "The Income Statement," examines the theoretical and practical issues underlying the determination and preparation of the income statement under accrual accounting. Chapter 2, "Earnings Measurement and Price Level Changes," examines the measurement of earnings under six alternative asset-valuation and income determination models, namely: (a) historical cost accounting, (b) replacement cost accounting, (c) net realizable-value accounting, (d) general price-level accounting, (e) general price-level replacement-cost accounting, and (f) general price-level net-realizable-value accounting.

XIV

Introduction

Chapter 3, "Earnings Determination following Wealth Measurement," shows that earnings is determined as a process of response to the wealth generated by the firm, measured by net value added, and a process of adjustment to the previous earnings level. Chapter 4, "Contextual Accruals and Cash Flow Based Valuation Models," examines the impact of the contextual factors of multinationality and corporate reputation on accrual and cash flow based models. The results of a price level regression confirmed that the market value of equity is higher the larger (smaller) the cash flows (accruals) under conditions of high multinationality and corporate reputation. Chapter 5, "Multinationality and Earnings Management," examines the relationship between the level of multinationality and managers' accounting choices. It is argued that the level of multinationality affects net income and net wealth and thereby political costs and political risk. The relationship provides management an incentive to reduce political costs and political risk associated with high mutinationality by using income-decreasing accruals. The results of the study indicate that management of firms with a high level of multinationality make accounting choices to reduce reported earnings. Chapter 6, "Earnings Management and Reputation Building," examines the relationship between the level of corporate reputation and managers' accounting choices. It is argued that the level of corporate reputation is linked to net income and net worth and thereby to political costs. The relationship provides an incentive to reduce political costs associated with high reputation by using income-decreasing accruals. The results of the study indicate that the management of firms with a high level of corporate reputation make accounting choices to reduce reported earnings. Chapter 7, "The Smoothing of Income Numbers," tests the effects of the dual economy on income-smoothing behavior. It is hypothesized that a higher degree of smoothing will be exhibited by firms in the periphery sector than by firms in the core sector as a reaction to different opportunity structures and experiences. The results indicate that a majority of firms may be resorting to income smoothing. A higher number are included among firms in the periphery sector. Chapter 8, "The Relevance of Earnings Levels versus Earnings Changes as an Explanatory Variable for Returns," models the security price/accounting earnings relationships using earnings level or earnings changes. The results of the study indicate that (a) both earnings level and earnings changes play a role in security valuation, and (b) the use of the levels rather than changes provides a better explanation of returns. Chapter 9, "Accrual Accounting and Cash Accounting," evaluates the relative merits of performance indicators derived from either an income statement or a balance sheet both based on accrual accounting or cash flow accounting. The balance sheet number showed lower variability and higher

Introduction

xv

persistency than the cash flow accounting and the income statement numbers. The phenomenon is attributed to income smoothing distortion and a selective market response hypothesis. One implication for the standardsetting bodies may be to favor an asset/liability view of earnings rather than a revenue/expense on cash flow view. Chapter 10, "Cash Flow, Earnings, and Corporate Control," examines the ability of cash flow and earnings-based measures of return to assess the difference between target firms and their industries and to explain target firms' abnormal returns during the takeover period. The results of the study show that the cash flow to total assets and the earnings to total assets were below the industry average in each of the three years preceding the year of the takeover. In addition, abnormal returns are negatively related to the difference in earnings to total assets, suggesting that target firm assets are indeed underutilized. The difference between target firm and target industry cash flow to total assets is positively related to target firm abnormal returns, suggesting that acquiring firms value the near-term cash flow of targets. Chapter 11, "The Information Content of Value Added, Earnings, and Cash Flow," examines the relative and incremental content of value added, earnings, and cash flow in the U.S. context. The results show a clear dominance of value added information over both earnings and cash flow information. Chapter 12, "Earnings-Returns Relation versus Net-Value-AddedReturns Relation," finds that models relating accounting and market returns have more explanatory power when (a) the accounting returns are experienced by the relative changes in net value added and (b) the relation is a nonlinear, convex-concave function. Chapter 13, "Accrual Accounting, Modified Cash Basis of Accounting, and Loan Decision," presents the results of an empirical study in which loan officers evaluated a loan application accompanied by financial statements based on either accrual accounting or modified cash basis of accounting (MCBOA). The loan officers first decided whether to grant the loan and determined an interest rate. Second, they evaluated the financial statements information on the basis of three quality attributes: overall reliability, freedom from clerical errors, and freedom from the effects of fraud. The results verified a functional fixation hypothesis by showing that the loan officers examining the financial statements of the same company using either accrual information or MCBOA showed clear preference for the company when faced with accrual information. A conditioning factor is used to explain the results. The book will be of interest to practicing accountants, academics, business executives, students, legislators, and others interested in the accurate measurement of changes in wealth and the appropriateness of earnings as a measure of the changes in wealth. Many people have helped in the development of this book. I received

XVI

Introduction

considerable assistance from the University of Illinois at Chicago research assistants, especially Yukie Miura. I also thank Eric Valentine, David Palmer, and the entire production team at Greenwood Publishing for their continuous and intelligent support. Finally, to Dimitra, thanks for making everything possible and enjoyable.

1 The Income Statement INTRODUCTION The income statement reports the results of a firm's operations for the accounting period. Other labels used include statement of income, statement of earnings, or statement of operations. Two concepts of income exist: 1. The capital maintenance concept 2. The transactional approach According to the capital maintenance concept, income is earned after capital (physical or financial) is maintained. The capital maintenance concept of income is fully explored in Chapter 2. A more useful approach to the determination of income is the transactional approach. The transactional approach relies on accrual accounting where the financial impacts of financial transactions and events on a firm are recorded for the period in which they occur, rather than when cash is received or paid. This chapter examines the theoretical and practical issues underlying the determination and preparations of the income statement under accrual accounting. VIEWS OF ARTICULATION AND EARNINGS Articulation The relation between balance sheet, income statement, and statement of cash flows is based on a principle of articulation, in the sense that they are all part of the same measurement process.

2

Earnings Measurement, Determination, Management

FASB conceptual framework views articulation as an important feature of financial statements. Consider the following statements from Statement of Financial Accounting Concepts N o . 5: The financial statements of an entity are [a] fundamentally related set that articulate with each other and derive from the same underlying data. 1 A fully articulated set of several financial statements that provides those various kinds of information about an entity's financial position and changes in its financial position is necessary to satisfy the broad purposes of financial reporting. 2 Financial statements interrelate (articulate) because they reflect different aspects of the same transactions or other vents affecting an entity.3 Sterling suggests the following articulation test: Articulation requires that the sum of the separate effects of all events during a fiscal period equal the change in magnitude of the pertinent economic resources and obligations from the beginning to the end of the period. If the sum of the separate effects recognized does not equal the change in magnitude, it is conclusive evidence that these were additional events that occurred during the period that have not yet been recognized. The difference between the sum of separate effects recognized and the change in magnitude is the combined effects of the additional previously unrecognized events. The difference must be recognized prior to the issuance of financial statements. 4 Sterling again argues that articulation is a matter of the additivity of the selected attribute and provides the following example: The quantity of cash, for example, is additive and therefore a cash flow statement must articulate with a cash position statement if both statements are faithful representations. If the cash flow statement shows a net cash increase of X dollars while the cash position shows a difference between the beginning and ending amount that is different from X dollars, then at least one of the statements is not a faithful representation. Articulation is not a convention to be decided by the FASB but rather a factual question about the behavior of the phenomena. The cash flow statement must articulate with the cash position statement for the straightforward reason that the phenomena articulate. 5 Within the articulation principle, there are t w o alternative views of earnings: 1. The revenue-expense approach 2. The asset-liability approach

The Income Statement

3

Earnings As shown in Chapter 7, the asset-liability view (also called the balance sheet or capital maintenance view) holds that revenues and expenses result from changes in assets and liabilities. Revenues are increases in assets and decreases in liabilities; expenses are decreases in assets and increases in liabilities. The income statement is reduced to reporting and measuring the changes in net assets. The revenue/expense view, also called the income statement or matching view, holds that revenues and expenses result from the need for a proper matching. The view focuses primarily on the measurement of the earnings of the firm, rather than the increase or decrease in net capital. As a result the balance sheet contains not only assets and liabilities, but also deferred charges and credits that are residuals to be carried to future periods in order to ensure proper matching and avoid distortion of earnings. REVENUES A N D GAINS Nature of Revenues and Gains The literature distinguishes between t w o approaches to the nature of revenues: 1. An inflow concept 2. An outflow concept The inflow concept of revenue defines revenues as an inflow of assets or an increase in assets arising from the operational activities of the firm. It represents an asset-liability approach. It is also consistent with the following APB and FASB definition of revenue. Revenue—gross increases in assets and gross decreases in liabilities measured in conformity with generally accepted accounting principles that result from those types of profit-directed activities.6 Revenues are the inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major or central operations. 7 The outflow concept of revenue defines revenue as an outflow of goods and services, a result of selling products, rendering services, and disposing of services. It represents a revenue-expense approach. N o t e the following depiction of revenue.

4

Earnings Measurement, Determination, Management

Revenue results from the sale of goods and rendering of services and is measured by the charge made to customers, clients, or tenants for goods furnished to them. 8 In both concepts, revenue does not include gains in their definitions. They are nonrecurring income to be displayed separately in the financial statements under the current operating income concept, and under the allinclusive income concept. They have been defined as follows: Gains are increases in net assets from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity during a period except those that result from revenues or investments by owners. 9 Revenue Recognition Sprouse and M o o n i t z state that: revenues should be identified with the period during which the major economic activities necessary to the creation and disposition of goods and services have been accomplished provided objective measurements of the results of those activities are available. The two conditions, i.e., accomplishments of major economic activity and objectivity of measurement, are fulfilled at different stages of activity in different cases, sometimes as late as time of delivery of product or the performance of a service, in other cases, at an earlier point of time.10 The definition implies that the accomplishment of the major economic activities can take place at different times and periods, which makes it an a w k w a r d method. O n e alternative to the reporting of revenue at the time of accomplishment of the major economic activities is the critical event approach. Under the critical event approach, the revenue from the sale of a p r o d u c t or service is recognized in full at a critical event date when the most critical decision is made or the most difficult task is performed. The events or points in time for recognizing revenue are as follows: 1. During production 2. At the completion of production 3. At the time of sale 4. When cash is collected 5. Until a future event occurs Revenue

Recognition

during

Production

T h e accretion approach suggests the recognition of revenue during production. The best example is furnished by accounting for long-term contracts. Because the construction can take place for a long period a n d the

The Income Statement

5

firm needs to show income every year, the question of revenue recognition is crucial. Two approaches exist: 1. The percentage-of-completion method 2. The completed contract method The completed contract method recognizes profit only when the contract is completed. The percentage-of-completion method recognizes the profit each period during the life of the contract in proposition to the accomplishment, in terms of either input measures or output measures. The input measures include either: (a) the cost-to-cost method, where the percentage of completion is measured by a comparison of the costs incurred to date with the expected contractual total costs; or (b) the efforts-expended method, where the percentage of completion is measured by a comparison of the work performed to date, as measured by labor hours, labor dollars, machine hours, or material quantities, to the expected amount on the contract. The output measures rely on key indicators of accomplishment of the contract that reflect the results achieved to date, such as units produced, units delivered, value added, or units of works accomplished. Revenue Recognition at Completion of Production Revenue is recognized at the completion of production for certain agricultural and mining operations. For those operations, not only is the production process a crucial part of the firm's operations, but also (a) the products have an immediate marketability at quoted prices, given the existence of a determinable selling price, and (b) there is an interchangeability of units, or (c) the producer is unable to determine costs. This method of revenue recognition is, however, rare. Revenue Recognition at Time of Sale Revenue is recognized most often at the time of sale, when legal title is transferred and the amount of revenue can be estimated with reasonable certainty. This approach is best expressed in Chapter 1 of ARB 43: Profit (revenue) is deemed to be realized when a sale in the ordinary course of a business is effected, unless the circumstances are such that collection of the sales price is not reasonably assumed.11 Revenue Recognition Where Cash Is Collected The measurement of revenue subsequent to sale represents a revenueallocation approach. It takes place when:

6

Earnings Measurement, Determination, Management

1. the accurate measurement of the asset received in exchange in the transaction is impossible to measure; or 2. there is a likelihood of additional material expenses related to the transaction and that cannot be estimated with a reasonable degree of accuracy; or 3. there is no reliable basis for estimating the collectibility. Two methods are generally used for deferring revenue recognition: 1. The installment method 2. The cost-recovery method Under the installment method revenue is recognized at the time of cash collection and a portion of gross profit is recognized in proportion to the cash received. The cost-recovery method is similar to the installment method, except that no gross profit is recognized until the cost of the product sold has been recovered. Revenue Recognition Delayed Until a Future Event Occurs When there is insignificant transfer of risk and benefits of ownership, revenue is deferred until an event occurs that corrects the situation and transfers sufficient risks and benefits to the purchasers. Generally, the "deposit" method is used to defer the recognition of revenue, until exact determination is made of the event that transfers the sufficient risks and benefits to the purchasers. EXPENSES AND LOSSES Nature of Expenses and Losses In introducing expenses and losses, a distinction has to be made of costs as well. They are conceptually related. The term "cost" has different meanings to accountants, economists, engineers, and others facing managerial problems. Consider the following definitions from the cost accounting literature: The term cost would seem to refer to some type of measured sacrifice evolving from an operational sequence of events and centering upon a particular activity or product 12 Cost is a foregoing, measured in monetary terms, incurred or potentially to be incurred to achieve a specific objective.13 The amount, measured in money, of cash expended or other property transferred, capital stock issued, services performed, or a liability incurred, in consideration of

The Income Statement

7

goods and services received or to be received. Costs can be classified as unexpired or expired costs. Unexpired costs (assets) are those which are applicable to the production of future revenues . . . Expired costs are those which are not applicable to the production of future revenues, and for that reason are treated as deductions from current measures, or charged against retained earnings.14

The following excerpts, from case analyses of costs, may help explain the difference between cost, expense, loss, and asset: Case 1: The acquisition of resources with potential benefits results in the creation of assets or unexpired costs. Case 2: The use of the assets in the manufacturing process results in the cost of a product that is inventoried. The eventual selling of the product transforms this product out into an expense to be matched with sales. This is consistent with the following definitions of expense: Expense in the broadest sense includes all expired costs which are deductible from revenues.15 Expense—gross decrease in assets or gross increase in liabilities recognized and measured in conformity with generally accepted accounting principles that result from those types of profit-directed activities of an enterprise.16 Both definitions represent the traditional revenue-expense orientation. Case 3: The use of the assets in the selling and administrative processes results in an expense to be recognized for the period. This is consistent with the following definition of expense: Expenses are outflows or other using up of assets or incurrences of liabilities (or a combination of both) during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's major or central operations. 17 The FASB definition represents a strong asset-liability approach. Case 4: The decrease of the assets from peripheral or incidental transactions and events that are beyond the control of the firm results in a loss. This is consistent with the FASB definition of a loss: Losses are decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances

8

Earnings Measurement, Determination, Management

affecting the entity except those that result from expenses or distributions to owners.18 It appears from the above definitions that cost corresponds to a sacrifice resulting from the use of assets. A basic distinction should be m a d e between unexpired cost (asset) and expired cost (cost), as well as between cost and expense. According to the third definition, cost results from the use of assets t o w a r d the creation of revenues. " C o s t " also must be distinguished from " e x p e n s e . " The AICPA Accounting Research Study N o . 3 defines expense as follows: The decrease in net assets as a result of the use of economic services in the creation of revenues or the imposition of taxes by government units. Expense is measured by the amount of the decrease in assets or the increase in liabilities related to the production and delivery of goods and the rendering of services. . . . In its broadest sense expense includes all expired costs which are deductible from revenues. In income statements, distinctions are made between various types of expired cost by captions or titles including such terms as cost, expense, or loss: e.g. cost of goods or service sold, operating expenses, marketing and administrative expenses, and loss on sale of property. 19 The four cases indicate that events occur in the following sequence: 1. acquisition creates an asset; 2. manufacturing creates a cost of a product or activity; 3. equation-matching or allocating creates an expense; 4. misuse creates a loss. The three central accounting techniques to create an expense are matching, allocation, and expiration. Basically, there are three possible cases: 20 1. Costs that are directly associated with the revenue of the period and are matched against revenue 2. Costs that are associated with period in some basis other than a direct relationship with revenue and are allocated to the period 3. Costs that cannot, as a practical matter, be associated with any period and are expired and expensed immediately While the third case is straightforward, the first t w o cases require the use of t w o important accounting techniques: matching and allocation.

The Income Statement

9

Matching and Allocation M a t c h i n g is an accounting procedure that requires first a determination of revenues, and second a matching with expenses that represent the effort needed for the generation of the revenues: The problem of properly matching revenues and costs is primarily one of finding satisfactory bases of association—clues to relationships which unite revenue deductions and revenue. . . . Observable physical connections often afford means of tracing and assigning. It should be emphasized, however, that the essential test is reasonableness, in the light of all the pertinent conditions, rather than physical measurements. 21 The problem is corrected by a reliance on three basic principles of matching: (1) association of cause and effect, (2) systematic and rational allocation, and (3) immediate recognition. The association of cause and effect requires that matching be made on the basis of some discernible positive correlation of costs with revenues. O n e expression of this principle is the cost attach concept. As stated by Paton and Littleton: Ideally, all costs should be viewed as ultimately clinging to definite items of goods sold or services rendered. If this conception could be effectively realized in practice, the net accomplishment of the enterprise could be measured in terms of units of output rather than intervals of time. . . . In the more typical situation the degree of continuity of activity obtaining tends to prevent the basis of affinity which will permit convincing assignments, of all classes of costs incurred, to particular operations, departments, and—finally—items of produce. Not all costs attach in a discernible manner, and this fact forces the accountant to fall back upon a time-period as the unit for associating certain expenses with certain revenues.22 As the statement indicates, the association of cause and effect constitutes a difficult principle, if not an impossible one. The allocation of costs over time is another way of implementing the matching principle. It is a partitioning process to separate classifications or periods of time, so that the periods receive the correct benefits or services of the asset, and in the process bear their share of the costs of the benefits received. A systematic and rational allocation is presumed to be used so that " t h e allocation method used should appear reasonable to an unbiased observer and should be followed systematically." 2 3 T o be theoretically justified, allocations are expected to meet the following three criteria: 1. Additivity: the total amount is allocated, so that the sum of the allocated amount is equal to the whole.

10

Earnings Measurement, Determination, Management

2. Unambiguity: the allocation method should result in a unique allocation, i.e., should result in only one set of parts. 3. Deferrability: the allocation method selected is clearly superior to other methods on the basis of convincing arguments.24 The three criteria are generally difficult to meet, which renders most allocations arbitrary and impossible. They are incorrigible because they can't be verified or refuted by objective, empirical means. They do not correspond to anything in the real world. As Thomas states: Conventional allocation assertions do not refer to real world partitioning; when an incorrigible allocation divides an accounting total, there is no reason to believe that this reflects the division of an external total into dependent parts. . . . Conventional allocation assertions do not refer to real world economic phenomena, but only to things in asserter's and readers' minds.25 One solution to this dilemma is to use allocation-free financial statements such as based on cash-flow statements, exit-price systems, and certain types of replacement-cost systems. In spite of these criticisms and limitations, in practice costs continue to be allocated to serve a variety of needs, such as inventory value determination, income determination, pricing and production determination, and meeting regulatory requirements. The immediate recognition of expenses is used for costs viewed in the current period or in previous periods that are assumed to no longer provide future benefit, or because there is a high degree of uncertainty about the existence of future benefits. CURRENT OPERATING VERSUS ALL-INCLUSIVE INCOME Income is generally measured for short periods of time, to provide users with useful information about the financial performance of the firm. What is to be included in the income figure has led, however, to two basic concepts of income—the current operating concept and all-inclusive concept of income. The current operating concept of income includes in the income statement only the results of decisions of the current period and arising from normal operations and reports in the retained earnings statement nonoperating items. The focus on the operating items in the current operating concept of income derives from their characteristics as recurring regular and predictable features of the operations of the firm. The advocates of the current operating concept of income argue that the end result is more meaningful and useful for interperiod and interfirm companies and for predicting possible future income and dividend flows if items extraneous to operating decisions are excluded. There is less risk of the financial statement users

The Income Statement

11

being misled or confused if the irregular, nonoperating items are excluded from the income statement. The all-exclusive concept of income includes all the components of comprehensive income in the income statement, i.e., all the items that affected the net increase or decrease in stockholders' equity during the period, with the exception of capital transactions. The advocates of the all-exclusive concept of income argue that the concept is viable because: 1. net income of the firm for the life of the firm should be equal to the sum of the annual report net incomes; 2. income smoothing may be checked by the inclusion of all income charges and credits; 3. a better picture of the total performance of the firm is conveyed, especially when both recurring and unusual, infrequently occurring items are displayed separately in the same income statement. The official position in this issue has varied over time. Prior to the issuance of APB 9, the AICPA favored the current operating concept of income. With the issuance of APB 9, Reporting the Results of Operations, the trend went toward the all-exclusive concept of income, with the opinion's conclusion that income should include all items of profit or loss during the period, with the exception of certain material prior-period adjustments that should be reflected as adjustments of the beginning retained earnings balance. The tilt toward the all-inclusive concept of income continued with the issuance of APB Opinions No. 15, 20, and 30, requiring disclosure of the earnings per share, cumulative effects of changes in accounting principles, extraordinary items, and results from discontinued operations on the income statement. The FASB has definitely adopted an all-inclusive concept of income in its definition of "comprehensive income" as part of its conceptual framework. FASB Statement of Concept No. 6 defines "comprehensive income" as follows: Comprehensive income is the change in equity of a business entity during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during the period except those resulting from investments by owners and distributions to owners.26 FORMAT APPROACHES The display of the operating of the income statement differs from one firm to another, using variations of two basic forms, the single-step format and the multiple-step format. The single-step income statement includes two broad groups, revenues and expenses. The total revenues include operating revenues, other reve-

12

Earnings Measurement, Determination, Management

nues, and gains not meeting the criteria of being extraordinary. The total expenses include the cost of goods sold, operating expenses, other expenses, and income tax expenses. The difference between the total revenues and total expenses is the income from continued operations. An example of a single-step format is shown in Exhibit 1.1. The single-step format is favored because of its simplicity and flexibility in reporting. The multiple-step format proceeds through several steps to arrive at income from continuing operations. In the first step the cost of goods sold is deducted from net sales, to produce gross profit or gross margin on sales. In the second step, the operating expenses are deducted from gross profit to arrive at operating income. The "other revenues and expenses," the nonoperating items, are then deducted (or added) to operating income to derive the pretax income from continuing operations. In the final step, income tax expenses are deducted from the pretax income from continuing operations to arrive at income before continuing operations. An example of a multipleset income statement is shown in Exhibit 1.2. These additional subclassifications on the multiple-step income statement are deemed more informative and useful to investors, creditors, and other users. The multiple-step income statement is becoming more popular, in spite of two potential limitations. The first limitation pertains to the potential different classifications of operating and nonoperating items by different firms, leading to noncomparable income statements. The second limitation pertains to the potential misleading inference from the multiplestep income statement that the recovery of expense is essential.27 EXTRAORDINARY ITEMS The ability to distinguish between normal recurring components of comprehensive income and nonrecurring items is essential to a sound evaluation of the results of current and past activities and the prediction of future results. And therein lies the importance of extraordinary items, as they may affect this ability. The first explicit guidance on accounting for extraordinary items came in APB No. 9, which required the explicit display in a specifically designated section of the income statement.28 The following definition of "extraordinary items" was provided: events and transactions of material effect which would not be expected to recur frequently and which would not be considered as recurring factors in any evaluation of the ordinary operating processes of the business.29 The ambiguity of the definition, as well as the need to ensure a more uniform interpretation of the provisions, led the Accounting Principles Board to issue APB No. 30, Reporting the Results of Operations, where extraor-

Exhibit 1.1 Karabatsos Corporation Single-Step Income Statements for the Year Ended December 31, 1991

Revenues Sales revenue (net of $5,000 discounts and $2,000 returns and allowances) Interest Revenue Dividend Revenue

153,000 2,000 1.00Q

Total Revenues

156,000

Expenses Cost and Goods Sold Selling Expenses General Administrative Expenses Depreciation Expenses Loss on Sales of Equipment Interest Expense Income Tax Expense

80,000

10,000 15,000 7,000

5,000 2,000 7r000

Total Expenses

126,000

IncomefromContinuing Operations ResultsfromDiscontinued Operations Incomefromoperations of discontinued segment A (net of $2,000 income taxes) Less on disposal of segment A (net of $3,000 income tax credit)

30,000 4,500 (2r000^

(2,500)

Income before extraordinary items Extraordinary lossfromexplosion (net of $700 income tax credit) Cumulative Effect on prior years' income of change in depreciation method (net of $800 income taxes) 2r400

27,500 (2,000)

Net Income

27,900

Components of Income

Earnings per Share

Income from continuing operations Resultsfromdiscontinued operations Extraordinary LossfromExplosion Cumulative Effect of prior Years' Income of Change in in depreciation method

(6.00) (0.50) (0.40)

Net Income

5.58

13

0.48

Exhibit 1.2 Karabatsos Corporation Multiple-Step Income Statements for the Year Ended December 31, 1991 Sales Revenue Less: Sales returns and allowances Sales discounts

5,000 2,000

160,000 7.000

Net Sales Cost of Goods Sold

153,000

Gross Profit

73,000

SQ.QQQ;

Operating Expenses Selling Expenses General and Administrative Expenses Depreciation Expense

10,000 7,000

Operating Income

15,000 32,000 41,000

Other Revenues and Expenses Interest Revenue Dividend Loss on Sales of Equipment Interest Expense

2,000 1,000 (5,000) (2,000)

(4,000)

Pretax Incomefromcontinuing operations Income tax expense

37,000 7,000

Incomefromcontinuing operations

30,000

Resultsfromdiscontinued operations Incomefromoperations of discontinued segment A (net of $2,000 income taxes) Loss on disposal of segment A (net of $3,000 income tax credit)

4,500 (2,000)

Income before extraordinary items Extraordinary lossfromexplosion (net of $700 income tax credit) Cumulative Effect on prior years' income of change in depreciation method (net of $800 income taxes)

27,500 (2,000)

Net Income

27,900

2.400

Earnings per Share

Components of Income Incomefromcontinuing operations Resultsfromdiscontinued operations Extraordinary LossfromExplosion Cumulative Effect of prior Years' Income of Change in in depreciation method

(6.00) (0.50) (0.40) 0.48 5.58

Net Income 14

The Income Statement

15

dinary item were characterized as both unusual in nature and infrequent in occurrence. 3 0 These characteristics were defined as follows: Unusual in nature—The underlying event or transaction should possess a high degree of abnormality and be of a type clearly unrelated to, or only incidentally related to, the ordinary and typical activities of the entity, taking into account the environment in which the entity operates. Infrequency of occurrence—The underlying event or transaction should be of a type that would not reasonably be expected to recur in the foreseeable future, taking into account the environment in which the entity operates. 31 Items and transactions defined as not meeting this definition included writedowns and write-offs of receivables, inventories, equipment leased to others, deferred research and development costs, or other intangible assets; gains or losses in foreign currency transactions or devaluations; gains or losses on disposal of segments of a business; other gains or losses on the sale or a b a n d o n m e n t s of accruals on long-term contracts. The newer criteria for extraordinary items made such items rare for a while. However, some FASB pronouncements are bringing them back. Examples include: 1. FASB Statement No. 4 requirement that a gain or loss in the extinguishment of debt be shown separately as an extraordinary item; 2. FASB Statement No. 15 requirement that a gain on restructuring debt be reported as an extraordinary item by the debtor; 3. FASB Statement No. 44 requirement that the initial write-off unamortized costs of interstate operating rights impaired by the Motor Carrier Act of 1980 be reported as an extraordinary item. RESULTS FROM DISCONTINUED OPERATIONS A segment of a business refers to a component of an entity whose activities represents a separate major line of business or class of customers. By discontinued operations is meant the operation of a segment that has been sold, a b a n d o n e d , spun off, or otherwise disposed of. A gain or loss is expected to be m a d e from the discontinued operations at the measurement date. It includes t w o factors: 1. the income (or loss) from operations of the discontinued segment from the measurement date until disposal date; 2. the loss (or gain) on the disposal. APB N o . 30 requires that the results from discontinued operations be reported net of tax on the income statement after the income from continuing operations, but before extraordinary items. The timing of the recognition

16

Earnings Measurement, Determination, Management

of the deferrals is dependent upon whether the results are gain or loss. If a loss is expected, it is recognized at the measurement date, whereas a gain is deferred and recognized on the disposal date, which is in accordance with the general principle of conservatism.

PRIOR PERIOD ADJUSTMENTS T o be classified as prior period adjustments, APB Opinion N o . 9 required events and transactions to be: a. specifically identified and directly related to the business activities of the particular prior period, b. not attributable to economic events occurring subsequent to the date of the financial statements for the prior period, c. dependent primarily on determination by persons other than management, d. not susceptible of reasonable estimation prior to such determinations. 32 In response to the restrictive nature of these requirements, the Securities and Exchange Commission (SEC) released on June 8, 1976 Staff Bulletin N o . 8, which excluded charges or credits resulting from litigation from being treated as prior period adjustments. Subsequently, the FASB issued its Statement N o . 16, Prior Period Adjustments, in which it limited prior period adjustments to the following: a. Correction of an error in the financial statements of a prior period b. Adjustments that result from the realization of income tax benefits of reacquisition operating loss carry-forwards of purchased subsidiaries33 With regard to certain changes, in accounting principles, prior period restatement (adjustment) is required, instead of a cumulative effect of adjustment, for the following cases: 1. a change from the LIFO inventory cost flow method to another method; 2. a change in the method of accounting for long-term construction-type contracts; 3. a change to or from the "full cost" method of accounting used in the oil and gas industry; 4. a change from retirement-replacement-betterment accounting to depreciation accounting from railroad track structures; 5. a change from the cost method to the equity method for investments in common stock.

The Income Statement

17

ACCOUNTING CHANGES Three types of accounting changes and errors are identified in APB Opinion No. 20, as follows: 1. Change in accounting principle: This type of change occurs when a firm adopt a generally accepted accounting principle that differs from the one previously used for reporting purposes. Examples include a change from FIFO to LIFO inventory cost flow assumptions, or a change from straight-line to accelerated depreciation. 2. Change in accounting estimate: This type of change is the result of the periodic presentation. The preparation of financial statements requires estimation of future events, and such estimates are subject to periodic review. Examples of such change include the changes in the life of depreciable assets and the estimated collectibility of receivables. 3. Change in reporting entity: This type of change is caused by changes in the reporting units, which may be the result of consolidations, changes in specific subsidiaries, or a change in the number of companies consolidated. 4. Errors: Errors are not accounting changes. They are the results of mistakes or oversights such as the use of incorrect accounting methods or mathematical miscalculation.34 All changes in accounting principles, except those specifically excluded by APB Opinion No. 20 and other APB Opinions and FAST statements, are accounted for as a cumulative effect change in the comprehensive income on the income statement of the period of change, in a separate section entitled "accounting changes." The effects of adopting the new accounting principle on income before extraordinary items and on net income (and on related per share amounts) of the period of change are disclosed in the notes to the financial statements. Furthermore, income before extraordinary items and net income computed on a pro forma basis is shown in the income statements of all periods presented as if the newly adopted accounting principles were applied during all periods affected.35 A change in accounting estimates is accounted for in the period of change if the change affects that period only, or in the period of change and future periods if the change affects both. 36 A change in accounting entity is accounted for retroactively by prior period restatement of all financial statements as if the new reporting entity had existed for all periods. A description of the change, the reason for it, as well as the effect of the change on income before extraordinary items, and related earnings per share are disclosed for all periods presented.37 An error is accounted for retroactively as prior period adjustments and therefore is excluded from the determination of net income for the period, under the provisions of FAST Statement No. 16. 38

18

Earnings Measurement, Determination, Management

EARNINGS PER SHARE Earnings per share is a summary that can assuredly communicate considerable information about a firm's performance. To establish consistency in earnings per share computations and promote comparability of accounting information, APB Opinion No. 15 was issued to require the disclosure of earnings per share and provide guidelines for computations. 39 The calculations are examples that the AICPA published shortly after a 189-page document that contains unofficial accounting interpretations for the computation of earnings per share. 40 The computation of earnings per share is different for two types of capital structures—simple and complex. A simple capital structure is one that consists of "only common stocks or includes no potentially dilutive convertible securities, options, warrants, or other rights that upon conversion or exercise could in the aggregate dilute earnings per share." 41 In the case of the simple capital structure, the earnings per share is computed by dividing the actual earnings applicable to the common shares by the weighted average number of shares outstanding. A complex capital structure includes in addition to common stocks such items as convertible preferred stocks and bonds, stock options and warrants, participating securities and two-class stocks, and contingent shares that are potentially a common stock equivalent. In the case of the complex capital structure, two earnings per share figures are required: 1. A primary earnings per share that is based on the outstanding common shares and the common stock equivalents that have a dilutive effect. 2. A fully diluted earnings per share that reflects the dilution of earnings per share that would have occurred if all contingent issuances of common stock that would have individually reduced earnings per share had taken place.42 The primary earnings per share is computed by dividing the earnings applicable to the common shares by weighted average number of shares of common stock and common stock equivalents (convertibles that meet a yield test plus warrants and stock options). The fully diluted earnings per share are equivalent to the earnings that would result if all potential dilution took place.43

Earnings per share is not, however, the only summary indicator that can be provided to users. An FASB report identified the potential for other summary indicators that can communicate considerable information about both a firm's performance and its financial position. Examples include return on investment and cash flow per share. CONCLUSIONS This chapter covered the conceptual and practical issues associated with the income statement prepared on the basis of transactional approach. Al-

The Income Statement

19

though the FASB seems to be bringing a lot of refinement of the document t o w a r d a clear determination of comprehensive income, a lot remains to be done, with a steady move toward an asset-liability approach to the financial statements.

NOTES 1. Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises (Stamford, CT: FASB, 1984), para. 5. 2. Ibid., para. 12. 3. Ibid., para. 23. 4. Robert R. Sterling, An Essay on Recognition, R. J. Chambers Research Lecture, 1985 (Sydney: The University of Sydney, Accounting Research Center, 1987), p. 82. 5. Ibid., pp. 57-58. 6. Accounting Principles Board, Statement No. 4, Basic Concepts and Accounting Principles underlying Financial Statements of Business Enterprises (New York: AICPA, 1970), para. 34. 7. Financial Accounting Standards Board, Statement of Financial Accounting Concept No. 6. Elements of Financial Statements (Stamford, CT: 1985), para. 78. 8. Committee on Terminology, Accounting Terminology Bulletin No. 2, Proceeds, Revenue, Income, Profit and Earnings (New York: AICPA, 1955), para. 5. 9. Financial Accounting Standards Board, Elements of Financial Statements (Stamford, CT: FASB, 1973), op. cit., para. 88. 10. Robert T. Sprouse and Maurice Moonitz, Accounting Research Study No. 3, A Tentative Set of Broad Accounting Principles for Business Enterprises (New York: AICPA, 1968), p. 47. 11. Committee on Accounting Procedure, ARB No. 43, Restatement and Revision of Accounting Research Bulletin (AICPA, 1953), Chapter 1, para. 1. 12. Wilber E. Haseman, "An Interactive Framework," The Accounting Review (October 1968), pp. 738-752. 13. American Accounting Association, Committee on Cost Concepts and Standard, "Report of the Committee on Cost Concepts and Standards," The Accounting Review (April 1952), p. 176. 14. Accounting Principles Board, Statement No. 4, Basic Concepts and Accounting Principles underlying Financial Statements of Business Enterprises (New York: AICPA, 1970). 15. Committee on Terminology, Accounting Terminology Bulletin No. 4, Proceeds, Revenue, Income, Profit and Earnings (New York: AICPA, 1955), para. 134. 16. Accounting Principles Board, Statement No. 4, op. cit., para. 134. 17. Financial Accounting Standards Board, Statement of Financial Accounting Concept No. 6, Elements of Financial Statements (Stamford, CT: FASB, 1985), para. 80. 18. Ibid. 19. R. T. Sprouse and M. Moonitz, Accounting Research Study No. 3, A Ten-

20

Earnings Measurement, Determination, Management

tative Set of Broad Accounting Principles for Business Enterprises (New York: AICPA, 1962), p. 25. 20. Accounting Principles Board, Statement No. 4, op. cit., para. 155. 21. William Paton and A. C. Littleton, An Introduction to Corporate Accounting Standards (Evanston, IL: American Accounting Association, 1940), p. 71. 22. Ibid. 23. Accounting Principles Board, Statement No. 4, op. cit., para. 19. 24. Arthur L. Thomas, "The Allocation Problem in Financial Accounting Theory," Studies in Accounting Research No. 3 (Sarasota, FL: AAA, 1969), pp. 6-15. 25. Arthur L. Thomas, "The Allocation Problem. Part Two," Studies in Accounting Research No. 9 (Sarasota, FL: AAA, 1974), p. 3. 26. Financial Accounting Standards Board, Statement of Financial Accounting Concept No. 1, Elements of Financial Statements (Stamford, CT: FASB, 1978), para. 45. 27. Ibid. 28. Accounting Principles Board, Opinion No. 9, Reporting the Results of Operations (New York: American Institute of Certified Public Accountants, 1966). 29. Ibid., para. 21. 30. Accounting Principles Board, Opinion No. 30, Reporting the Results of Operations (New York: American Institute of Certified Public Accountants, 1973). 31. Ibid., para. 19-20. 32. Accounting Principles Board, Opinion No. 9, op. cit., para. 23. 33. Financial Accounting Standards Board, Statement No. 16, Prior Period Adjustments (Stamford, CT: FASB, 1977), para. 11. 34. Accounting Principles Board, Opinion No. 20, Accounting Changes (New York: AICPA, 1971). 35. Ibid., paras. 18-22. 36. Ibid., para. 31. 37. Ibid., paras. 34-35. 38. Financial Accounting Standards Board, Statement No. 16, op. cit. 39. Accounting Principles Board, Opinion No. 15, Earnings Per Share (New York: AICPA, 1969). 40. J. T. Ball, "Computing Earnings per Share," Unofficial Accounting Interpretations of APB Opinion No. 15 (New York: AICPA, 1970). 41. Accounting Principles Board, Opinion No. 15, op. cit., para. 14. 42. Ibid., para. 15. 43. P. A. Boyer and C. H. Gibson, "How about Earnings per Share?" The CPA Journal Vol. 2 (1979) p. 16-21.

SELECTED READINGS Accounting Terminology Bulletin No. 4. Cost, Expense and Loss. AICPA, 1957. American Accounting Association. A Tentative Statement of Accounting Principles underlying Corporate Financial Statements. AAA, 1936. APB Opinion No. 4. Basic Concepts and Accounting Principles underlying Financial Statements of Business Enterprises. AICPA, 1970. APB Opinion No. 9. Reporting the Results of Operations. AICPA, 1966.

The Income Statement

21

APB Opinion No. 17. Intangible Assets. AICPA, 1970. APB Opinion No. 20. Accounting Changes. AICPA, 1971. APB Opinion No. 30. Reporting the Results of Operations. AICPA, 1973. Committee on Accounting Procedure. Restatement and Revision of Accounting Research Bulletins. ARB No. 43. AICPA, 1953. Committee on Terminology. Accounting Terminology Bulletin No. 2. Proceeds, Revenue, Income, Profit, and Earnings. AICPA, 1953. FASB Discussion Memorandum. An Analysis of Issues related to the Conceptual Framework of Financial Reporting: Elements of Financial Statements and Their Measurement. Stamford, CT: FASB, 1976. Financial Accounting Standards Board. Statement of Financial Accounting Standards No. 2. Accounting for Research and Development Costs. Stamford, CT: FASB, 1974. . Statement of Financial Accounting Concepts No. 6. Elements of Financial Statements. Stamford, CT: FASB, 1973. . Statement of Financial Accounting Standards No. 7. Accounting and Reporting by Development Stage Enterprises. Stamford, CT: FASB, 1975. . Statement of Financial Accounting Standards No. 12. Accounting for Certain Marketable Securities. Stamford, CT: FASB, 1975. . Statement of Financial Accounting Standards No. 96. Accounting for Income Taxes. Stamford, CT: FASB, 1980. Frishkoff, Paul. Reporting of Summary Indicators: An Investigation of Research and Practice. Stamford, CT: FASB, 1981. Horngren, Charles T. "How Should We Interpret the Realization Concept?" The Accounting Review (April 1965): 323-333. Jeanicke, Henry R. Survey of Present Practices in Recognizing Revenues, Expenses, Gains, and Losses. Stamford, CT: FASB, 1981. "Matching Concept." The Accounting Review (April 1965): 368-372. Mobley, Sybil C. "The Concept of Realization: A Useful Device." The Accounting Review (April 1966): 292-296. Myers, John H. "Revenue Realization, Going-Concern and Measurement of Income." The Accounting Review (April 1959): 232-238. Philips, G. Edwards. "The Accretion Concept of Income." The Accounting Review (January 1963): 14-25. "The Realization Concept." The Accounting Review (April 1965): 312-322. Sprouse, R. T., and M. Moonitz. Accounting Research Study No. 3. A Tentative Set of Broad Accounting Principles for Business Enterprises. New York: AICPA, 1962. Thomas, Arthur L. Michigan Business Reports No. 49. Revenue Recognition. Ann Arbor: Bureau of Business Research, Graduate School of Business Administration, University of Michigan, 1966. . Studies in Accounting Research No. 3. The Allocation Problem. Sarasota, FL: American Accounting Association, 1974.

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2 Earnings Measurement and Price Level Changes Income may be recognized only after "capital" has been kept intact. Consequently, income measurement depends on the particular concept of capital maintenance that is chosen. The various concepts of capital maintenance imply different ways of evaluating and measuring the elements of financial statements. Thus, both income determination and capital maintenance are defined in terms of the asset-valuation base used. A given assetvaluation base determines a particular concept of capital maintenance and a particular income concept. An asset-valuation base is a method of measuring the elements of financial statements, based on the selection of both an attribute of the elements to be measured and the unit of measure to be used in measuring that attribute. Four attributes of all classes of assets and liabilities that may be measured are: (1) historical cost, (2) current entry price (for example, replacement cost), (3) current exit price (for example, net realizable value), and (4) capitalized or present value of expected cash flows. The two units of measure that may be used are units of money and units of purchasing power. Combining the four attributes and the two units of measure yields the following eight alternative asset-valuation and income-determination models. 1. Historical-cost accounting measures historical cost in units of money. 2. Replacement-cost accounting measures replacement cost (that is, current and entry price) in units of money. 3. Net-realizable-value accounting measures net realizable value (that is, current exit price) in units of money.

24

Earnings Measurement, Determination, Management

4. Present-value accounting measures present value in units of money. 5. General price-level accounting measures historical cost in units of purchasing power. 6. General price-level replacement-cost accounting measures replacement cost in units of purchasing power. 7. General price-level net-realizable-value accounting measures net realizable value in units of purchasing power. 8. General price-level present-value accounting measures present value in units of purchasing power. Each of these alternatives yields a different financial statement that imparts a different meaning and relevance to its users. In this chapter, w e will evaluate these alternatives using a simplified example to enhance conceptual clarity a n d comparability a m o n g the approaches. The nature of the differences a n d the basis of comparison a m o n g the results of the various alternatives will also be highlighted. T H E N A T U R E OF THE DIFFERENCES The differences a m o n g the alternative asset-valuation and incomedetermination models arise from the different attributes to be measured and the units of measure to be used. W e will examine each characteristic of the elements of the financial statements in the following sections. Attributes to Be Measured The attributes of assets and liabilities refer to w h a t is being measured. First w e will define the four attributes to be measured: 1. Historical cost refers to the amount of cash-equivalent paid to acquire an asset, or the amount of cash-equivalent liability. 2. Replacement cost refers to the amount of cash or cash-equivalent that would be paid to acquire an equivalent or the same asset currently, or that would be received to incur the same liability currently. 3. Net realizable value refers to the amount of cash or cash-equivalent that would be obtained by selling the asset currently, or that would be paid to redeem the liability currently. 4. Present or capitalized value refers to the present value net cash flows expected to be received from use of the asset, or the net outflows expected to be disbursed to redeem the liability. W e m a y classify these attributes in three ways: 1. These measures may be classified with respect to whether they focus

Earnings Measurement and Price Level Changes

25

on the past, present, or future. Historical cost focuses on the past, replacement cost and net realizable value focus on the present, and present value focuses on the future. 2. These measures may be classified with respect to the kind of transactions from which they are derived. Historical cost and replacement cost concern the acquisition of assets, or the incurrence of liabilities; net realizable value and present value concern the disposition of assets, or the redemption of liabilities. 3. This classification refers to the nature of the event that originates the measure. Historical cost is based on an actual event, present value is based on an expected event, and replacement cost and net realizable value are based on hypothetical events. One question that we will examine in this chapter is: What attribute or attributes of the elements of financial statements should be measured in financial accounting or reporting?

Units of Measure Financial accenting measurements can be made in one of two units of measure: (1) units of money, or (2) units of general purchasing power. Similarly, each of the four attributes we have defined is measurable in either units of money or units of general purchasing power. In the United States and most other countries, conventional financial statements are expressed in units of money. Given the continuous decline of purchasing power of the dollar, however, another unit of measure—the unit of purchasing power—is frequently presented as a preferable alternative, because it recognizes changes in the general price level. Do not confuse the general price level with either the specific price level or the relative price level. A change in the general price level refers to a change in the prices of all goods and services throughout the economy; the reciprocal of such changes would be a change in the general purchasing power of the monetary unit. A change in the specific price level refers to a change in the price of a particular product or service. Current-value accounting differs from historical-cost accounting in that the former recognizes changes in the specific price level on the basis of either replacement cost or net realizable value. Finally, a change in the relative price level of a commodity refers to the part of the specific price change that remains after the effects of the general price-level change have been eliminated. Thus, if all prices increase by 32 percent and the price of a specific good increases by 10 percent, the relative price change is only 20 percent, or (132/110) - 1. All three types of price changes may be incorporated in the assetvaluation and income determination models. Note that both historical cost

26

Earnings Measurement, Determination, Management

and current value are expressed in units of money and that general pricelevel restatements may be made for both. Another question that we will examine in this chapter is: What unit of measure should be used to measure any particular attribute of the elements of financial statements? BASIS FOR COMPARISON AND EVALUATION We have established that the alternative accounting models (historicalcost accounting, general price-level accounting, replacement-cost accounting, general price-level-adjusted replacement-cost accounting, netrealizable-value accounting, present-value accounting, and general pricelevel-adjusted present-value accounting) are based on a choice of one of four available attributes (historical cost, replacement cost, net realizable value, and present value) and one of two available units of measure (units of money and units of general purchasing power). Now, we will compare the models on the basis of whether they avoid timing errors and avoid measuring-unit errors, and we will evaluate them in terms of interpretability1 and relevance. Although theoretically considered the best accounting models, the present-value models will not be included in our comparison and evaluation owing to their recognized practical deficiencies. First, present-value models require the estimation of future net cash receipts and the timing of those receipts, as well as selection of the appropriate discount rates. Second, when applied to the valuation of individual assets, these models require the arbitrary allocation of estimated future net cash receipts and the timing of those receipts, as well as selection of the appropriate discount rates. Third, when applied to the valuation of individual assets, present-value models require the arbitrary allocation of estimated future net cash receipts among the individual assets.2 Owing to this lack of objectivity, present-value models have been largely rejected as impractical. In this chapter, we will compare and evaluate the remaining accounting models. The criteria for comparison and evaluation will be examined next.

Timing Errors The criteria for determining what attribute or attributes of the elements of financial statements should be measured in financial accounting and reporting should favor the attribute that avoids timing errors. Timing errors result when changes in value occur in a given period but are accounted for and reported in another period. A preferable attribute would be the recognition of changes in value in the same period that the changes occur. Ideally, "profit is attributable to the whole process of business activity." 3

Earnings Measurement and Price Level Changes

27

Measuring-Unit Errors The criteria for determining what unit of measure should be applied to attributes of the elements of financial statements should favor the unit of measure that avoids measuring-unit errors. Measuring-unit errors occur when financial statements are not expressed in units of general purchasing power. A preferred measuring unit would recognize the general price-level changes in the financial statistics. Interpretability Our first criterion for evaluation is the interpretability of the accounting model. In other words, the resulting statistics should be understandable in terms of both meaning and use. According to Sterling, When an attribute involves an arithmetical calculation, the "empirical interpretation" of that attribute requires that it be placed in an "if. . . then . . ." statement.4 Thus, for an accounting model to be interpretable, it must be placed in an "if. . . then . . ." statement to convey to the user an understanding of its meaning as well as to demonstrate one of its uses. Given that we have two possible units of measure, the interpretation of the accounting models, by definition, will be one of the following: 1. If the accounting model measures any of the attributes in units of money, its results are expressed in the number of dollars (NOD) or, as Chambers refers to it, the number of odd dollars (NOOD). 5 2. If the accounting model measures historical cost in units of general purchasing power, its results still are expressed in NOD. 3. If the accounting model measures current values in units of general purchasing power, its results are expressed in the command of goods (COG) or, as Chambers refers to it, the command of goods in general (COGG). 6 Relevance The second criterion for evaluation is the relevance of the accounting model. In other words, the resulting financial statements should be useful. Sterling defines relevance as follows: If a decision model specifies an attribute as an input or as a calculation, then that attribute is relevant to that decision model.7 Because decision models are not available or are not well specified, relevance focuses on what ought to be measured. For our purposes, the prob-

28

Earnings Measurement, Determination, Management

lem is to decide whether NOD or COG constitutes the relevant measure. From a normative point of view, the answer is straightforward. Because COG expresses changes in both the specific and general price levels, it should be considered the most relevant attribute. COG expresses the goods that could be commanded in either the input or the output market. Thus, COG can be defined, in terms of the input market, as price-level-adjusted replacement-cost or, in terms of the output market, as price-level-adjusted net realizable value. ILLUSTRATION OF THE DIFFERENT ACCOUNTING MODELS To illustrate the different accounting models, we will consider the simplified case of the DeCooning Company, which was formed January 1, 19X6, to distribute a new product called "Omega." Capital is composed of $3,000 equity and $3,000 liabilities that carry a 10 percent interest. On January 1, the DeCooning Company began operations by purchasing 600 units of Omega at $10 per unit. On May 1, the company sold 500 units at $15 per unit. Changes in the general and specific price levels for the year 19X6 are: January 1

May 1

December 31

Replacement cost

$10

$12

$13

Net realizable value

—

15

17

General price-level index

100

130

156

A brief description of each accounting model follows, accompanied by illustrations using the given data. Alternative Accounting Models Expressed in Units of Money To illustrate and isolate only the timing difference, first we will present the alternative accounting models that do not reflect changes in the general price level. These models are (1) historical-cost accounting, (2) replacementcost accounting, and (3) net-realizable accounting. The income statements and the balance sheets for 19X6 under the three accounting models are shown in Exhibit 2.1 and 2.2, respectively. Historical-Cost

Accounting

Historical-cost accounting, or conventional accounting, is characterized primarily by (1) the use of historical cost as the attribute of the elements of financial statements, (2) the assumption of a stable monetary unit, (3) the matching principle, and (4) the realization principle.

Earnings Measurement and Price Level Changes

29

Exhibit 2.1 DeCooning Company Income Statements for the Year Ended December 31, 19X6 Historical

Replacement Net Realizable

Cost

Cost

Value

Revenues

$7,500a

$7,500

$9,200 b

Cost of Goods Sold

$5,000°

$6.000d

$7r300e

$2,500

$1,500

$1,900

300

300

300

$2,200

$1,200

$1,600

Gross Margin Interest (10%) Operating Income Realized Holding Gains and Losses

(included above)

i,ooof

1,000

Unrealized Holding Gains and Losses

(not applicable)

300 8

300

General price-Level Gains and Losses

(not applicable)

(not applicable)

$2,200 .

$2,500

(not applicable) $2r900

a: 500 X $15 = $7,500 b: 7,500 + ($17 X 100) = $9,200 c: 500 X $10 = $5,000 d: 500 X $12 = $6,000 e: 6,000 + ($13 X 100) = $7,300 f: 500 ($12 - $10) = $1,000 g: 100 ($13 - $10) = $300

Accordingly, historical-cost income, or accounting income, is the difference between realized revenues and their corresponding historical cost. As shown in Exhibit 2.1, accounting income is equal to $2,200. What does this figure represent to the DeCooning Company? Generally, it is perceived as a basis for the computation of taxes and dividends and for the evaluation of performance. Its possible use in various decision models results from the unconditional and long-standing acceptance of this version of income by the accounting profession and the business world. This attachment to accounting income may be explained primarily by the fact that it is objective, verifiable, practical, and easy to understand. Accountants and business people may prefer accounting income over other measures of income owing to its practical advantages and the concern that confusion could result from the adoption of another accounting model. Despite these practical advantages, both timing and measuring-unit er-

30

Earnings Measurement, Determination, Management

Exhibit 2.2 DeCooning Company Balance Sheet for the Year Ended December 31, 19X6 Historical

Replacement

Net Realizable

Cost

Cost

Value

$7,200

$7,200

$7,200

Assets Cash Inventory Total Assets

1.000

U0Q a

l,7Q0b

$8.200

$8,500

$3,900

$3,000

$3,000

$3,000

3,000

3,000

3,000

2,200

2,200°

2,200C

Equities Bonds (10%) Capital Retained Earnings Realized Unrealized Total Equities

(not applicable^ $8.200

300 $8,500

700 d $8,900

a: 100 X $13 = $1,300 b: 100 X $17 = $1,700 c: May be divided into Current Operating Profit ($1,200) and Realized Holding Gains and Losses ($1,000). d: Unrealized Operating Gain $400 ($1,700 - $1,300) 4- Unrealized Holding Gain $300

rors are reflected in DeCooning's accounting income figure of $2,200. First, the accounting income contains timing errors because this single figure (1) includes operating income and holding gains and losses that are recognized in the current period and that occurred in previous periods, and (2) omits the operating profit and holding gains and losses that occurred in the current period but that are recognizable in future periods. Second, the accounting income contains measuring-unit errors because (1) it does not take into account changes in the general price level that would have resulted in amounts expressed in units of general purchasing power, and (2) it does not take into account changes in specific price level, because it relies on historical cost (rather than replacement cost of net realizable value) as the attribute of the elements of financial statements.

Earnings Measurement and Price Level Changes

31

Then how should we evaluate historical-cost financial statements? First, they are interpretable. Historical-cost financial statements are based on the concept of money maintenence, and the attribute being expressed is the number of dollars (NOD). The balance sheet reports the stocks in NOD as of December 31, 19X6, and the income statement reports the change in NOD during the year. Second, historical-cost financial statements are not relevant because the command of goals (COG) is not measured. A measure of COG reflects changes in both the specific price level and the general price level, and, as such, represents the ability to buy the amount of goods necessary for capital maintenence. In summary, historical-cost financial statements (1) contain timing errors, (2) contain measuring-unit errors, (3) are interpretable, and (4) are not relevant. Replacement-Cost

Accounting

Replacement-cost accounting, as a particular case of current-entry-pricebased accounting, is characterized primarily by (1) the use of replacement cost as the attribute of the elements of financial statements, (2) the assumption of a stable monetary unit, (3) the realization principle, (4) the dichotomization of operating income and holding gains and losses, and (5) the dichotomization of realized and unrealized holding gains and losses. Accordingly, replacement-cost net income is equal to the sum of replacement-cost operating income and holding gains and losses. Replacement-cost operating income is equal to the difference between realized revenues and their corresponding replacement costs. From Exhibit 2.1, the DeCooning Company's replacement-cost income of $2,500 is composed of (1) replacement-cost operating income of $1,200, (2) realized holding gains and losses of $1,000, and (3) unrealized holding gains and losses of $300. What do these figures represent for DeCooning? The replacement-cost operating income of $1,200 represents the "distributable" income, or the maximum amount of dividends that DeCooning can pay and maintain its productive capacity. The realized holding gains and losses of $1,000 are an indicator of the efficiency of holding resources up to the point of sale. The realized holding gains and losses are an indicator of the deficiency of holding resources after the point of sale and may act as a predictor of future operating and holding performances. In addition to these practical advantages, replacement-cost net income contains timing errors only on operating profit. It does, however, contain measuring-unit errors. First the replacement-cost net income contains timing errros because (1) it omits the operating profit that occurred in the current period but that is realizable in future periods, (2) it includes the operating profit that is recognized in the current period but that occurred in previous periods, and (3) it includes holding gains and losses in the same

32

Earnings Measurement, Determination, Management

periods in which they occur. Second, the replacement-cost net income contains measuring-unit errors because (1) it does not take into account changes in the general price level that would have resulted in amounts expressed in units of general purchasing power and (2) it does take into account changes in the specific price level, because it relies on replacementcost as the attribute of the elements of financial statements. We may evaluate replacement-cost financial statements as follows. First, they are interpretable. Replacement-cost financial statements are based on the concept of productive-capacity maintenance, and the attribute being expressed is the number of dollars (NOD) in the income statement. The asset figures, however, are interpretable as measures of the command of goods (COG). The asset figures shown in Exhibit 2.2 are expressed in both the specific price level and the general price level and therefore represent the COG required for capital maintenance. Second, because COG is the relevant attribute, the replacement-cost net income is not relevant, even though the asset figures are relevant. In summary, replacement-cost financial statements (1) contain timing errors in operating profit, (2) contain measuring-unit errors, (3) are interpretable as NOD for income-statement figures and as COG for asset figures, and (4) provide relevant measures of COG only for asset figures. Net-Realizable- Value Accounting Net-realizable-value accounting, as a particular case of current-exit-pricebased accounting is characterized primarily by (1) the use of net realizable value as the attribute of the elements of financial statements, (2) the assumption of a stable monetary unit, (3) the abandonment of the realization principle, and (4) the dichotomization of operating income and holding gains and losses. Accordingly, net-realizable-value net income is equal to the sum of netrealizable-value operating income and holding gains and losses. Netrealizable-value operating income is equal to the operating income on sales and the net operating income on inventory. Operating income on sales is equal to the difference between realized revenues and their corresponding replacement costs of the item sold. In Exhibit 2.1, the DeCooning Company's net-realizable-value net income of $2,900 is composed of (1) netrealizable-value operating income of $1,600, (2) realized holding gains and losses of $1,000 and (3) unrealized holding gains and losses of $300. Note that the net-realizable-value operating income of $1,600 is composed of operating income on sales of $1,200 and operating income on inventory of $400. Thus, in Exhibit 2.2, unrealized retained earning equals the sum of unrealized holding gains and losses of $300 and operating income on inventory of $400. What do these figures represent for DeCooning? They are similar to the figures obtained with replacement-cost accounting, except for the operating

Earnings Measurement and Price Level Changes

33

Exhibit 2.3 DeCooning Company Timing-Error Analysis for the Year Ended December 31, 19X6 Historical

Replacement

Cost

Cost

Total operating and Reported

Reported

Net Realizable Value

Reported

Holding Gains

Income

Ercor

Income

Error Income

Error

$2,900

$2,200

$700

$2,500

$400 $2,900

0

income on inventory, which results from the abandonment of the realization principle and the recognition of revenues at the time of production and at the time of sale. Net-realizable-value net income is an indicator of the ability of the firm to liquidate and to adapt to new economic situations. To these practical advantages, we may add that net-realizable-value net income contains no timing errors, but it does contain measuring-unit errors. First, the net-realizable-value net income does not contain any timing errors (as shown in Exhibit 2.3) because (1) it reports all operating profit and holding gains and losses in the same period in which they occur, and (2) it excludes all operating and holding gains and losses that occurred in previous periods. Second, the net-realizable-value net income contains measuring-unit errors because (1) it does not take into account changes in the general price level (if it had, it would have resulted in amounts expressed in units of general purchasing power), and (2) it does take into account changes in the specific price level, because it relies on net realizable value as the attribute of the elements of financial statements. We may evaulate net-realizable-value financial statements as follows. First, they are interpretable. Net-realizable-value financial statements are based on the concept of productive-capacity maintenance. The attribute being measured is expressed in NOD on the income statement and in COG on the balance sheet, unlike replacement-cost of COG in the output market rather than in the input market. Second, because COG is the relevant attribute, net-realizable-value income is not relevant, although asset figures are relevant. In summary, net-realizable-value financial statements (1) contain no tim-

34

Earnings Measurement, Determination, Management

ing errors, (2) contain measuring-unit errors, (3) are interpretable as NOD for net income and as COG for asset figures, and (4) provide relevant measures of COG only for asset figures. Alternative Accounting Models Expressed in Units of General Purchasing Power To illustrate both timing and measuring-unit errors in this section, we will present accounting models that reflect changes in the general price level. These models are (1) general price-level-adjusted, historical-cost accounting, (2) general price-level-adjusted, replacement-cost accounting, and (3) general price-level-adjusted, net-realizable-value accounting. Continuing with our example of the DeCooning Company, the income statement and the balance sheet for 19X6, under the three accounting models, appear in Exhibit 2.4 and 2.5, respectively. The general price-level gain or loss is shown in Exhibit 2.6. General Price-Level-Adjusted, Historical-Cost

Accounting

General price-level-adjusted, historical-cost accounting is characterized primarily by (1) the use of historical cost as the attribute of the elements of financial statements, (2) the use of general purchasing power as the unit of measure, (3) the matching principle, and (4) the realization principle. Accordingly, general price-level-adjusted, historical-cost income is the difference between realized revenues and their corresponding historical costs, both expressed in units of general purchasing power. In Exhibit 2.4, general price-level-adjusted, historical-cost income is equal to $1,080. Included in the $1,080 historical-cost income figure is a $180 general pricelevel gain, computed as shown in Exhibit 2.5. Again, what does the $1,080 figure represent to the DeCooning Company? It represents accounting income expressed in dollars that have the purchasing power of dollars at the end of 19X6. In addition to the practical advantages listed for accounting income, general price-level-adjusted, historical-cost income is expressed in units of general purchasing power. For these reasons, the use of such an accounting model may constitute a less radical change for those used to historical-cost income than any current-value accounting model. Despite these practical advantages, the general price-level-adjusted, historical-cost income of $1,080 contains the same timing errors that historical-cost income contains. However, general price-level-adjusted, historical-cost income contains no measuring-unit errors, because it takes into account changes in the general price level. It does not, however, take into account changes in the specific price level, because it relies on historical cost, rather than replacement cost or net realizable value, as the attribute of the elements of financial statements. How should we evaluate the general price-level-adjusted, historical-cost

Earnings Measurement and Price Level Changes

35

Exhibit 2.4 DeCooning Company: General Price-Level Income Statements for the Year Ended December 31, 19X6

Revenues Cost of Goods Sold Gross Margin Interest (10%) Operating Income

Historical

Replacement

Net Realizable

Cost

Cost

Cost

$9,000*

$9,000

$10,700°

7.800 c

7,200 d

8,500 e

$1,200.

$1,300.

$ 2.200 .

390.

3Q0

300

$ 900

$1,500

$ 1,900

Real Realized Holding Gains and Losses Real Unrealized Holding Gains and Losses General Price-Level Gain or Loss Net Income

(included above) (not applicable) 180 h $1,080.

$

(600) f

(600)

(260) g

(260)

130. 820

$

180 1.220.

a: $7,500 X 156/130 = $9,000 b: $9,000 4- ($17 X 100 units) = $10,700 c: $5,000 X 156/100 = $7,800 d: $6,000 X 156/130 = $7,200 e: $7,200 + ($13 X 100 units) = $8,500 f: [($12 X 156/130) - ($10 X 156/100)] X 500 = ($600) g: [$13 - ($10 X 156/100)] X 100 units = ($260) h: See Exhibit 2.6.

financial statements presented in Exhibits 2.4 and 2.5? First, they are interpretable. General price-level-adjusted, historical-cost financial statements are based on the concept of purchasing-power money maintenance. The attribute being measured is NOD in some cases and COG in other cases. Hence, general price-level-adjusted, historical-cost income and all balance sheet figures, with the exception of cash (and monetary assets and liabilities), may be interpreted as COG measures. Second, only the cash figures (and monetary assets and liabilities) are relevant, because they are expressed as COG measures. In summary, general price-level-adjusted, historical-cost financial statements (1) contain timing errors, (2) contain no measuring-unit errors, (3)

36

Earnings Measurement, Determination, Management

Exhibit 2.5 DeCooning Company: General Price-Level Balance Sheets for the Year Ended December 31, 19X6 Historical Cost

Replacement Cost

$7,200

$7,200

Net Realizable Value

Assets Cash Inventory Total Assets Equities Bonds (10%) Capital Retained Earnings Realized Unrealized General Price-Level Gain or Loss Total Equities

$8,760

UQ0

$5,500.

$7,200 1,70Q $8r900

$3,000 4,680 b

$3,000 4,680

$3,000 4,680

1.5«a

900

(not applicable)

900

900

140c

<3W)

130

180

180

$8,760

$3,500.

$8,900

a: $1,000 X 156/100 = $1,560 b: $3,000 X 156/100 = $4,680 c: Unrealized Operating Gain $400 ($1,700 - $1,300) + Unrealized Holding Loss $260

are interpretable, and (4) provide relevant measures of COG only for cash figures (and monetary assets and liabilities). General Price-Lev el-Adjusted, Replacement-Cost

Accounting

General price-level-adjusted, replacement-cost accounting is characterized primarily by (1) the use of replacement cost as the attribute of the elements of financial statements, (2) the use of general purchasing power as the unit measure, (3) the realization principle, (4) the dichotomization of operating income and real unrealized holding gains and losses, and (5) the dichotomization of real realized and real unrealized holding gain and losses. Accordingly, general price-level-adjusted, replacement-cost income is equal to the difference between realized revenues and their corresponding replacement costs, both expressed in units of general purchasing power. Similarly, general price-level-adjusted, replacement-cost financial statements eliminate "fictitious holding gains and losses" to arrive at "real holding gains and losses." Fictitious holding gains and losses represent the general price-level restatement that is required to maintain the general purchasing power of nonmonetary items. We can see from Exhibit 2.4 that general price-level, replacement-cost income is equal to $820. Included in the $820 income figure is a $820 general price-level gain, computed as shown in

Earnings Measurement and Price Level Changes

37

Exhibit 2.6 DeCooning Company: General Price-Level Gain or Loss for the Year Ended December 31, 19X6 Unadjusted Amount Net Monetary Assets on January 1, 19X5 $ 3,000 Add: Monetary receipts During 19X6 Sales 7.500 Net Monetary Items $10r500 Less: Monetary Payments Purchases $6,000 Interest (10%) 300 Total $ ur300 Computed Net Monetary Assets, December 31,19X6 Actual Net Monetary Assets, December 31, 19X6 General Price-Level Gain

Conversion Factor

Adjusted Amount

156 /100

$ 4,680

156/130

9r000 $13r680

156/100 156/156

$9,360 300 $ 9r660 $ 4,020 $ 4r200 $ 180

Exhibit 2.5. The $820 figure represents DeCooning's replacement-cost-net income, expressed in units of general purchasing power at the end of 19X7. Such a measure of income has all of the advantages of replacement-cost accounting income and the added advantage of being expressed in units of general purchasing power. For these reasons, general price-level-adjusted, replacement-cost accounting constitutes a net improvement over replacement-cost accounting, because this accounting model not only adopts replacement cost as the attribute of the elements of financial statements but also employs a general purchasing power as the unit of measure. Despite these improvements, however, general price-level-adjusted, replacement-cost income contains the same timing errors that replacementcost income contains. Second, general price-level-adjusted, replacement-cost income contains no measuring-unit errors, because it takes into account changes in the specific price level. In addition, this measure of income takes into account changes in the specific price level, because it adopts replacement cost as the attribute of the element of financial statements. How should we evaluate the general price-level-adjusted, replacementcost financial statements presented in Exhibits 2.4 and 2.5? First, they are interpretable. General price-level-adjusted, replacement-cost financial statements are based on the concept of purchasing-power, productive-capacity maintenance. The figures on both the income statement and the balance sheet are expressed as COG measures. Second, general price-level-adjusted, replacement-cost financial statements are relevant, because they are expressed as COG measures. Note, however, that COG is in the input market, rather than the output market.

38

Earnings Measurement, Determination, Management

In summary, general price-level-adjusted, replacement-cost financial statements (1) contain timing errors, (2) contain no measuring-unit errors, (3) are interpretable, and (4) provide relevant measures of COG in the input market. General Price-Lev el-Adjusted, Net-Realizable-Value

Accounting

General price-level-adjusted, net-realizable-value accounting is characterized primarily by (1) the use of net realizable value as the attribute of the elements of financial statements, (2) the use of general purchasing power as the unit of measure, (3) the abandonment of the realization principle, (4) the dichotomization of operating income and real holding gains and losses, and (5) the dichotomization of real realized and real unrealized gains and losses. Accordingly, general price-level-adjusted, net-realizable-value net income is equal to the sum of net-realizable-value operating income and holding gains and losses, both expressed in units of general purchasing power. The general price-level-adjusted, net-realizable-value operating income is equal to the sum of operating income arising from sale and operating income in inventory, both expressed in units of general purchasing power. From Exhibit 2.4 the general price-level-adjusted, net-realizable-value net income of $1,220 is composed of (1) general price-level-adjusted, net-realizable-value operating income of $1,900, (2) real realized holding losses of ($600), (3) real unrealized holding losses of ($260), and (4) a general price-level gain of $180. Again, the general price-level-adjusted, net-realizable-value operating income of $1,900 is composed of general price-level-adjusted, net-realizablevalue operating income on sales of $1,500 and general price-level-adjusted, net-realizable-value operating income on inventory of $400. In addition to the advantages of net-realizable-value net income, general price-level-adjusted, net-realizable-value net income is expressed in units of general purchasing power. For these reasons, general price-level-adjusted, net-realizable-value accounting represents a net improvement on netrealizable-value accounting, because it not only adopts net realizable value as an attribute of the elements of financial statements but also employs general purchasing power as the unit of measure. Thus, general price-level-adjusted, net-realizable-value income contains no timing errors (as explained in the discussion of net-realizable-value accounting) and no measuring-unit errors, because it is expressed in units of general purchasing power. How should we evaluate the general price-level-adjusted, net-realizablevalue financial statements presented in Exhibits 2.4 and 2.5? First, they are interpretable. General price-level-adjusted, net-realizable-value financial statements are based on the concept of purchasing power, productivecapacity maintenance. The figures on both the income statement and the

Earnings Measurement and Price Level Changes

39

balance sheet are expressed as COG measures. Second, these financial statements are relevant, because they are expressed as COG measures. Note, however, that COG is in the output market, rather than the input market. In summary, general price-level-adjusted, net-realizable-value financial statements (1) contain no timing errors, (2) contain no measuring-unit errors, (3) are interpretable, and (4) provide relevant measures of COG in the output market. Such statements, therefore, meet all the criteria established for the comparison and evaluation of the alternative accounting models. TOWARD A SOLUTION TO THE PROBLEM OF FINANCIAL REPORTING AND CHANGING PRICES Long recognized as a problem in the accounting literature, the issue of accounting for changing prices has been extensively studied by the various accounting standard-setting bodies. The AICPA Committee on Accounting Procedures in 1947, 1948, and 1953 8 and APB Opinion No. 6 entitled Status of Accounting Research Bulletins, all examined the problems related to changes in the general price level without success. These attempts were followed by the AICPA's publication of Accounting Research Study No. 6, Reporting the Financial Effects of Price-Level Changes, in 1963, and by APB Statement No. 3, Financial Statements for General Price-Level Changes, in June 1969. Both documents recommended the supplemental disclosure of general price-level information without success. The Financial Accounting Standards Board approached the price-level issue at a time when inflation was a major concern in the economy. After issuing a Discussion Memorandum (Reporting the Effects of General Price-Level Changes in Financial Statements) on February 15, 1974, an Exposure Draft (Financial Reporting in Units of General Purchasing Power) on December 31, 1974, a Research Report (Field Tests of Financial Reporting in Units of General Purchasing Power) in May 1977, another Exposure Draft (Financial Reporting and Changing Prices) on December 26, 1978, and a supplemental Exposure Draft to the 1974 proposed statement on general purchasing-power adjustments (Constant-Dollar Accounting) on March 2, 1979, the Board issued FASB Statement No. 33, Financial Reporting and Changing Prices, in September 1979, calling for information on the effects of both general inflation and specific price changes.

Financial Reporting and Changing Prices: A Step Forward FASB Statement No. 33 is the result of years of attempts by the diverse standard-setting bodies to develop methods of reporting the effects of inflation on earnings and assets. In its deliberations, the FASB considered a

40

Earnings Measurement, Determination, Management

variety of accounting systems, 9 which can be grouped under the following headings: 1. Measuring of inventory and property, plant, and equipment a. Historical cost b. Current reproduction cost c. Current replacement cost d. Net realizable value e. Net present value of expected future cash flows (value in use) f. Recoverable amount g. Current cost h. Value of business (current cost of lower recoverable amount) 2. Concepts of capital maintenance a. Financial capital maintenance b. Physical capital maintenance (the maintenance of operating capacity) 3. Measuring units a. Measurements in nominal dollars b. Measurements in constant dollars This list suggests that the FASB examined all of the alternative assetvaluation and income-determination models presented in this chapter. T h e Board concluded, however, that supplementary information should be presented according to historical-cost/constant-dollar accounting and currentcost accounting. M o r e specifically, the FASB n o w requires major companies to disclose the effects of both general inflation and specific price changes as supplementary information in their published annual reports. Major companies are defined as companies with assets of more than $1 billion (after deducing accumulated depreciation) or with inventory and property, plant, and equipment (before deducing accumulated depreciation) or more than $ 1 2 5 million. Specifically, FASB Statement N o . 33 requires major firms to report: 1. Constant-dollar disclosures (current year) a. Information on income from continuing operations for the current fiscal year, on a historical-cost-constant-dollar basis. b. The general purchasing-power gain or loss on net monetary items for the current fiscal year. The general purchasing-power gain or loss on net monetary items shall not be included in income from continuing operations. 2. Current-cost disclosures (current-cost) An enterprise is required to disclose: a. Information on income from continuing operations for the current fiscal year, on a current-cost basis. b. The current-cost amounts of inventory and property, plant, and equipment at the end of the current fiscal year. c. Increase or decrease for the current fiscal year in the current-cost amounts of inventory and property, plant, and equipment, net of inflation. The increase or decrease in current-cost amounts shall not be included in income from continuing operations.

Earnings Measurement and Price Level Changes

41

3. Five-year summary data a. Net sales and other operating revenues. b. Historical-cost/constant-dollar information: (1) Income from continuing operations. (2) Income per common share from continuing operations. (3) Net assets at fiscal year-end. c. Current-cost information (except for individual years in which the information was excluded from the current-year disclosures): (1) Income from continuing operations. (2) Income per common share from continuing operations. (3) Net assets at fiscal year-end. (4) Increases or decreases for the current fiscal year in the current-cost amounts of inventory and property, plant, and equipment net of inflation. d. Other information: (1) General purchasing-power gain or loss on net monetary items. (2) Cash dividends declared per common share. (3) Market price per common share at fiscal year-end. 4.

Limitation Whenever the recoverable amount of an asset is less than either the constantdollar value or the current-cost value, the recoverable amount should be used to value the asset. "Recoverable amount" means the current value of the net cash flow expected to be realized from the use or sale of the asset.

5.

Methodology a. The constant-dollar method should use the Consumer Price Index for All Urban Consumers. b. The current-cost method may use internally or externally developed specificprice indices or evidence such as vendor invoice prices or price lists to determine the current cost of an asset. The method selected should be based on availability and cost, and should be applied consistently. c. The constant-dollar amounts should be based on average-for-the-year indices. d. The current costs should be based on average current costs of the period for the restatement of items required to compute operating income (cost of goods sold, depreciation, and depletion, and should be restated at end-of-period current costs, net of general inflation, for the measurement of increases or decreases in inventory, plant, property, and equipment. The latter statement requires the use of year-end current costs restated in average-for-the-period constant dollars. 10

FASB Statement N o . 33 also provides the following information to explain the m i n i m u m disclosure requirements for constant-dollar and currentcost data: 1. Income from continuing operation is income after applicable income taxes, excluding the results of discontinued operations, extraordinary items, and the cumulative effects of accounting changes. If none of the foregoing is present for a business enterprise, income from continuing operations is identical to net income.

42

Earnings Measurement, Determination, Management

2. The general purchasing-power gain or loss on net monetary items and the increase or decrease in current-cost amounts are excluded from income from continuing operations. 3. Current-cost information need not be disclosed if it is not materially different from constant-dollar information. The reasons for omission of current-cost information must be disclosed in notes to the supplemental information. 4. Information relating to income from continuing operations may be presented either in the format of a conventional income statement or in a reconciliation format that discloses adjustments to income from continuing operations in the historical-cost-nominal-dollar income statement. 5. The average Consumer Price Index for All Urban Consumers (CPI-U) is used by business enterprises that present only the minimum constantdollar data for a fiscal year. If an enterprise presents comprehensive financial statements on a constant-dollar basis, either the average or the year-end CPI-U may be used. 6. An enterprise that presents only the minimum data required by FASB Statement No. 33 need not restate any financial statement amounts other than inventories, plant assets, cost of goods sold, and depreciation, depletion, and amortization expenses. 7. If the historical-cost/constant-dollar amounts or the current-cost amounts of inventories and plant assets exceed the recoverable amounts of those assets, all data required by FASB Statement No. 33 must be presented on the basis of the lower recoverable amounts. The recoverable amount of an asset expected to be sold is the net realizable value of the asset (expected sales proceeds less costs of completion and disposal). The recoverable amount of an asset in continuing use is its value in use (net present value of future cash inflows, including ultimate proceeds on disposal). Thus, value in use is synonymous with direct valuation. 8. The current costs of inventories, plants, cost of goods sold, and depreciation, depletion, and amortization expense may be determined by one of the following methods: a. Indexation by use of either externally or internally developed specificprice indices. b. Direct pricing by use of current invoice prices; vendor price lists, quotations, or estimates; or standard manufacturing costs that reflect current costs. 11 Exhibits 2.7, 2.8, and 2.9 illustrate these FASB requirements. Thus, FASB Statement No. 33 requires two supplemental income computations—one dealing with the effects of general inflation, and the other dealing with specific price changes. Both types of information are intended to help users make decisions about investment, lending, and other matters in the following specific ways: 1. Assessment of future cash flows: Present financial statements include

43

Earnings M e a s u r e m e n t a n d Price Level Changes

Exhibit 2.7 Statement of Income from Continuing Operations Adjusted for Changing Prices for the Year Ended December 31, 19X6 (in thousands of average 19X5 dollars)

As Reported in the Primary Statements

Adjusted for General Inflation

Adjusted for Changes in Specific Prices (Current costs)

$500,000

$500,000

$500,000.

$400,000

$450,000

$455,000

20,000 40,000 15,000 20,000

25,000 40,000 15,000 20,000

26,000 40,000 15,000 20,000

Total Expenses

$495,000

$550rOOO

$556r000

Income (loss) from continuing operations

$

$(50,000)

$ (56,000)

$

$

Net sales and other operating revenues Cost of goods sold Depreciation and amortization expense Other operating expenses Interest expense Provision for income taxes

5,000

Gain from decline in general purchasing power of net amounts owned

5,000

?.Q00

Increase in specific prices (current costs) of inventories and property, plant, and equipment held during the year

$ 30,000

Effect of increase in general price level

$

20,000

Excess of increase in specific prices over increase in general price level

$

10,000

a: As of December 31,19X5, current cost of inventory is $55,000 and current cost of property, plant, and equipment, net of accumulated depreciation, is $80,000.

44

Earnings Measurement, Determination, Management

Exhibit 2.8 Five-Year Comparison of Selected Supplemental Financial Data Adjusted for Changing Prices (in thousands of average 19X5 dollars) 19X1 Net sales and other operating revenus $400,000 Historical-cost information adjusted for general inflation Income (loss) from continuing operations Income (loss) from continuting operations per common share net assets at year-end Current-cost information Income (loss) from continuing operations Income (loss) from continuing operations per common share Excess of increse in specific prices over increse in general price-level Net assets at year-end Gain from decline in general purchasing power of net amounts owned 2.05 Cash dividends declared per common share 30 Market price per common share at year-end 181.5 Average consumer price

Year Ended December 31 19X2 19X3

19X4

$420,000

$450,000

$500,000

(29,000)

(20,000)

(2.0) 100,000

(2.0) 100,000

(10,000)

(10,000)

(1.0)

(1.0)

5,000 120,000

10,000 130,000

4,500 2.15 40 205.0

5,000 2.20 39 ^220.9

2.10 45 195.4

measurements of expenses and assets at historical prices. When prices are changing, measurements that reflect current prices are likely to provide useful information for the assessment of future cash flows. 2. Assessment of enterprise performance: The worth of an enterprise can be increased as a result of the prudent timing of asset purchases when prices are changing. That increase is one aspect of performance. Measurements that reflect current prices can provide a basis for assessing the extent to which past decisions about the acquisition of assets have created opportunities for earning cash flows. 3. Assessment of the erosion of operating capability. An enterprise typically must hold minimum quantities of inventory, property, plant, equipment, and other assets to maintain its ability to provide goods and services. When the prices of those assets are increasing, larger amounts of money must be invested to maintain the previous levels of output. Information on the current prices of resources that are used to generate revenues can help users assess the extent to which and the manner in which operating capability has been maintained. 4. Assessment of the erosion of general purchasing power. When general price levels are increasing, larger amounts of money are required to maintain a fixed amount of purchasing power. Investors typically are concerned with assessing whether or not an enterprise has maintained the purchasing

Earnings Measurement and Price Level Changes

45

Exhibit 2.9 Statement of Income from Continuing Operations Adjusted for Changing Prices for the Year Ended December 31, 19X6 (in thousands of average 19X5 dollars) Incomefromcontinuing operations, as reported on the income statement Adjustments to restate costs for the effect of general inflation Costs of goods sold Depreciation and amortization expense Lossfromcontinuing operations adjusted for general inflation Adjustments to reflect the difference between general inflation and changes in specific prices (current costs) Cost of goods sold Lossfromcontinuing operations adjusted for changes in specific prices Gainfromdecline in general purchasing power of net amounts owned Increase in specific prices (current costs) of inventories and property, plant, and equipment held during the year Effect of increase in general price level Excess of increase in specific prices over increase in general price level

$ 5,000 $(50,000) 5.000

55,000 $(50,000)

$ (5,000) (L00Q)

(6.Q0Q) $f56r000) $ 5r000

$ 30,000 20r000 $ 10r000

a: As of December 31, 19X5, current cost of inventory is $55,000 and current cost of property, plant, and equipment, net of accumulated depreciation, is $80,000.

power of its capital. Financial information that reflects changes in general purchasing p o w e r can help investors make that assessment. 1 2 Obviously, because it requires the presentation of both general price-level and specific price-level information, FASB Statement N o . 33 is a step forw a r d . It falls short, however, of a total solution, which would require the use of general price-level-restated, current-cost accounting in conjunction with general price-level-restated, replacement-cost accounting or with general price-level-restated, net-realizable-value accounting. Moreover, some of the specific requirements discussed in FASB Statement N o . 33 do not per-

tain to most situations 13 CONCLUSION Given the existence of four measurable attributes of the elements of financial statements and t w o units of measure in which to express these

46

Earnings Measurement, Determination, Management

attributes, eight alternative asset-valuation and income-determination models exist: 1. Historical-cost accounting 2. Replacement-cost accounting 3. Net-realizable-value accounting 4. Present-value accounting 5. General price-level-adjusted, historical-cost accounting 6. General price-level-adjusted, replacement-cost accounting 7. General price-level-adjusted, net-realizable-value accounting 8. General price-level-adjusted, present-value accounting In this chapter, we have compared and evaluated six of these models on the basis of four criteria: (1) the avoidance of timing errors, (2) the avoidance of measuring-unit errors, (3) their interpretability, and (4) their relevance as measures of c o m m a n d of goods (COG). Although the present-value models are conceptually preferable, they were not includeed in our comparison and evaluation because their subjectivity and the uncertainty surrounding their use make their implementation currently impractical. O u r comparison of the remaining models revealed that general pricelevel-adjusted, net-realizable-value accounting is the only model to meet each of the four criteria set forth in the chapter and therefore most closely represents a preferred-income position. FASB Statement N o . 3 3 , Financial Reporting and Changing Prices, falls short of adopting this solution and, instead, requires the disclosure of supplemental information on the effects of both inflation and specific-price changes. NOTES 1. Robert R. Sterling, "Relevant Financial Reporting in an Age of Price Changes," Journal of Accountancy (February 1975): 42-51; S. Basu and J. R. Hanna, Inflation Accounting: Alternatives, Implementation Issues, and Some Empirical Evidence (Hamilton, Ontario: Society of Management Accountants of Canada, 1977). 2. A. L. Thomas, The Allocation Problem in Accounting (Sarasota, FL: American Accounting Association, 1969). 3. R. T. Sprouse, and Maurice Moonitz, A Tentative Set of Broad Accounting Principles for Business Enterprises, Accounting Research Study No. 3 (New York: American Institute for Certified Public Accountants, 1962): 55. 4. Sterling, "Relevant Financial Reporting in an Age of Price Changes," p. 44. 5. R. J. Chambers, "NOD, COG, and PuPu: See How Inflation Teases!" Journal of Accountancy (September 1975): 61.

Earnings Measurement and Price Level Changes

47

6. Ibid., p. 61. 7. Sterling, "Relevant Financial Reporting in an Age of Price Changes," p. 46. 8. AICPA Committee on Accounting Procedures, Accounting Research Bulletin No. 33, Depreciation and High Costs (New York: American Institute of Certified Public Accountants, December 1944); AICPA Committee on Accounting Procedures, Accounting Research Bulletin No. 43, Restatement and Revision of Accounting Research Bulletins, Chap. 9, Sect. A (New York: American Institute of Certified Public Accountants, June 1953). 9. FAB Statement No. 33, Financial Reporting and Changing Prices (Stamford, CT: Financial Accounting Standards Board, September 1979): 47-48. 10. Ibid., paras. 29, 30, 35, 51, and 52. 11. Ibid., paras. 9, 11, 12, 14, 17, 20, and 22. 12. Ibid., paras. 1-2. 13. Several FASB pronouncements dealing with specific situations have been issued subsequent to FASB Statement No. 33. These include FASB Statement No. 39, Financial Reporting and Changing Prices: Specialized Assets—Mining and Oil and Gas (October 1980); FASB Statement No. 40, Financial Reporting and Changing Prices: Specialized Assets—Timber lands and Growing Timber (November 1980); FASB Statement No. 4 1 , Financial Reporting and Changing Prices: Specialized Assets—Income-Producing Real Estate (November 1980); and FASB Statement No. 46, Financial Reporting and Changing Prices: Specialized Assets—Motion Picture Films (March 1981). SELECTED READINGS Basu, S., and J. R. Hanna. Inflation Accounting: Alternatives, Implementation Issues, and Some Empirical Evidence. Hamilton, Ontario: Society of Management Accountants of Canada, 1977. Chambers, R. J. Accounting, Evaluation, and Economic Behavior. Englewood Cliffs, NJ: Prentice-Hall, 1966. . "NOD, COG, and PuPu: See How Inflation Teases!" Journal of Accountancy (September 1975): 56-62. Edwards, E. O., and P. W. Bell. The Theory and Measurement of Business Income. Berkeley: University of California Press, 1961. Gynther, R. S. "Capital Maintenance, Price Changes, and Profit Determination." The Accounting Review (October 1970): 712-730. Hanna, J. R. Accounting-Income Models: An Application and Evaluation, Special Study No. 8. Toronto: Society of Management Accountants of Canada, July 1974. Kerr, Jean St. G. "Three Concepts of Business Income." In An Income Approach to Accounting Theory, edited by Sidney Davidson et al. Englewood Cliffs, NJ: Prentice-Hall, 1964: 40-48. Louderback, J. G. "Projectability as a Criterion for Income Determination Methods." The Accounting Review (April 1971): 298-305. Parker, P. W., and P. M. D. Gibbs. "Accounting for Inflation: Recent Proposal and Their Effects." Journal of the Institute of Actuaries (December 1974): 1-10. Revsine, L., and J. J. Weygandy. "Accounting for Inflation: The Controversy." Journal of Accountancy (October 1974): 72-78.

48

Earnings Measurement, Determination, Management

Rosen, L. S. Current-Value Accounting and Price-Level Restatements. Toronto: Canadian Institute of Chartered Accountants, 1972. Rosenfield, Paul. "Accounting for Inflation: A Field Test." Journal of Accountancy (June 1969): 45-50. . "CPP Accounting: Relevance and Interpretability." Journal of Accountancy (August 1975): 52-60. . "The Confusion between General Price-Level Restatement and CurrentValue Accounting." Journal of Accountancy (October 1972): 63-68. Sterling, Robert R. "Relevant Financial Reporting in an Age of Price Changes." Journal of Accountancy (February 1975): 42-51. . Theory of Management of Enterprise Income. Lawrence: University Press of Kansas, 1970. Wolk, H. I. "An Illustration of Four Price-Level Approaches to Income Measurement." In Accounting Education: Problems and Prospects, edited by J. Don Edwards. Sarasota, FL: American Accounting Association, 1974: 415-423. Zeff, S. A. "Replacement Cost: Member of the Family, Welcome Guest, or Intruder?" The Accounting Review (October 1962): 611-625.

3 Earnings Determination following Wealth Measurement INTRODUCTION The earnings process includes determination, management, and smoothing. Earnings determination involves finding the "acceptable" or "desired" level of reported earnings of the firm. Earnings management is the process of deliberate use of generally accepted accounting principles to reach a desired level of reported earnings. Finally, income smoothing is the deliberate reduction of the overall-time variability of the resulting earnings numbers. The research on earnings management is primarily concerned with the influence and importance of accounting accruals in arriving at a summary value of earnings. This study does not refute the existence and potential of earnings management as a deliberate process of managing the components of earnings or of supplementary disclosures. Instead, it presents earnings management as a second-stage operation preceded by a process of earnings determination. Basically, a value of earnings is first determined as the appropriate signal the firm should be sending to the market. Second, a variety of accrual options available under generally accepted accounting principles, and susceptible to manipulation, are used for managing earnings to arrive at the same desired value obtained in the process of earnings determination. Earnings determination is modeled as a response to the net wealth generated by the firm or net value added and as an adjustment to the previous This chapter has been adapted from: Ahmed Riahi-Belkaoui, "Net Value Added and Earnings Determination," Review of Quantitative Finance and Accounting (forthcoming), with permission of the publisher.

50

Earnings Measurement, Determination, Management

level of earnings. The main purpose of this chapter is to empirically test this net value added-earnings policy model. The model is estimated annually for nonfinancial firms over the period 1976 through 1995. The evidence is consistent with the role of net value added and the previous level of earnings in the determination of earnings. The chapter contributes to the emerging literature on earnings determination and earnings management. By relying on a broad section of firms, the study documents the overall descriptive behavior of the net value addedearnings policy model and lays the foundation for more contextually specific approaches. Thus the evidence in support of this model should be of great interest to accounting researchers and those who require estimation of net earnings of a firm. A SIMPLE VALUE ADDED-EARNINGS POLICY MODEL AND TESTABLE IMPLICATIONS The Value Added Concept in Accounting Value added is a measure of wealth that can be easily derived from published accounting numbers. 1 It represents the total return of the firm earned by all providers of capital, plus employees and the government. It can be expressed as follows:

or

where: R S B W I DD T DP

= = = = = = = =

retained earnings sales revenue purchases of material and services wages interest dividends taxes depreciation .

Equation (1) expresses the gross value added; equation (2) expresses the net value added. In both equations, the left side (the subtractive side) shows the value added (gross or net) and the right side (the additive side) shows the distribution of wealth among the stakeholders. The measurement of wealth and the resulting empirical research on its usefulness favor the use

Earnings Determination following Wealth Measurement

51

of net value added over gross value added to avoid the arbitrary and incorrigible effects of depreciation allocation. Accordingly, net value added is used in this study as the measure of wealth generated by the firm. Value Added-Earnings Policy Model The fundamental assumption underlying the value added-earnings policy model, derived from equations (1) and (2), is that earnings are related to permanent net value added in a period. A simple linear specification of this is:

where Eit and NVAit* denote earnings and permanent net value added of firm / in period t, respectively. Permanent net value added refers to the unobserved wealth that the firm can produce in perpetuity. The factor of proportionality in (3), alt, is referred to as the net value added response coefficient. JLI„ is a mean zero random distribution term that includes all the potential variables other than permanent net value added that affect earnings. The intercept a0t represents the mean of the missing variables. If the observed net value added, NVAit, is used as a proxy for the unobservable permanent net value added in perpetuity, NVAit*, the net value added and earnings relations in equation (3) may be estimated again in level forms as follows:

The disturbance term in equation (4a) includes all the variables that affect earnings other than net value added. The results of the incomesmoothing hypothesis suggest that managers adjust earnings to a new desired level of earnings derived from a previous level of earnings. Basically, the previous level of earnings acts as an anchor that needs to be exceeded in the determination of the new desired level of earnings in order to send a favorable signal to the market. This adjustment process can be obtained by a lagged level as an additional variable in equation (4a):

We refer to alt as the net value added response coefficient and a2t as the earnings adjustment coefficient. Equation (4b) generates the testable crosssectional implications of the permanent net value added-earnings model. It implies that earnings may be determined as a response to a level of observed net value added and as an adjustment to the previous earnings level.

Earnings Measurement, Determination, Management

52

Exhibit 3.1 Summary Statistics for Variables of Earnings Policy Model Mean Net Value Added (NVAJ

Std. Dev.

Minimum

1st Quartile

Median

Und Quartile

Maximum

1514.098

3400.364

62.480

125.809

490.9606

1429.925

48,471.17

229.2392

607.599

10.540

11.927

56.620

196.531

7275.884

Earnings

1 Q\)

SAMPLE SELECTION AND DESCRIPTIVE STATISTICS Sample Selection The availability of data for each of the variables included in equation (4b) defined the sample used. More specifically, two measures are defined from COMPUSTAT data items as follows: 1. Net value added (NVAt) = the sum of labor expenses, corporate taxes, dividends, interest expense, minority shareholders in subsidiaries, and retained earnings. 2. Earnings (Et) = income available to common equity = income before extraordinary items - preferred dividends. The firms examined in this study represented all the NYSE and AMEX firms that have available data over the period 1976 to 1995 in COMPUSTAT. The data extracted resulted in a sample of 4,410 firm-year observations. To limit the impact of extreme observations, values of NVAt, Et, and Et_1 within the top and bottom 1 percent of their respective annual distribution were excluded. This left 3,998 observations (95.5% of the initial sample). All the variables are scaled by total assets. Descriptive Statistics and Correlation Analysis Exhibit 3.1 presents the descriptive statistics of the three variables employed in the empirical analyses. Exhibit 3.2 includes the correlation matrix. The only significant correlation exists between net value added (NVAt) and the previous year level of earnings. RESULTS The value added-earnings policy model, as summarized by equation (4b), is examined empirically via cross-sectional regressions. The results are reported in Exhibit 3.3.

Earnings Determination following Wealth Measurement

53

Exhibit 3.2 Correlation Matrix Net Value Added (NVAJ

Earnings (Et)

Net Value Added (NVAJ

1.000

Earnings (E t )

0.23914

1.000

0.63774

0.32969

Previous Year Earnings (E,_,)

Previous Year Earnings (Ei.,)

1.000

The regression using the pooled (all years) sample yields estimated coefficients a a of 0.0075 (^-statistic = 2.513) and oc2 of 0.6928 (^-statistic = 48.623). Further both a a and oc2 as well as the F-values are significant at the 0.05 level or better in all 20 years. The R2 are important enough deviating from a low of 18.65 percent to a high of 74.66 percent. To investigate the potential bias in the coefficients due to cross-sectional correlation in the error terms of the regression, we assumed that each annual regression is independent. Therefore, the mean and standard error of the coefficients obtained from the annual regressions are used to test whether this mean is statistically different from zero. The computation is shown in the last line of Exhibit 3.3. Both coefficients a t and oc2 are statistically different from zero at the 0.05 level for a : and 0.01 level for oc2. We concluded that the significance of the two coefficients is unlikely to be the result of potential cross-sectional correlations. To investigate potential collinearity among the variables in equation (4b), we computed the condition indexes for detecting multicollinearity. The highest condition index obtained was 3.5, and in most yearly regressions the maximum condition index was 3.5. Thus, collinearity does not seem to influence our results, following the suggestion of a mild collinearity for a maximum index between 5 and 10. For final specification tests we performed several analyses on the residuals from each multivariate regression that included checks for normality and use of various scatter plots. A null hypothesis of normality could not be rejected at the 0.01 level in all cases. Finally, the ^-statistics were computed after correcting for heteroscedasticity. Overall, the evidence suggests that the net value added level (NVA,) and the previous year level of earnings (YLt) are relevant to explaining current earnings. In a sense, earnings determination may be a process of a response to a level of net value added and an adjustment to the previous earnings level.

Exhibit 3.3 Earnings and Net Value Added (r-statistics in parentheses) Model: E Year

No. Of Firms

a0

*i

«3

Adj. R2

1976

210

0.0275 (1) (5.420)*

0.0080 (2.134)**

0.5682 (13.834)*

1977

211

0.0375 (5.327)*

0.0035 (2.134)8

0.6345 (16.458)8

1978

210

-0.0041 (-0.802)

0.0086 (2.173)**

0.8657 (17.329)*

62.28%

1979

218

0.0211 (5.201)*

0.0059 (2.861)*

0.7938 (18.921)*

65.66%

1980

228

0.0056 (1.418)

0.0038 (2.560)*

0.9014 (22.064)*

72.09%

1981

230

0.0096 (2.936)*

0.0132 (2.869)*

0.8044 (23.366)*

74.66%

1982

236

0.0167 (3.963)*

0.0131 (2.796)*

0.9220 (20.309)*

65.45%

1983

237

0.0082 (1.455)

0.0262 (3.235)*

0.9102 (17.834)*

57.49%

1984

224

0.0144 (1.374)*

0.0214 (2.186)**

0.6060 (14.785)*

51.05%

1985

211

0.0026 (0.280)

0.0112 (2.778)*

0.8091 (10.616)*

34.42 %

53.26% 62.32%

1986

208

0.0060 (0.815)

0.0384 (2.791)*

0.5291 (8.813)*

32.83%

1987

202

0.0080 (1.657)**

0.0065 (2.616)*

0.9208 (19.109)*

67.84%

1988

211

0.0156 (1.458)8

0.0136 (2.457)8

0.8651 (18.348)8

1989

203

-0.0035 -(0-4150)

0.0370 (2.477)*

0.5251 (8.012)*

1990

205

0.0289 (3.825)*

0.0060 (2.429)*

0.3689 (6.241)*

1991

194

0.0408 (6.995)*

0.0009 (2.088)**

0.4392 (8.715)*

30.24%

1992

203

0.0347 (50530)*

0.0168 (2.488)*

0.6813 (11.371)*

39.90%

1993

257

-0.0049 -(0.884)

0.0012 (2.103)**

0.8357 (15.022)*

50.45%

1994

256

0.0314 (1.862)**

0.0033 (2.035)**

0.6900 (11.261)*

33.52%

1995

256

-0.0151 -(1.609)**

0.0294 (2.449)*

0.8628 (10.947)*

33.25%

All years

4410

0.0124 (7.555)*

1 0.0075 (2.513)*

0.6928 (48.623)*

40.74%

Mean

2

0.0145*

58.46%

30.98% |

18.65%

0.8074*

1. ^-statistics are provided in parentheses. * Significant at a ^ 0.01. **Significant at a =s 0.05. 2. This is the mean of the yearly coefficients estimated to control for the effect of cross-sectional correlation in the error terms.

56

Earnings Measurement, Determination, Management

SUMMARY AND CONCLUSIONS This study shows that earnings is determined as a process of response to the wealth generated by the firm, measured by net value added, and a process of adjustment to the previous earnings level. The first result implies the existence of a positive net value added response coefficient, in the sense that the management of the firm determines the level of earnings proportionally to the level of wealth generated as measured by the net value added. The net value added response coefficient represents how much the firm changes its earnings in response to a new level of net value added. Basically, wealth generation precedes earnings determination. A knowledge of the wealth created in a given year as measured by the net value added and the existence of a net earnings response model is used by management to determine the level of earnings compatible with the wealth generated. The second result implies the existence of earnings adjustment coefficient in the sense that management determines the level of earnings in a given year proportionally to the previous year level of earnings. The earnings adjustment coefficient represents how much the firm changes its earnings. The previous year level of earnings acts as an anchor before adjustments are made to send a signal to the market of an ascending trend in earnings.

NOTE 1. Ahmed Riahi-Belkaoui, Value Added Reporting: The Lessons for the U.S. (Westport, CT: Greenwood Publishing, 1992).

SELECTED READINGS Accounting Standards Steering Committee. The Corporate Report. London: Accounting Standards Steering Committee, 1975. American Accounting Association. "Committee on Accounting and Auditing Measurement, 1989-90." Accounting Horizons (September 1991): 81-105. Bannister, James W., and Ahmed Riahi-Belkaoui. "Value Added and Corporate Control in the U.S." Journal of International Financial Management and Accounting (autumn 1991): 241-257. Belsley, D. A., E. Kuh, and R. E. Welsh. Regression Diagnostics: Identifying Influential Data and Sources of Collinearity. New York: Wiley, 1980. Karpik, P., and Ahmed Riahi-Belkaoui. "The Effects of the Implementation of the Multidivisional Structure on Shareholders' Wealth: The Contingency of Diversification Strategy." Journal of Business, Finance and Accounting (April 1994): 349-366. Riahi-Belkaoui, Ahmed. Performance Results in Value Added Reporting. Westport, CT: Greenwood Publishing, 1996.

Earnings Determination following Wealth Measurement

57

. Value Added Reporting: The Lessons for the U.S. Westport, CT: Greenwood Publishing, 1992. White, H. "A Heteroscedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Heteroscedasticity." Economica (May 1980): 817-838.

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4 Contextual Accruals and Cash Flow Based Valuation Models: Impact of Multinationality and Reputation INTRODUCTION This chapter investigates the impact of the contextual factors of multinationality and reputation on accrual and cash flow based valuation. The nature and amount of information in cash flows and accruals was first examined by Wilson 1 using stock behavior around the release of annual reports. He concluded that the market reacts more favorably the larger (smaller) are the cash flows (current accruals). Bernard and Stober2 were, however, unable to confirm Wilson's results over a longer period, and according to the state of the economy.3 This chapter extends the works of Wilson and Bernard and Stober in two ways. The first is to assess the generality and robustness of Wilson's results by using a total market value based valuation model rather than an excess-return based model. 4 The results confirm Wilson's results. The second is to examine two contextual models of the implications of cash and accruals. We argue that the preference of cash flows over accruals will arise under conditions of high multinationality and high reputation. Support for the hypotheses was found. In sum, we are able to identify the economic logic underlying how the market assimilates information about cash and accruals under the specific contextual environments of multinationality and corporate reputation.

60

Earnings Measurement, Determination, Management

MARKET VALUATION MODELS A Simplified Model A simplified model relates market value of equity at the end of a period to the corresponding accruals and cash flows as follows:

where: MVlt = market value of equity of firm J at the end of year t Ait = total accruals of firm J at the end of year t CFtt = cash flows of firm I at the end of year t All variables are deflated by the total assets at the end of year t Impact of Multinationality Investors recognize the enhancement of firm value through internationalization. The evidence shows that investors recognize multinationality given that multinational firms show lower systematic risk and unsystematic risk compared to securities of purely domestic firms. To test the incremental association between market value of equity and multinationality, after controlling for accruals and cash flows, model (1) is adjusted as follows:

where: MULTYit = level of multinationality of firm I at the end of year t Impact of Reputation To create the right impression or reputation, firms signal their key characteristics to constituents to maximize their social status. Basically, corporate audiences were found to construct reputation on the basis of accounting and market information or signals regarding firm performance. 5 These reputations have become established and constitute signals that may affect actions of firms' stakeholders, including their shareholders. Specifically, a good reputation can be construed as a competitive advantage within an industry. This implies that investors consider corporate reputation in determining firm value. To test for incremental association between the market value equity and reputation after controlling for accruals cash flows and multinationality, model (2) is adjusted as follows:

Contextual Accruals and Cash Flow Based Valuation Models

61

where: REPit = corporate reputation score for firm I at the end of year t RESEARCH METHOD In this study, incremental associations between market value and cash flow from operations, multinationality, and corporate reputation, after controlling for accruals, are presented as evidence of the relevance of the contextual environment of flow based valuation models. To describe and assess the significance of these relationships, we use three linear regression approaches (models 1 to 3) that relate market value of equity to the accounting and nonaccounting variables mentioned earlier. Data and Sample Selection The population consists of firms included in both Forbes' Most International 100 American manufacturing and service firms and Fortune's surveys of corporate reputation from 1987 to 1990. The security data are collected from the CSRP Return files. The accounting variables are collected from COMPUTSTAT. Cash flows from operations are reported under SFAS No. 95 (Compustat item 308). The derivation of the total accruals, multinationality, and corporate reputation variables are explained later. The final sample included 360 firm-year observations that have all the accounting and nonaccounting variables. Measuring Total Accruals Total accruals are calculated for each firm as follows:

where: DEPlt = depreciation expense and the depletion charge for firm I, in year t ARlt — accounts receivable balance for firm I, at the end of year t INVlt = inventory balance for firm J, at the end of year t APlt = accounts payable for firm 7, at the end of year t TPlt = taxes payable balance for firm I, at the end of year t DTlt = deferred tax expense for firm I, in year t TAlt = total asset balance for firm I, at the end of year t

62

Earnings Measurement, Determination, Management Measuring Multinationality

Previous research has attempted to measure the following attributes of multinationality: 1. Performance—in terms of what goes on overseas 2. Structure—in terms of how resources are used overseas 3. Attitude or Conduct—in terms of what is top management orientation Sullivan6 developed nine measures of which five were shown to have a high reliability in the construction of a homogeneous measure of nationality: (1) foreign sales as a percentage of total sales (FSTS), (2) foreign assets over total assets (FATA), (3) overseas subsidiaries as a percentage of total subsidiaries (OSTS), (4) top management's international experience (TMIE), and (5) psychic dispersion of international operations (PDIO). In this study we follow a similar approach by measuring multinationality through three measures: (1) foreign sales/total sales (FSTS), (2) foreign profit/total profits (FPTP), and (3) foreign assets/total assets (FATA). As shown in Exhibit 4.1, one common factor appears in intercorrelations among the three variables, as the first eigenvalue alone exceeds the sum of commonalities. The common factor is significantly and positively correlated with the three measures. As pointed out, these factor scores were used to measure the degree of multinationality of firms in the sample. Measuring Corporate Reputation The Fortune survey covers every industry group comprising four or more companies. The industry groups are based on categories established by the U.S. Office of Management and Budget (OMB). The survey asked executives, directors, and analysts in particular to rate a company on the following eight key attributes of reputation: 1. Quality of management 2. Quality of products/services offered 3. Innovativeness 4. Value as long-term investment 5. Soundness of financial position 6. Ability to attract/develop/keep talented people 7. Responsibility to the community/environment 8. Wise use of corporate assets

Contextual Accruals and Cash Flow Based Valuation Models

63

Exhibit 4.1 Selected Statistics Related to a C o m m o n Factor Analysis of Three Measures of Multinationality for Forbes' The M o s t International 1 0 0 U.S. Firms for the 1 9 8 7 1 9 9 0 Period 1.

Eigenvalues of the Correlation Matrix: Eigenvalues

2.

1

2

3

1.8963

0.9169

0.1868

Factor Pattern FACTOR1

3.

4.

FS/TS

0.93853

FP/TP

0.40913

FATA

0.92089

Final Communality Estimates:

Total = 1.389626

FS/TS

FP/TP

FA/TA

0.8808

0.16738

0.84804

Standardized Scoring Coefficients FACTOR1

5.

FS/TS

0.49494

FP/TP

0.21575

FA/TA

0.48563

Descriptive Statistics of the Common Factor Extracted from the Three Measures of Multinationality Maximum

201.059

Third Quartile

52.231

Median

41.50

First Quartile

30.648

Minimum

5.198

Mean

43.062

Variable definitions: FS/TS: Foreign sales/ Total sales. FP/TP: Foreign profits/Total profits. FA/TA: Foreign assets/Total assets.

64

Earnings Measurement, Determination, Management

Ratings were on a scale of 0 (poor) to 10 (excellent). The score met the multiple-constituency ecological model view of organizational effectiveness. For purposes of this study, the 1987 to 1990 Fortune magazine surveys were used. To obtain a unique configuration, a factor analysis is used to isolate the factor common to the eight measures of reputation. All the observations were subjected to factor analysis and one common factor was found to explain the intercorrelations among the eight individual measures. Exhibit 4.2 reports the results of the common factor analysis. One common factor appears to explain the intercorrelations among the eight variables, as the first eigenvalue alone exceeds the sum of the commonalities. The common factor is significantly and positively correlated with the eight measures. As pointed out earlier, based on the factor scores, highreputation firms were chosen from the top 24 percent of the distribution factor scores while low-reputation firms were chosen from the bottom 25 percent of the distribution factor scores.

RESULTS Panel A of Exhibit 4.3 reports description statistics for the variables used in our tests and Panel B shows correlation among variables. The correlations reported in Panel B of Exhibit 4.3 show that all correlations between MVit, Ait, CFit, MULTYit, and REPit are significant at the 0.01 level. The significant associations among other variables indicate some degree of collinearity among the independent variables in the regression analyses. However, the maximum conditions index in all subsequent regressions with earnings and both cash flow variables is only 4.45. Mild collinearity is diagnosed for maximum condition indices between 5 and 10 and severe collinearity for an index over 30. Thus, collinearity does not seem to influence our results. For each of the multivariate regressions to be reported, we perform additional specification tests, including checks for normality and consideration of various scatter plots. A null hypothesis of normality could not be rejected at the 0.01 level in all cases, and the plots revealed some heteroscedasticity but no other obvious problems. Therefore, we calculated the tstatistics after correcting for heteroscedasticity. Exhibit 4.4 presents the regression result for models (1) to (3). Model (1) relates the total market value deflated by total assets to the accruals and cash flows from operations, also deflated by total assets. As shown in Exhibit 4.4, the coefficient for total accruals is significantly negative while the coefficient for cash flows is significantly positive. As expected, the total market value is negatively related to the total accruals and positively related to cash flows. These results show that the market reacts favorably the larger (smaller) are the cash flows (current accruals). At the same time, the results

Contextual Accruals and Cash Flow Based Valuation Models

65

Exhibit 4.2 Selected Statistics Related to a Common Factor Analysis of Measures of Reputation 1.

Eigenvalues of the Correlation Matrix: Eigenvalues 1 6.7805

2.

2 0.5562

4 0.1343

3 0.3835

5 0.1808

6 0.0544

7 0.0476

8 0.0331

Factor Pattern* FACTOR1

3.

4.

R,

0.9537

RA

0.96506

*7

0.8080

R2

0.9184

Rs

0.8987

R*

0.9484

/?3

0.879

R6

0.9809

Final Communality Estimates;:

Total = 1.389626

R,

R2

*3

RA

R,

R6

*7

*8

0.9096

0.8435

0.7737

0.9312

0.8077

0.9621

0.6520

0.8996

Standardized Scoring Coefficients FACTOR1

5.

/?,

0.1406

R2

0.1354

R,

0.1279

tf 6

RA

0.1423

tf7

0.1191

/?,

0.1325

tfg

0.1398

0.1446

Descriptive Statistics of the Common Factor Extrarted from the Three Measures of Reputation Maximum

9.001

Third Quartile

7.274

Median

6.604

First Quartile

6.076

Minimum

3.1548

Mean

6.5926

*R] - Quality of management. R2 = Quality of products/services. ft, = Innovativeness. R4 = Value as long-term investment. R5 = Soundness of financial position. /?6= Ability to attract, develop, and keep talented people. Rn = Responsibility to the community and environment. Rs = Wise use of corporate assets.

Exhibit 4 3 Descriptive Statistics and Correlations Panel A: Descriptive Statistics Variables MVt A, CFt MULTYi, REP,

Mean

Standard Deviation

Minimum

25%

Median

75%

0.894 0.047 0.104 43.062 6.592

0.791 0.024 0.062 19.682 0.974

0.018 0.010 0.052 5.198 3.154

0.381 0.031 0.065 30.648 6.076

0.665 0.047 0.112 41.503 6.604

1.132 0.062 0.143 52.231 7.264

MVU

A,

CFt

MULTY,

REP,

1.000 0.061* 0.717* 0.096* 0.512'

1.000 0.454' 0.023 0.070

1.000 -0.012 0.495*

1.000 0.009

1.000

Panel B: Correlations

MV, A, CFi MULTY, REI>

MVit = Market-value of equity for firm i in period t. Ait = Total accruals for firm i in period t. CFit = Cash flows from operations for firm i in period t. MULTYit = Index of multinationality for firm / in period t. REPi( = Index of complete reputation for firm / in period t.

Maximum 5 0.175 0.254 201.059 9.001

Contextual Accruals and Cash Flow Based Valuation Models

67

Exhibit 4.4 Regression Results of Linear Models1

Intercept

A„ CF„

Model 1

Model 2

Model 3

0.17035 (2.737)* -11.2791 (-9.521)* 11.8366 (24.703)*

-0.1082 (-1.36) -16.7071 (-14.621)* 14.6982 (30.106)* 0.0043 (3.3347)*

0.6296 360

0.7328

-0.6129 (-2.870)' -16.2253 (-12.406)* 13.8484 (22.240)* 0.0047 (3.253) 0.0821 (2.534)* 0.7588

MULTY,, REP, Adjusted R2 n

2

MV^f = Market, value of equity of firm / at the end of year t. Ait = Total accruals of firm / at the end of year t. CFit = Cash flows of firm / at the end of year /. MULTYit = Level of multinationality of firm / at the end of year t. REPit = Corporate reputation score for firm / at the end of year t. *Significant at 0.01 level. "Significant at 0.05 level. show that accruals and cash flows from operations each provide incremental value-relevance beyond one another in explaining market value. Model (2) relates the total market value to multinationality in addition to accruals and cash flows from operations. As shown in Exhibit 4.4, the coefficient of multinationality is significantly positive at the 0.01 level. In addition, R2 increased from 62.96 percent in model (1) to 73.28 percent in model (2). The evidence suggests that multinationality provides incremental value-relevance beyond accruals and cash flows in explaining market value. Model (3) relates the market value to the accounting variables of accruals and cash flows and the nonaccounting variables of multinationality and corporate reputation. As shown in Exhibit 4.4, the coefficient for corporate reputation (0.0821) is significantly positive at the 0.01 level. This evidence

68

Earnings Measurement, Determination, Management

suggests that corporate reputation provides incremental value relevance beyond accruals, cash flows, and multinationality in explaining market value. S U M M A R Y A N D CONCLUSIONS This chapter examined the generality and robustness of an accrual and cash flow based model that includes the contextual factors of multinationality and corporate reputation. The evidence confirms previous results using total m a r k e t value as a dependent variable and a price level rather than a return/changes regression. Basically the market value is larger the larger (smaller) the cash flows (current accruals). In addition, the preference of cash flows over accruals arises under conditions of high multinationality and high corporate reputation. The results verify the economic logic underlying h o w the market assimilates information about cash and accruals under the specific contexts of multinationality and reputation. First, a price level regression seems to provide a better specification of this economic logic. Second, contextual factors play a fundamental role in the same economic logic. Future research needs to examine the role of other contextual factors in the determination of the relationship between the market value and accruals and cash flows.

NOTES 1. P. Wilson, "The Relative Information Content of Accruals and Cash Flows: Combined Evidence at the Earnings Announcement and Annual Report Release Date," Journal of Accounting Research (September 1986): 165-200. 2. V. Bernard and T. Stober, "The Nature and Amount of Information in Cash Flows and Accruals," The Accounting Review (October 1989): 624-652. 3. Recent research on the value-relevance of cash flows and accruals documents a positive relationship between accruals and firm value. 4. It has been argued that in situations where prices lead earnings, price level regressions are better specified than return/changes regressions for estimating the price earnings relation. 5. Ahmed Riahi-Belkaoui and Ellen Pavlick, "Asset Management Performance and Reputational Building for Large U.S. Firms," British journal of Management 2 (1991): 231-238. 6. Daniel Sullivan, "Measuring the Degree of Internationalization of a Firm," journal of International Business Studies (1994): 325-342.

SELECTED READINGS AH, A. The Incremental Information Content of Earnings, Working Capital from Operations, and Cash Flows, journal of Accounting Research 32 (1994): 61-73. Belkaoui, Ahmed. "Organizational Effectiveness, Social Performance and Economic

Contextual Accruals and Cash Flow Based Valuation Models

69

Performance." Research in Corporate Social Performance and Policy 12 (1992): 143-155. Bernard, V., and T. Sober. "The Nature and Amount of Information in Cash Flows and Accruals." The Accounting Review (October 1989): 624-652. Fornbrum, C , and M. Shanley. "What's in a Name? Reputational Building and Corporate Strategy." Academy of Management Journal 33 (1990): 233-258. Riahi-Belkaoui, Ahmed, and E. Pavlik. "Asset Management Performance and Reputation Building for Large U.S. Firms." British Journal of Management 2 (1991): 231-238. Sullivan, Daniel. "Measuring the Degree of Internationalization of a Firm." Journal of International Business Studies (1994): 325-342. Wilson, G P. "The Incremental Information Content of the Accrual and Funds Components of Earnings after Controlling for Earnings." The Accounting Review 62 (1987): 293-322.

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5 Multinationality and Earnings Management INTRODUCTION This chapter develops and tests the hypothesis that managers of high multinationality firms make accounting choices to reduce reported earnings compared to managers of low multinationality firms. Unlike other studies we assume that earnings management is a present and continuous phenomenon rather than a behavior conditioned by an eventual crisis. While all firms are potentially resorting to earnings management, the level of multinationality is assumed to affect the nature of earnings management with high multinationality firms potentially resorting to income-reducing accruals. We argue that high levels of multinationality causes higher profitability and/or higher political costs. A result of the higher reported accounting numbers is the possible perception of the accounting rates of return as "excessive" and indicative of monopolistic power on the part of the firm, thereby increasing the political costs. In such a case, managers' reporting of lower earnings may be expected to reduce political costs and/or political risk. Accrual analysis is performed on a sample of high and low multinationality firms to determine the extent of earnings management. Our findings indicate that managers of high multinationality firms facing potentially high political costs and political risk report income decreasing accruals compared to low multinationality firms.

72

Earnings Measurement, Determination, Management

MULTINATIONALITY AND EARNINGS MANAGEMENT The multinational firm is a collection of valuable options and generates profits that enhance its value. The arbitrage benefits result from (a) the exploitation of various institutional imperfections; (b) timing options; (c) technology options; and (d) staging options. Better financing bargains, as well as capital availability, are also possible through internationalization. In addition, multinational firms can achieve arbitrage benefits in financing cash flows by (a) exploiting financial bargains; (b) reducing taxes on financial flows; and (c) mitigating risks or shifting them to agents with a comparative advantage in beating them. These arbitrage benefits have resulted in both higher profitability and higher political risk. Both increased profitability and political risk are expected to induce managers to resort to income-reducing accruals. First, the increase in the profitability of multinational firms increases both their political visibility and political costs. The political-cost hypothesis predicts that managers confronted with the possibility of politically imposed wealth transfer will resort to earnings management to reduce the likelihood and size of this transfer. Thus, high multinationality and high income firms who are particularly vulnerable to wealth-extracting political transfers in the form of legislation and/or regulation will have an incentive to resort to accruals to reduce their reported income numbers compared to low multinationality and low income firms. Second, political risk is a phenomenon that characterizes an unfriendly climate to visibly profitable multinational firms. It refers to the potential economic losses arising as a result of governmental measures or special situations that may limit or prohibit the multinational activities of a firm. One way to limit the potential emergence of political risk is to reduce the reported earnings number. Earnings management in high multinational firms may be a way of reducing the factors mitigating the emergence of political risk. We hypothesize that high multinational firms make accounting choices to reduce income and net worth compared to low multinationality firms. HI: High multinationality firms make income-decreasing accruals compared to low multinationality firms. RESEARCH DESIGN The objective of the design is to examine the potential relationships between multinationality and the total accruals of firms as those accruals reflect accounting choices made by management. The technique for the estimation of nondiscretionary accruals is adopted in this study. It estimates nondiscretionary accruals by regressing total accruals on the change in sales

Multinationality and Earnings Management

73

(a proxy for level of activity) and on the fixed asset balance. The approach leads to an estimate of discretionary accruals that is less biased and less noisy than earlier models and eliminates the assumption that accruals remain stationary over time. The basic model is as follows:

where: = accruals in year £/Total Assets,, — change in sales from year t - 1 to year t, (Sales Revenue,, — Sales Revenue,,. J/Total Assests,, FIXASSETStt = fixed assets at the end of year t (Fixed Assets,,)/ Total Assets,,

Ait CHSALESit

In the estimation process, model (1) is expanded to include an indicator variable to measure the discretionary accruals of high multinationality firms. The expansion includes also total assets as a measure of size and dummy variables for each of the year of analysis. The effect of multinationality is tested by estimating model (3).

where TA is total assets and YR is a dummy variable for a year of analysis. The expected sign of the coefficient for CHSALES is positive. It is expected to be negative for all the other explanatory variables. The coefficient of MULTY will be negative if managers lower accruals for high multinationality firms. A two-step generalized least square error components model is used in this study, as it is more efficient than the within-group estimator, fixed effects covariance model. DATA Sample and Method The sample consisted of all the firms included in Forbes'' "Most International" 100 American manufacturing and service firms in the 1987 to 1990 period. Financial data were collected from both the Forbes articles and COMPUSTAT. Total accruals are calculated for each firm as follows:

74

Earnings Measurement, Determination, Management

where: DEPit = depreciation expense and the depletion charge for firm J, in year t ARit = accounts receivable balance for firm I, at the end of year t INVit — inventory balance for firm /, at the end of year t APit = accounts payable for firm J, at the end of year t TPit = taxes payable balance for firm I, at the end of year t DTtt = deferred tax expense for firm I, in year t TAit = total asset balance for firm I, at the end of year t The data are pooled over time and across firms, resulting in a sample of 339 firm-years. To test the effect of multinationality on discretionary accruals, a dichotomous indicator variable, MULTY, is added to model (1). MULTY takes on the value of 1 for the group firms classified as high multinationality firms and 0 for firms classified as low multinationality firms. Model (1) is also expanded to include YRin dummy-coded variable as 1 for year t (t = 1987-1990), and TAit for the total assets of the firm. The YR variables measure the time effect for each of the four years. The TA variable is added as a result of the size hypothesis whereby large firms are expected to make income-decreasing choices relative to small firms. The effect of size is important given the evidence presented later about the significant difference in size between the high multinationality and the low multinationality firms. Measuring Multinationality Previous research has attempted to measure three attributes of the degree multinationality: 1. Performance in terms of what goes on overseas 2. Structure in terms of how resources are used overseas 3. Attitude or conduct in terms of what is top management orientation Nine measures were identified (1) foreign sales as a percentage of total sales (FSTS), (2) research and development intensity (RDI), (3) advertising intensity (AI), (4) export sales as a percentage of total sales (ESTS), (5) foreign profits as a percentage of total profits (FPTP), (6) foreign assets over total assets (FATA), (7) overseas subsidiaries as a percentage of total subsidiaries (OSTS), (8) top management's international experience (TMIE), and (9) psychic dispersion of international operations (PDIO). Of these nine measures, an item-total analysis showed the five variables of FSTS, FATA, OSTS, PDIO, and TMIE to have reliability in the construction of a homogeneous measure of multinationality. We follow a similar approach in this study,

Multinationality and Earnings Management

75

using an ensemble of variables to measure multinationality. Three measures of multinationality generally available are used in this study: foreign sales/ total assets (FSTS), foreign profits/total profits (FPTP), and foreign assets/ total assets (FATA). To obtain a unique contribution, a factor analysis is used to isolate the factor common to the three measures of multinationality. All the observations were subjected to factor analysis and one common factor was found to explain the intercorrelations among the three individual measures. Exhibit 5.1 reports the results of the common factor analysis. One factor appears to explain the intercorrelations among the three variables, as the first eigenvalue alone exceeds the sum of commonalities. The common factor is significantly and positively correlated with the three measures. As pointed out earlier, based on these factor scores, high multinationality firms were chosen from the top 25 percent of the distribution factor scores while low multinationality firms were chosen from the bottom 25 percent of the distribution factor scores. TESTS AND RESULTS Descriptive statistics for selected variables and the factor scores are presented in Exhibit 5.2. Exhibit 5.3 shows the correlations among the variables used in this study. The correlations reported in Exhibit 5.3 show that the correlations between A, CHSALES, FIXASSETS, and TA are significant at the 0.01 and 0.05 levels. The significant association among the variables indicates some degree of multicollinearity among the independent variables in the regression analyses. However, the maximum condition index in all subsequent regressions with total accruals A is only 4.36. Mild collinearity is diagnosed for maximum condition indices between 5 and 10 and severe collinearity for an index over 30. Thus, collinearity does not seem to influence our results. For each of the multivariate regressions to be reported, we perform additional specification tests, including checks for normality and consideration of various scatter plots. A null hypothesis of normality could not be rejected at the 0.01 level in all cases, and the plots revealed some heteroscedasticity but no other obvious problems. Therefore, we calculated the tstatistics after correcting for heteroscedasticity. The results for the error-components estimation of model (1) are reported in Exhibit 5.4. As expected, both CHSALES and FIXASSETS are statistically significant. The overall model is also significant with an F-value of 32.618 and an adjusted R2 of 15 percent. It appears that a significant portion of the variation in accruals of multinational firms can be explained by changes in sales and the fixed asset balance. The error-components regression results for model (2) are reported in Exhibit 5.5. The results support the view that the variation in accruals can be explained by the change in sales, the fixed asset balance, and time-

Exhibit 5.1 Selected Statistics Related to a Common Factor Analysis of Three Measures of Multinationality for Forbes' The Most International 100 U.S. Firms for the 19871990 Period 1.

Eigenvalues of the Correlation Matrix: Eigenvalues

2

1

2

3

1.8963

0.9169

0.1868

Factor Pattern FACTOR1

3.

4

FS^S

0.93853

FPflTP

0.40913

FA/TA

0.92089

Final Communality Estimates:

Total = 1.3 89626

FS/TS

FPATP

FA/TA

0.8808

0.16738

0.84804

Standardized Scoring Coefficients FACTOR1

5

FS/TS

0.49494

FP/TP

0.21575

FA/TA

0.48563

Descriptive Statistics of the Common Factor Extraaed from the Three Measures of Multinationality Maximum

201.059

Third Quartile

52.231

Median

41.50

First Quartile

30.648

Minimum

5.198

Mean

43.062

Variable definitions: FS/TS: Foreign SalesATotal sales FP/TP: Foreign profits/Total profits FA/TA: Foreign assets/Total assets 76

Exhibit 5.2 Descriptive Statistics A. High-Multinationality Sample Mean

Standard Deviation

Maximum

Median

Minimum

Foreign Revenues/ Total Revenues

39.53

1554

75.1

39.85

9.2

Foreign Profit/Total Profit

55.97

39.09

315.9

50.8

10.7

Foreign Assets/ Total Assets

32.33

11.78

58.8

29.5

7.8

Total Revenues (thousands)

3554.8

29002.1

136932

24081

6672

Total Assets (thousands)

53146.3

50198.3

231768

34465

7451

Net Profit (thousands)

1715

1720.01

8020

1305

.4407

Score

47.96

17.27

89.27

44.69

12.00

Mean

Standard Deviation

Maximum

Median

Minimum

Foreign Revenues/ Total Revenues

30.75

11.71

74.9

30.00

9.6

Foreign Profit/Total Profit

39.90

34.13

230

27.30

0.1

Foreign Assets/ Total Assets

28.88

12.84

84.7

27.35

3.6

Total Revenues

6458.09

3093.3

17803

5734

2318

Total Assets

9459.35

14813.01

118250

5154

2034

Net Profit

344.83

320.27

1124.3

352.2

-515.2

38.13

15.82

96.08

36.03

8.82

Variables

B. Low-Multinationality Sample Variables

|Score

77

Earnings Measurement, Determination, Management

78

Exhibit 5.3 Pearson Correlation Coefficients Variables

A

CHSALES

FIXASSETS

SCORE

TA

A

1.000

0.1254**

0.4150*

0.0557

-0.3573*

1.000

0.3745*

-0.0438

-0.2123*

1.000

0.0608

-0.5336*

1.000

-0.0078

CHSALES FIXASSETS SCORE TA

1.000

'•Significant at a = 0.01 **Significant at a = 0.05 Variable definitions: A = total accruals CHSALES = change in sales FIXASSETS = fixed assets at the end of the year SCORE = multinationality score TA = total assets

Exhibit 5.4 Results of Regression Estimation—Model (1)

Interdependent Variables Intercept CHSALES FIXASSETS nR2 Adjusted R2

Expected Sign +

-

Coefficient

f-value

One-tailed probability

-0.0236 0.0160 -0.1431

7.328 4.049 -7.675

0.0001 0.0001 0.0001

339 0.1622 0.1572

Variable definitions:

where: DEP = depreciation expense AR = accounts receivable INV = inventory AP = accounts payable TP — taxes payable DT = deferred tax expense TA = total assets CHSALESit = (net salesy, - net sales;,_ FIXASSETS,, = fixed assets/TA tf

x)lTAit

F = statistics 32.618

Probability 0.0001

Multinationality and Earnings Management

79

Exhibit 5.5 Results of Regression Estimation—Model (2)

Interdependent Variables Intercept CHSALES FIXASSETS MULTY TA YR> YR2 YR3 R2 Adjusted R2 n

Expected Sign + +

-

Coefficient -0.0146 0.0026 -0.1717 -0.0080 -0.0000006 -0.0029 -0.0018 -0.00122 0.3411 0.3121

f-value -2.470 4.155 -6.436 -2.555 2.487 -4.758 -4.051 -4.330 F = statistics 4.758

One-tailed probabality 0.0146 0.0002 0.0001 0.0116 0.0102 0.0001 0.0001 0.0001 Probability 0.0001

166

Variable definitions: TA = total assets YR = year MULTY = 1 if multinationality is high, 0 if multinationality is low

dependent effects. In addition, the variable of interest, MULTY, is significant at the 0.04 level, with a one-tailed test, and its sign is negative. Because high multinationality was coded as 1, the negative sign of MULTY indicates that discretionary accruals of high multinationality firms were lower than those of low multinationality firms, which supports the political cost and political risk hypotheses. A second test compared the residuals of high multinationality and low multinationality firms. The mean residual is —0.0037 for the high multinationality group and 0.0024 for the low multinationality group. With a ttest estimated by using unequal variances, the difference between the two means is significant at the 0.05 level on the basis of the one-tailed test (t = 2.074). Thus, high multinationality firms took significantly more incomereducing discretionary accruals than low multinationality firms. SUMMARY AND CONCLUSIONS This study examines, on a longitudinal basis, whether managers of multinational firms respond to the political costs associated with a high level of multinationality by adjusting their discretionary accruals. The total accruals for the 100 largest U.S. multinationals were examined over the 1987-1990 period by using the residuals of a fixed effects covariance model that regressed total accruals on the change in sales, the fixed asset balance,

80

Earnings Measurement, Determination, Management

and a d u m m y variable for each year of study. The hypothesis is tested using a tested design with a d u m m y variable, coded 1 for high multinationality, included in the accrual model. This multinationality variable was significant and negatively signed, which indicates that the total accruals were lower for high multinationality firms. In addition, the mean residual was negative for high multinationality firms and positive for low multinationality firms. The results support the political cost and political risk hypotheses associated with multinationality and are consistent with the view that managers adjust earnings in response to a high level of multinationality. The results, however, are limited because the sample includes only the largest U.S. multinationals. This limitation suggests one area for future research. The longitudinal approach could be extended to explore responses to a wider range of multinationality. SELECTED READINGS Belsley, D., E. Kuh, and R. Welsch. Regression Diagnostics: Identifying Influential Data and Sources of Collinearity. New York: Wiley, 1980. Cahan, S. "The Effect of Antitrust Investigations on Discretionary Accruals: A Refined Test of the Political-Cost Hypothesis." The Accounting Review 67 (January 1992): 77-95. Christie, A. A. "Aggregation of Test Statistics: An Evaluation of the Evidence on Contracting and Size Hypotheses." Journal of Accounting and Economics 12 (January 1990): 15-36. Hall, S. C , and W. W. Stammerjohan. "Damage Awards and Earnings Management in the Oil Industry." The Accounting Review 1 (January 1997): 4 7 65. Monti-Belkaoui, J., and A. Riahi-Belkaoui. The Nature, Estimation and Management of Political Risk. Westport, CT: Greenwood Publishing, 1999. Riahi-Belkaoui, A. International and Multinational Accounting. London: Dryden Press, 1994. . Multinationality and Financial Performance. Westport, CT: Greenwood Publishing, 1996.

6 Earnings Management and Reputation Building INTRODUCTION Corporate reputation, as a signal of the firm's organizational effectiveness, is essential for various decisions ranging from resource allocation and career decisions to product choices, to name only a few. Receiving a good reputation is helpful to firms in: (1) the creation of a better image in the capital markets and to investors, (2) the potential of charging premium prices to consumers, and (3) the generation of excess returns by inhibiting the mobility of rivals in an industry. Various studies have explicitly investigated the relationship between corporate reputation and various economic and noneconomic indicators that may be used by the corporate audiences to construct reputations. Although the signals used in these three studies show attendance by corporate audiences to different information cues, this study proposes that of most importance to these parties are signals about earnings management. Specific hypotheses are made relating assessments of corporate reputation to various information signals about a firm's earnings management. For a sample of 373 firm-year observations of U.S. multinational firms over fiscal years 1986-1990, we find that a corporate reputation index is negatively related to accruals and positively related to cash flows. HYPOTHESIS DEVELOPMENT This study hypothesizes that corporate audiences attend to the extent of a firm's earnings management in constructing reputational earnings. The

82

Earnings Measurement, Determination, Management

focus on earnings management results from its influence and importance in arriving at a summary measure of firm performance. Earnings management is generally defined as purposeful intervention in the external financial process with the intent of obtaining some private gain. The variety of accrual options available under generally accepted accounting principles and the susceptibility of these accruals to manipulation are witness to the potential management of earnings. These accruals can be made continuously, allowing managers to adjust or "manage" earnings to achieve some optimal level each year. These accruals have informational content given their association with share returns on both long intervals and short intervals. One conclusion is that the market reacts more favorably the larger (smaller) are the cash flows (current accruals). Given the evidence in related research that corporate audiences construct reputations on the basis of accounting and market signals of performance, and given the relevance of accrual and cash flows to share returns, it may be expected that firms that manage earnings will have worse reputations generally than those that do not. In addition, given the general favorable predisposition of the market and the users toward cash flows over accruals, it may also be expected that reputation will be negatively associated with accruals and positively associated with cash flows. In constructing reputation signals from accounting and market indicators of performance, corporate audiences are assumed to assign a negative salience to accruals and a positive salience to cash flows. Accordingly, the following hypotheses are proposed: H,: Corporate reputation is negatively associated with total accruals. H2: Corporate reputation is- positively associated with cash flows.

METHODS Sample The population consists of firms included in both Forbes' Most International 100 American firms and Fortune's surveys of corporate reputation from 1986 to 1990. The accounting variables are derived from COMPUSTAT. The corporate reputation measures are derived from Fortune's surveys. The derivation of the corporate reputation score is explained later. The final sample includes 373 firm-year observations. It includes 110 sample firms that were in one of the five years present in both the Forbes and the Fortune lists. Of the 110 firms 65 appeared consistently on both lists for the five years studied.

Earnings Management and Reputation Building

83

Methods for Analyzing Earnings Management and Corporate Reputation To analyze the effect of earnings management or corporate reputation, the following regression is estimated:

where: REPlt Ait CFit LSIZEit YRit FIRMit

= = = = = =

corporate reputation score of firm / for period t total accruals of firm / for period t deflated by total assets cash flows of firm / for period t deflated by total assets log of total assets of firm i for period t dummy-coded as 1 for year (t = 1986, 1990) dummy-coded as 1 for firm I (I = 1, 110)

The YR variables measure the time effect for each of the five years. The FIRM variables measure the firm effect for each of the 110 sample firms. The two variables, when combined, define a unique intercept for each firm/ year observation. In the context of equation (1) the first hypothesis is Ht: ^l < 0. The second hypothesis is H2: oc2 > 0. The related research suggests that « 3 < 0. All the analyses are conducted on observations that are pooled crosssectionally over time. MEASURES Dependent Variable The main dependent variable of reputation is a score obtained from annual data published by Fortune magazine. The Fortune survey covers every industry group comprising four or more companies. The industry groups are based on categories established by the U.S. Office of Management and Budget (OMB). The survey asked executives, directors, and analysts in particular industries to rate a company on the following eight key attributes of reputation: 1. 2. 3. 4. 5.

Quality of management Quality of products/service offered Innovativeness Value as a long-term investment Soundness of financial position

84

Earnings Measurement, Determination, Management

6. Ability to attract/develop/keep talented people 7. Responsibility to the community/environment 8. Wise use of corporate assets Ratings were on a scale of 0 (poor) to 10 (excellent). The score meets the multiple-consisting ecological model view of organization effectiveness. For purpose of this study, the 1986 to 1990 Fortune magazine surveys are used. To obtain a unique configuration, a factor analysis is used to isolate the factor common to the eight measures of reputation. All the observations are subjected to factor analysis and one common factor was found to explain the intercorrelations among the eight individual measures, as the eigenvalue above exceeds the sum of the commonalities. Exhibit 6.1 reports the results of the common factor analysis. The common factor is significantly and positively correlated with eight measures. The factor scores are used to measure the corporate reputation score of firms in this study. Independent Variables The independent variables include cash flows, firm size, and total accruals. These variables are collected from COMPUSTAT. Cash flows from operations are reported under SFAS No. 95 (COMPUSTAT item 308). The total accruals are calculated for each firm as follows:

where: DEPlt — depreciation expense and the depletion charge for firm /, in year t ARlt — accounts receivable balance for firm /, at the end of year t INVit = inventory balance for firm /', at the end of year t — accounts payable balance for firm i, at the end of year t APtt TPtt = taxes payable balance for firm /, at the end of year t DTit = deferred tax expense for firm /, in year t TAlt = total asset balance for firm *', at the end of year t RESULTS Exhibit 6.2 presents the basic descriptive statistics for all the variables in model (1) and the intercorrelations among these variables. The low intercorrelations among adjusted predictor variables used in the model gave no reason to suggest multicollinearity, and various diagnostic tests run in the

Earnings Management and Reputation Building

85

Exhibit 6.1 Selected Statistics Related to a Common Factor Analysis of Measures of Reputation 1.

Eigenvalues of the Correlation Matrix: Eigenvalues 2 4 1 3 5 6 6.7726 1.4596 0.3841 0.1347 0.1120 0.0549 2. Factor Pattern* FACTOR1 *7 R, 0.9530 R4 0.9645 R, 0.9180 Rs 0.8982 Rs R? 0.8789 R6 0.9805 3. Final Communality Estimates: Total = 1.389626 R}

R2

R3

R4

R5

R6

7 0.0482

8 0.0331

0.8072 0.9479

R-j

*8

0.9083 0.8428 0.7726 0.9314 0.8069 0.9614 0.6515 0.8986 4. Standardized Scoring Coefficients FACTOR1 Rx 0.1407 R4 0.1424 R7 0.1191 R2 0.1355 R5 0.1325 Rs 0.1399 R3 0.1297 R6 0.1447 5. Descriptive Statistics of the Common Factor Extracted from the Three Measures of Multinationality Maximum 9.002 Third Quartile 7.288 Median 6.614 First Quartile 6.105 Minimum 3.235 Mean 6.622 7?, = quality of management. R2 = quality of products/services. R3 = innovativeness. R4 = value as a long-term investment. R5 = soundness of financial position. R6 = ability to attract, develop, and keep talented people. R7 = responsibility to the community and environment. R8 = wise use of corporate assets. regression models, where size was expressed as the logarithm of total assets, confirmed that it was not a problem. The P-statistic for the model is significant at the 0.0001 level and the adjusted R2 varies from 25.83 percent for innovativeness as a dependent variable to 85.70 percent for soundness of financial position as a dependent variable. The variables A, CF, and LSIZE were related to the reputation variables at the 0.01 probability or better. The signs of each of the variables were as expected. The YR and FIRM variables were tested jointly with an F-test. The F-statistic was significant at the 0.0001 level, which indicates that the dummy variables as a whole were significantly related to total accruals. The individual YR and FIRM variables cannot be easily interpreted. They are only meaningful

86

Earnings M e a s u r e m e n t , Determination, M a n a g e m e n t

Exhibit 6.2 Summary Statistics for Empirical Variables Panel A: Distributional Characteristics Mean

Standard Deviation

Median

Range

REP

6.622

0.963

6.611

5.787

ATTA

0.047

0.025

0.046

0.175

CF/TA

0.104

0.062

0.112

0.400

LSIZE

9.325

1.106

9.073

4.735

Variables

Panel B: Pearson Correlation Among Regression Variables

REP A/TA CF/TA LSIZE

REP

A/TA

CF/TA

LSIZE

1.000 0.039 0.491 a 0.015

1.000 -0.428* -0.295*

1.000 -0.390*

1.000

REP = reputation score A/TA = total accruals deflated by total assets CF/TA = cash flows from operations deflated by total assets LSIZE = logarithms of total assets a Statistical significance at the 1% level for one-tailed test.

when combined to form intercept for each of the 373 firm-year observations. Exhibit 6.3 presents the results of the regression coefficients for all the independent variables using both the reputation score and the eight measures of reputation, as dependent variables. Results of normality tests on the error terms justified the use of the regression technique. Hypothesis 1 predicts that total accruals will negatively affect reputation. With no exceptions, the results in Exhibit 6.3 corroborate the hypothesis that corporate audiences tend to assign higher (better) reputations to firms with lower total accruals. Hypothesis 2 predicts that cash flow from operations will positively affect reputation. With no exceptions, the results in Exhibit 6.3 corroborate the hypothesis that corporate audiences tend to assign higher reputation for firms with a higher cash flow from operations. The control factor of size is, as predicted, positively associated with reputation in all cases. In short, the overall reputation of firms is negatively related to total accruals created by earnings management and positively related to cash flows. For the eight component scores of reputation the same results hold. The subdivision regression alone offers one unique interesting result. The highest R2 is obtained, as would be expected, when

Exhibit 6.3 Explaining Corporate Reputation Independent Variables/ Dependent Variables

Intercept

A

CF

LSIZE

F

Adjusted R1

Reputation Score Quality of Management Quality of Products/ Services Offered Innovativeness Value as a long-term Investment Soundness ofFinancial Position Ability to Attract/Develop/Keep Talented People \Responsibility to Community/ Environment \ Wise use of resources

3.95(9.128)* 4.42 (8.309)* 5.83 (13.699)*

-7.71 (-4.188)* -9.80 (-4.330)* -4.70 (-2.559)*

10.64(13.500)* 10.62(10.97)* 7.69 (9.932)*

0.20 (4.994)* 0.18(3.609)* 0.08 (2.048)*

61.19* 40.13* 34.46'

32.62 23.94 21.20

4.30 (8.793)* 2.84 (5.884)*

-5.19 (-2.493)* -8.94 (-4.352)*

7.79(8.751)* 12.44(14.153)'

0.14(3.254)' 0.29(6.411)'

25.83* 68.16*

16.65 35.07

2.29(4.122)*

-12.29 (-5.194)*

16.11(15.910)*

0.36 (6.979)*

85.70*

4.52

3.31 (7.009)*

-7.05 (-3.508)*

10.72 (12.473)*

0.25 (5.681)*

53.15*

29.55

4.70(12.181)*

-2.52 (-1.540)*

7.39 (10.532)*

0.11(3.277)'

39.80*

93.79

4.32(9.182)"

-10.18 (-5.112)'

11.39(13.370)*

0.14 (3.181)"

60.12

32.33

The regression are OLS t statistics are shown in parenthesis based upon the White (1980) corrected standard errors. a

Statistical significance at the 1 % level for one-tailed test.

88

Earnings Measurement, Determination, Management

soundness of financial position is used as a dependent variable. Reputation as measured by soundness of financial position is affected by earnings management with a negative association with total accruals and positive association with cash flow from operations. This points to an interesting congruence between earnings management and external audiences' assessment. DISCUSSION AND CONCLUSIONS Earnings management affects the level of income through the use of total accruals, but does not affect the level of cash flows from operations. Corporate audiences may be concerned by managers' use of earnings management. This study has hypothesized that, consequently, corporate audiences will construct reputational rankings on the basis of the extent of earnings management. More specifically, the results of an empirical study of the 100 most multinational firms supported the hypothesis that corporate audiences construct reputations on the basis of information about a firm's extent of earnings management by assigning higher reputation for firms with a higher cash flow from operations and lower reputation for firms with higher total accruals. Given the potential that reputation rankings may crystallize the statuses of firms within an industrial social system, firms, through a thorough understanding of the informational medium for which corporate audiences construct reputations, signal these audiences about the extent of earnings management through both accruals and cash flow information. Firms with low accruals and high cash flow receive high reputation from corporate audiences. SELECTED READINGS Belkaoui, A. "Organizational Effectiveness, Social Performance and Economic Performance." Research in Corporate Social Performance and Policy 12 (199 143-153. Fornbrum, C. J., and M. Shanley. "What's in a Name? Reputation Building and Corporate Strategy." Academy of Management Journal 53 (1990): 233-258. Riahi-Belkaoui, A., and E. Pavlik. "Asset Management Performance and Reputation Building for Large U.S. Firms." British Journal of Management 2 (1991): 231-238.

7 The Smoothing of Income Numbers: Some Empirical Evidence on Systematic Differences between Core and Periphery Industrial Sectors

INTRODUCTION While the subject of income smoothing was discussed and tested previously, the effects of the dual economy on income smoothing were never tested for specifically and separately. Accordingly, this study will attempt to discover whether managers do in fact behave as if they engage in goal-directed determination of the cues and signals conveyed to users of financial statements through income numbers and whether this behavior differs between managers in the core (cs) and periphery (ps) sectors.

INCOME SMOOTHING: RELATED RESEARCH Income smoothing may be defined as either the intentional or deliberate dampening of fluctuations about some level of earnings that is currently considered to be normal for a firm. The various empirical studies in income smoothing assumed various smoothing objects (i.e., operating income or ordinary income), various smoothing instruments (i.e., operating expenses, ordinary expenses, or extraordinary items), and various smoothing dimensions (either accounting smoothing or "real" smoothing). Accounting smoothing affects income This chapter is adapted with permission of the editor from: Ahmed Belkaoui and Ronald D. Picur, "The Smoothing of Income Numbers: Some Empirical Evidence on Systematic Differences between Core and Periphery Industrial Sectors," Journal of Business Finance and Accounting (winter 1984): 527-546.

90

Earnings Measurement, Determination, Management

through accounting dimensions, namely smoothing through events' occurrence and/or recognition, smoothing through allocation over time, and smoothing through classification. Real smoothing affects income through the deliberate or intentional changing of the operating decisions and their timing. Various motivations for smoothing are given in the literature such as: (1) to enhance the reliability of prediction based on the observed smoothed series of accounting numbers along a trend considered best or normal by management, (2) to gain tax advantages and to improve relations with creditors, employees, and investors, (3) to reduce the uncertainty resulting from the fluctuations of income numbers in general and reducing systematic risk in particular by reducing the covariance of the firm's returns with the market returns. These reasons for motivation result from the need felt by management to neutralize environmental uncertainty and dampen the wide fluctuations in the operating performance of the firm subject to organizational slack behavior and budgetary slack behavior. Each of these behaviors necessitates decisions affecting the incurrence and/or allocation of discretionary expenses (costs) that result in income smoothing. In addition to these behaviors intended to neutralize environmental uncertainty, it is also possible to identify organizational characterizations that differentiate among different firms in their extent of smoothing. Kamin and Ronen 1 examined the effects of the separation of ownership and control on income smoothing under the hypothesis that management-controlled firms are more likely to be engaged in smoothing as a manifestation of managerial discretion and budgetary slack. Their results confirmed that a majority of the firms examined behave as if they were smoothers and a particularly strong majority is included among management-controlled firms with high barriers to entry. Other organizational characterizations may exist that differentiate among different firms along the dimension of the attempt to smooth. One such characterization derived from theories of economic dualism divides the industrial structure into two distinct sectors— the core and the periphery sectors. STRATIFICATION IN A DUAL ECONOMY AND INCOME SMOOTHING Models of sectorial economic differentiation derived from theories of economic dualism include various perspectives such as theories of dual economy, dual labor markets, and labor force segmentation. Common to all these perspectives is the proposal of a division of the industrial structure of the economy into two distinct sectors (at least in the two-sector model)

The Smoothing of Income Numbers

91

consisting of the core and periphery sectors. These models, however, differ in their definition and conceptualization of these sectors. In the dual labor market and labor force segmentation perspective, the sectors are defined in terms of the characteristics of labor markets and w o r k e r behavior. For example Piori defines the t w o sectors as follows: The central tenet of the analysis . . . is that the role of employment and of the disposition of manpower in the perpetuation of poverty is best understood in terms of a dual labor market. One sector oi that market, which I have termed elsewhere the primary market, offers jobs which possess several of the following traits: high wages, good working conditions, employment stability and job security, equity and due process in the administration of work rules, and chances for advancement. The other, or secondary sector, has jobs which, relative to those in the primary sector, are decidedly less attractive. They tend to involve low wages, poor working conditions, considerable variability in employment, harsh and often arbitrary discipline, and little opportunity to advance. The poor are confined to the secondary labor market. The elimination of poverty requires that they gain access to primary employment. 2 In the dual economy perspective, the sectorial classification derives from the nature of modern industrial capitalism. M o r e precisely, the sectorial classification resulted from the creation during the late nineteenth and early twentieth centuries of a core industrial sector dominated by large oligopolistic corporations. W h a t remained, characterized by smaller firms and a less competitive environment, is considered the periphery sector. For example, Bluestone et al. characterize the t w o sectors as follows: The core economy includes those industries that comprise the muscle of American economic and political power. . . . Entrenched in durable manufacturing, the firms in the core economy are noted for high productivity, high profits, intensive utilization of capital, high incidence of monopoly elements, and high wages. The automobiles, steel, rubber, aluminum, aerospace, and petroleum industries are ranking members of this part of the economy. Workers who are able to secure employment in these industries are, in most cases, assured of relatively higher wages and better than average working conditions and fringe benefits. Beyond the fringes of the core economy lies a set of industries that lack almost all of the advantages normally found in center firms. Concentrated in agriculture, nondurable manufacturing, retail trade, and sub-professional series, the peripheral industries are noted for their small firm size, labor intensity, low profits, low productivity, intensive product market competition, lack of unionization, and low wages. Unlike core sector industries, the periphery lacks the assets, size and political power to take advantage of economies of scale or to spend large sums on research and development. 3 Theories of dual economy suggest that these sectorial differences have important implications for the opportunity structures and environments

92

Earnings Measurement, Determination, Management

faced by individual firms. Firms in the periphery sector face a more restricted opportunity structure and a higher degree of environmental uncertainty than firms in the core sector. The environmental uncertainty is more evident with regard to the market for labor. The core sector is characterized by high productivity, nonpoverty wages, and employment stability, while the periphery sector is characterized by relatively low average and marginal productivity, low wages, and employment instability. The core sector uses its market power and high degree of profitability to hire and train the best workers and maintain nonpoverty wages levels without seriously eroding their profit margin. In fact, Beck and Horan examined the importance of industrial sectors as hypothesized by the dual economy literature on the process of earnings determination and found substantively and statistically significant differences in the labor force composition and economic status between core and periphery industrial sectors.4 A direct result of this situation is that turnover in the core sector is likely to be more expensive and less attractive than in the periphery sector. As stated by Harrison: Secondary (periphery) employers have several reasons for placing a low value on turnover, in sharp contrast to their fellows in the primary market. They can, as a rule, neither afford nor do their technologies require them to invest heavily in "specific training." Instead, they tend to rely on the "general training" (e.g., literacy, basic arithmetic) provided socially. With minimal investment in their current labor force, and given the ready availability of substitute labor outside the firm, such employers are at the least indifferent to the rate of turnover.5 Given the evidence on the difference in labor composition, economic status of employees, low turnover, higher wages, and unionized labor force, the firms in the core industry face less uncertainty in their labor management than firms in the periphery industry. Firms in the periphery industry have more opportunity and more predisposition to smooth both their operating flows (for example, through their labor management) and reported income measures, than firms in the core sector. In other words, the two economic sectors rely on their differential ability to maximize profits through the structuring of their labor processes. TEST FOR SMOOTHING The test consists of observing the behavior of the following smoothing variables: (1) operating expenses (OPEX) not included in cost of sales, (2) ordinary expenses (OREX), and (3) operating expenses plus ordinary expenses (OPEX + OREX), vis-a-vis the behavior of two objects of smoothing, (1) operating income (OP) and (2) ordinary income (OR). It is assumed that management knows the future streams of inflows and

The Smoothing of Income Numbers

93

outflows and their time distinction, and has determined what should be the normal trend of OP and OR. To determine their normal trend, two expectation models will be used here, namely a time trend model and a market trend model. The Time Trend Two models will be used. (a) The series of smoothed variables, OP and OR, and of smoothing variables OPEX, OREX, and OPEN + OREX were detrended in a time regression over a maximum span of twenty years, 1958 to 1977, as per the equations below

where: i = 1 for OP, /" = 2 for OR, i = 3 for OPEN, i = 4 for OREX, and / = 5 for OPEX + OREX Ytjt = observed OP, OR, OPEX, OREX, OPEX + OREX for firm / in year t (b) The first differences in OPEX, OREX, and OPEX + OREX were detrended in a time regression as per equation (2):

where: i = 1 for OPEX, / = 2 for OREX, i = 3 for OPEX + OREX The Market Trend The first differences in OP, OR, OPEX, OREX, and OPEX + OREX were regressed on a macro index of first differences measured, respectively, as the mean observed first differences of OP, OR, OPEX, OREX, and OPEX + OREX as per equation (3):

where: i = 1 for OP, 2 for OR, 3 for OPEX, 4 for OREX, and 5 for OPEX + OREX Mtt = sample mean index of OP, OR, OPEX, OREX, and OPEX + OREX where:

94

Earnings Measurement, Determination, Management

TEST CRITERION The test criterion was based on the correlation coefficient between the deviations of the smoothing objects and the deviations of the smoothing variables. A positive correlation is consistent with a smoothing behavior. Then for each subsample classified with respect to core or periphery variables as well as for the complete sample, we will test whether the correlation coefficients are significantly positive using a binomial test. The statistic Zp will be computed to test the null hypothesis that r is distributed symmetrically about r — 0 using the alternative hypothesis r > 0. Zp is the standard normal statistic.

where: X — small frequency n = number of observations A concentration of highly positive correlation within the 0.01 level of significance would indicate that it is sensible to use the magnitude of the association in addition to its sign. This was not possible in this study owing to the differences in the number of observations used for each firm in the sample. This number varied between a minimum of ten years and a maximum of twenty years. Data for the firms in the periphery sector were understandably less available than for the firms in the core sector. Instead of testing the magnitude for the association, the study tested the differences in smoothing behavior. A x2 test uses only the proportions of smoothers in each group to indicate different proportions of smoothers.

where: Xi — number of firms that indicate a smoothing behavior in group i nt = total number of firms in group /

The Smoothing of Income Numbers

95

THE DATA SAMPLE AND THE CLASSIFICATION OF FIRMS INTO CORE AND PERIPHERY SECTORS To determine the differences in smoothing behavior between firms in the core sector and firms in the periphery sector, it was necessary to determine the distinction between core and periphery economic sectors, and to classify the sample in these two main groups. The data included 171 U.S. firms from forty-two industries that were classified into core and periphery sectors. The core sector was allocated to those industries that exhibit high levels of capital intensity, unionization, large assets, high profit margins, product diversification, and market concentration. These include mining, construction, durable and nondurable manufacturing, transportation, communications, utilities, wholesale trade, finance, professional services, and public administration. Industries were assigned to the periphery sector because of their small firm size, seasonal and other variations in product supply and demand, labor intensity, weak unionization, and low assets. These include agriculture, portions of durable and nondurable manufacturing, retail trade, business and repair, and personal and entertainment services. This classification into a core and a periphery group resulted in 114 firms in the core sector and fifty-seven firms in the periphery sector, chosen on the basis of availability of data for the period of the analysis. RESULTS AND DISCUSSION An overall summary of the results is shown in Exhibit 7.1. This shows the significant differences in the extent to which firms in the periphery sector and the core sector may be smoothing income. Under the time expectation model No. 1 and the market model, all the differences, with one exception, are significant. Under the time expectation model No. 2, based on first differences, all the differences are not significant. Two points are noteworthy. First, where the differences are not significant, the proportion of smoothers in the periphery sector is still higher than in the core sector. Second, while most of the significant differences are at a = 0.10, the difference resulting from a smoothing of ordinary income with operating and ordinary expenses under the first time expectation model, and the difference resulting from smoothing ordinary income with ordinary expenses under the market model, were significant at a = 0.05. The extent of smoothing in each sector is shown in Exhibits 7.2-7.13, and is indicated by Zip. With no expectations, the extent of smoothing for the periphery sector was significant in all cases. It was significant in seven of the twelve cases for the core sector. Three points are noteworthy. First, for the periphery sector, the extent of smoothing was significant at a higher level of confidence for the smoothing of operating income with operating

Earnings Measurement, Determination, Management

96 Exhibit 7.1 Overall Summary of Results Smoothing Object

2. 3.

Income Trend

'Smoothing' Core Periphery Firms % Firms %

Differences

Time 0) Market Time (2)

57 56 57

68 71 70

33 35 35

82 83 81

S*l S* NS2

Time 0) Market Time (2)

54 45 46

64 59 57

28 24 26

76 62 65

S* S**3 NS

Time (1) Market Time (2)

55 51 47

59 58 55

28 23 22

74 62 56

S* NS NS

Time (1) OREX + OPEX Market Time (2)

60 50 50

61 57 56

36 28 28

78 72 68

S**

OP

OPEX

OR

OPEX

OR

OREX

OR 1.

Smoothing Variables

s* NS

S* « Significant at 0.10 level and indicates that the results arc consistent in the greater smoothing. NS » Not significant S** - Significant at 0.05 level and indicates that the results are consistent with greater smoothing by Periphery firms than Core firms.

Source: Ahmed Belkaoui and Ronald D. Picur, "The Smoothing of Income Numbers: Some Empirical Evidence on Systematic Differences between Core and Periphery Industrial Sectors," Journal of Business Finance and Accounting (winter 1984), p. 534. Reprinted with permission.

expense under each of the three expectation models. Second, for both the core and periphery sectors, the extent of smoothing was always significant under the first time expectation model. Third, the insignificant results in the core sector were mainly under the market income expectation and the second time expectations models. Worth noting from the findings is that, first, both core and periphery sectors lead in terms of proportion of smoothers and extent of smoothing. Second, in attempting to smooth income, managers in both sectors are more inclined to look for a "normal" time trend as a guide rather than a market trend or a first difference trend. With respect to the first identified finding, it may be advanced that the motivation to smooth is higher for managers in the periphery sector who have to face a more restricted opportunity structure and a higher degree of environmental uncertainty than firms in the core sector. With respect to the second identified finding, it may be advanced that what management considers the normal trend of OP and

97

The Smoothing of Income Numbers Exhibit 7.2 Smoothing of Operating Income with Operating Expenses (Time Expectation Model No. 1) Core Sector r>0

r>0

No. of firms 57 % (68) r 0.51

27 (32)

Periphery Sector

Zp -2.83*

r>0

r>0

33 7 (82) (17) 0.60

Control Effect X1

Zp -4.26*

2.229"

* Significant at 0.05 and ** Significant at 0.10 r>0 indicates positive correlation coefficients (consistent with smoothing) r" is the mean of the distribution of the correlation coefficients Source: Ahmed Belkaoui and Ronald D. Picur, "The Smoothing of Income Numbers: Some Empirical Evidence between Core and Periphery Sectors," Journal of Business Finance and Accounting (winter 1984), p. 534. Reprinted with permission.

Exhibit 7.3 Smoothing of Operating Income with Operating Expenses ("Market" Income Expectation Model) Core Sector r>0

r<0

No. of firms 56 23 % (71) (29) r 0.38

Periphery Sector

Zp -3.71*

r>0

r<0

35 (83) 0.48

7 (17)

Control Effect X2

Zp -4.47*

1.659**

* Significant at 0.05 and •• at 0.10 r>0 indicates positive correlation coefficients (consistent with smoothing) r" is the mean of the distribution of the correlation coefficients Source: Ahmed Belkaoui and Ronald D. Picur, "The Smoothing of Income Numbers: Some Empirical Evidence between Core and Periphery Sectors," Journal of Business Finance and Accounting (winter 1984), p. 535. Reprinted with permission.

Earnings Measurement, Determination, Management

98

Exhibit 7.4 Smoothing of Operating Income with Operating Expenses (Time Expectation Model No. 2) Core Sector r>0

r<0

No. of firms 57 25 % (70) (30) r 0.38

Periphery Sector

Zp

r>0

r<0

-3.53*

33 (81) 0.52

8 (19)

Control Effect A*

Zp -3.96*

1.484

* Significant at 0.05 r > 0 indicates positive correlation coefficients (consistent with smoothing) F is the mean of the distribution of the correlation coefficients Source: Ahmed Belkaoui and Ronald D. Picur, "The Smoothing of Income Numbers: Some Empirical Evidence between Core and Periphery Sectors," Journal of Business Finance and Accounting (winter 1984), p. 535. Reprinted with permission.

Exhibit 7.5 Smoothing of Ordinary Income with Operating Expenses (Time Expectation Model No. 1) Core Sector r>0

r<0

No. of firms 54 30 % (64) (36) 0.41 r

Periphery Sector

Zp

r>0

r<0

Zp

2.618*

28 (76) 0.49

9 (24)

-2.96*

Control Effect

X2 2.204**

Significant at 0.05 and •• at 0.10 r > 0 indicates positive correlation coefficients (consistent with smoothing) r is the mean of the distribution of the correlation coefficients Source: Ahmed Belkaoui and Ronald D. Picur, "The Smoothing of Income Numbers: Some Empirical Evidence between Core and Periphery Sectors," Journal of Business Finance and Accounting (winter 1984), p. 535. Reprinted with permission.

The Smoothing of Income Numbers

99

Exhibit 1.6 Smoothing of Operating Income with Operating Expenses ("Market" Income Expectation Model) Core Sector r>0

r<0

No. of firms .45 31 % (59) (41) r 0.31

Periphery Sector r>0

r<0

Zp

-1.605*24 (62) 0.49

15 (38)

-1.60*

Zp

Control Effect X-2 3.799*

" Significant at 0.05 r>0 indicates positive correlation coefficients (consistent with smoothing) r is the mean of the distribution of the correlation coefficients Source: Ahmed Belkaoui and Ronald D. Picur, "The Smoothing of Income Numbers: Some Empirical Evidence between Core and Periphery Sectors," Journal of Business Finance and Accounting (winter 1984), p. 536. Reprinted with permission.

Exhibit 1.1 Smoothing of Operating Income with Operating Expenses (Time Expectation Model No. 2) Periphery Sector

Core Sector

No. of firms % r

r>0

r<0

46 (57) 0.30

34 (42)

Zp -1.34*

2>0

r<0

Zp

26 (65) 0.49

14 (35)

-2.055*

Control Effect X2 0.351

* Significant at 0.05 r>() indicates positive correlation coefficients (consistent with smoothing) r is the mean of the distribution of the correlation coefficients Source: Ahmed Belkaoui and Ronald D. Picur, "The Smoothing of Income Numbers: Some Empirical Evidence between Core and Periphery Sectors," Journal of Business Finance and Accounting (winter 1984), p. 536. Reprinted with permission.

100

Earnings Measurement, Determination, Management

Exhibit 7.8 Smoothing of Ordinary Income with Operating Expenses (Time Expectation Model No. 1) Core Sector r>0

r<0

No. of firms 55 38 % (59) (41) r 0.41

Z„

Periphery Sector r>0

r<0

-1.762*28 (74) 0.44

10 (26)

Control Effect

X2

Z, -7.08'

1.87T

* Significant at 0.05 r>0 indicates positive correlation coefficients (consistent with smoothing) r is the mean of the distribution of the correlation coefficients Source: Ahmed Belkaoui and Ronald D. Picur, "The Smoothing of Income Numbers: Some Empirical Evidence between Core and Periphery Sectors," Journal of Business Finance and Accounting (winter 1984), p. 536. Reprinted with permission.

Exhibit 7.9 Smoothing of Ordinary Income with Operating Expenses ("Market" Income Expectation Model)

Core Sector r>0 No. of firms % r

r<0

51 37 (58) (42) 0.36

Periphery Sector

Zp

r>0

r<0

Zp

1.49

23 (62) 0.42

14 (38)

-1.64*

Control Effect X2 0.056"

Significant at 0.05 and •• at 0.10 r>0 indicates positive correlation coefficients (consistent with smoothing) r is the mean of the distribution of the correlation coefficients Source: Ahmed Belkaoui and Ronald D. Picur, "The Smoothing of Income Numbers: Some Empirical Evidence between Core and Periphery Sectors," Journal of Business Finance and Accounting (winter 1984), p. 537. Reprinted with permission.

101

The Smoothing of Income Numbers Exhibit 7.10 Smoothing of Ordinary Income with Operating Expenses (Time Expectation Model No. 2) Core Sector r<0

r>0

No. of firms 47 39 % (55) (45) r 0.38

Periphery Sector

Zp

r>0

r<0

Zp

0.863

22 (56) 0.43

17 (44)

-0.960

Control Effect X2 0.0001

• Significant at 0.05 r>0 indicates positive correlation coefficients (consistent with smoothing) r is the mean of the distribution of the correlation coefficients Source: Ahmed Belkaoui and Ronald D. Picur, "The Smoothing of Income Numbers: Some Empirical Evidence between Core and Periphery Sectors," Journal of Business Finance and Accounting (winter 1984), p. 537. Reprinted with permission.

Exhibit 7.11 Smoothing of Operating Income with Operating Expenses (Time Expectation Model No. 1) Core Sector

No. of firms % r

r>0

r<0

60 (61) 0.41

39 (39)

Periphery Sector

Zp -2.11*

2>Q

r<0

32 (78) 0.49

9 (22)

Control Effect X2

Zp -3.75*

3.179*

* Significant at 0.05 r>0 indicates positive correlation coefficients (consistent with smoothing) r is the mean of the distribution of the correlation coefficients Source: Ahmed Belkaoui and Ronald D. Picur, "The Smoothing of Income Numbers: Some Empirical Evidence between Core and Periphery Sectors," Journal of Business Finance and Accounting (winter 1984), p. 537. Reprinted with permission.

Earnings Measurement, Determination, Management

102

Exhibit 7.12 Smoothing of Ordinary Income with Ordinary and Operating Expenses ("Market" Income Expectation Model) Core Sector r>0

r<0

No. of firms 50 38 % (57) (43) 0.30

Periphery Sector

Zp

r>0

r<0

Zp

-1.27

28 (72) 0.39

11 (28)

-2.88*

Control Effect

x2 1.964*

• Significant at 0.05 r>0 indicates positive correlation coefficients (consistent with smoothing) r is the mean of the distribution of the correlation coefficients Source: Ahmed Belkaoui and Ronald D. Picur, "The Smoothing of Income Numbers: Some Empirical Evidence between Core and Periphery Sectors," Journal of Business Finance and Accounting (winter 1984), p. 538. Reprinted with permission.

Exhibit 7.13 Smoothing of Operating Income with Ordinary and Operating Expenses (Time Expectation Model No. 2) Core Sector r>0

r<0

No. of firms 50 39 % (56) (44) r 0.33

Zp -1.165

Periphery Sector r>0

r<0

Zp

28 (68) 0.48

13 (32)

-2.488*

Control Effect

X2 1.248

* Significant at 0.05 r>0 indicates positive correlation coefficients (consistent with smoothing) r is the mean of the distribution of the correlation coefficients Source: Ahmed Belkaoui and Ronald D. Picur, "The Smoothing of Income Numbers: Some Empirical Evidence between Core and Periphery Sectors," Journal of Business Finance and Accounting (winter 1984), p. 538. Reprinted with permission.

The Smoothing of Income Numbers

103

O R is the easy-to-conceive and to compute time trend rather than the market or the first differences trend. CONCLUSION This study has tested the effects of a dual economy on income smoothing behavior. The main hypothesis was that a higher degree of smoothing of income numbers will be exhibited by firms in the periphery sector than firms in the core sector as a reaction to differences in opportunity structures, experiences, and environmental uncertainty. The results indicate that a majority of the firms may be resorting to income smoothing with a higher n u m b e r included a m o n g firms in the periphery sector. These results add to other attempts to identify organizational characteristics that differentiate between firms in their extent of smoothing. Future research looking into the impact of other organizational characteristics of firms that have a propensity to smooth may be helpful to users of accounting numbers. NOTES 1. J. Y. Kamin and J. Ronen, "The Smoothing of Income Numbers: Some Empirical Evidence on Systematic Differences among Management-Controlled and Owner-Controlled Firms," Accounting Organizations and Society 3(2) (1978): 141-153. 2. M. Piori, "The Dual Labor Market: Theory and Implications," in D. M. Gordon (ed.), Problems in Political Economy: An Urban Perspective (Lexington, MA: Heath, 1977): 93. 3. B. W. Bluestone, N. Murphy, and M. Stevenson, Low Wages and the Working Poor (Ann Arbor: Institute of Labor and Industrial Relations, University of Michigan, 1973): 28-29. 4. E. M. Beck and P. M. Horan, "The Structure of American Capitalism and Status Attainment Research: A Reassessment of Contemporary Stratification Theory, unpublished paper, Department of Sociology, University of Georgia, Athens, 1978, p. 704. 5. B. Harrison, "The Theory of the Dual Economy," in B. Silverman and M. Yanovitch (eds.), The Worker in "Post Industrial" Capitalism (New York: Free Press, 1974): 280. SELECTED READINGS Baran, P. A., and P. N. Sweezy. Monopoly Capital. New York: Monthly Review Press, 1966. Barefield, R. M., and E. E. Comiskey. "The Smoothing Hypothesis: An Alternative Test." The Accounting Review (April 1972): 291-298. Barnea, A., J. Ronen, and S. Sadan. "Classificatory Smoothing of Income with Extraordinary Items." The Accounting Review (January 1976): 110-122. Beck, E. M., and P. M. Horan. "The Structure of American Capitalism and Status

104

Earnings Measurement, Determination, Management

Attainment Research: A Reassessment of Contemporary Stratification Theory." Unpublished paper, Department of Sociology, University of Georgia, Athens, 1978. Beck, E. M., and C. M. Tolbert II. "Stratification in a Dual Economy: A Sectoral Model of Earnings Determination." American Sociological Review (October 1978): 704-720. Beidleman, C. R. "Income Smoothing: The Role of Management." The Accounting Review (October 1973): 653-667. Bluestone, B. W., N. Murphy, and M. Stevenson. Low Wages and the Working Poor. Ann Arbor: Institute of Labor and Industrial Relations, University of Michigan, 1973. Cain, G. G. "The Challenge of Segmented Labor Market Theories to Orthodox Theory." Journal of Economic Literature 14 (1976): 1215-1257. Copeland, R. M. "Income Smoothing," Empirical Research in Accounting: Selected Studies, 1968. Journal of Accounting Research 6 (Suppl) (1968): 101-116. Harrison, B. "The Theory of Dual Economy." In B. Silverman and M. Yanovitch (eds.). The Worker in "Post Industrial" Capitalism. New York: Free Press, 1974: 269-278. Hodson, R., and R. L. Kaufman. "Economic Dualism: A Critical Review." American Sociological Review (December 1982): 727-739. Kamin, J. Y., and J. Ronen. "The Smoothing of Income Numbers: Some Empirical Evidence on Systematic Differences among Management-Controlled and Owner-Controlled Firms." Accounting Organizations and Society 3(2) (1978): 141-153.

8 The Relevance of Earnings Levels versus Earnings Changes as an Explanatory Variable for Returns INTRODUCTION In examining the relevance of earnings as an explanatory variable for returns, various models and studies express price as a multiple of earnings. The formulation of the earnings variable differs from one study to another. One model links security returns to changes in earnings or abnormal returns to unexpected earnings.1'2 A second model relates security returns to the earnings level.3,4 The results of the studies using the second model provide evidence of earnings as an explanatory variable for returns. Previous studies provide evidence that annual current earnings divided by the beginning-of-period price are associated with stock returns, and that current and future levels of earnings are associated with stock returns when the earnings reporting period is quarterly, semiannual, or annual. The results of both studies use the second model. They are limited to an indication of the potential relevance of the level of current and future earnings divided by the beginning-of-period price. This study relies on both models. It extends previous results by examining also the relevance of annual changes of current and future earnings divided by beginning-of-period price. The results provide evidence that: (a) current and future levels of earnings as well as current and future changes in earnings divided by beginning-ofperiod price are associated with current period stock returns, and (b) the use of level of earnings rather than changes in earnings provided a better explanation of returns.

106

Earnings Measurement, Determination, Management

MODELS OF THE RELATION BETWEEN EARNINGS AND RETURN Two models of the relation between earnings and returns have been used in research. The first model, Model A, bases the returns and earnings association on a book valuation model. It is derived as follows. First: Price and book value as measures of the "stock" value of the shareholders' equity are related as follows:

where Pjt is the price per share value per share of firm / at time Second: Accounting earnings "flow" value or changes in value by taking first differences of the

of firm / at time t, and BVjt is the book t. and security returns as measures of the of the shareholders' equity may be derived variables in equation (1) as follows:

where:

Ajt = accounting earnings of firm / over the time period t — 1 to t djt ~ the dividend of firm / over time period t — 1 to t

Third: The relation between earnings and returns is obtained by substituting (3) and (2) and dividing by Pjt — 1 as follows:

where:

Equation (4) shows that if stock price and book value are related, then earnings divided by beginning-of-period price explains returns. The second model, Model B, bases the returns and earnings association on an earnings valuation model. It is derived as follows. First: An earnings valuation model expresses price (including dividend) as a multiple of earnings as follows:

The Relevance of Earnings Levels

107

Second: Changes in both sides of the equation coupled with division by beginning-of-period price yields the second model as follows:

Given the evidence that earnings lag current returns for several future periods, both models can also be expressed as follows. 1. Model A

2. Model B

DATA AND SAMPLE SELECTION The sample of 10,356 firm-annual observations is drawn from the period 1977-1986 and consists of companies that meet the following criteria: (1) annual earnings per share and the factor to adjust for stock splits and share dividends are available on the 1991 COMPUSTAT Primary, Secondary, Tertiary and Full Coverage Annual Industrial File, and (2) daily adjusted stock returns including dividends are available from the Center for Research in Security Prices and Dividends. EMPIRICAL ANALYSIS The regression models (7) and (8) are estimated for the pooled crosssection and time series sample as well for each year (t) of available data. The results from regression (7) and (8) are found, respectively, in Exhibit 8.1 and Exhibit 8.2. For the regressions using the pooled sample of all 10,356 firm-year observations, the coefficients are significantly different from zero at the 0.01 level in most cases. The R2 from the pooled regression based on the levels model in equation (6) is 59.50 percent compared to the R2 of 54.70 percent from the equivalent regression for the changes model in equation (7).5 For the year-to-year regressions, the R2 from the changes model is higher in all cases but one, and is at least three times as high in two of the ten cases.6,7 Exhibit 8.3 presents statistical comparisons of both models. It compares the explanatory power of the two models for each year tested. In all but one case, the explanatory power of the level model, Model A, is signifi-

108

Earnings Measurement, Determination, Management

Exhibit 8.1 Explanatory Power of Current and Future Annual Levels of Earnings for Current Annual Returns1

Year All Periods

«*

V

**

S>

V

V

Adjusted

F

PRDF

Sample Size

54 70 54.70

10355

2502.23*

0.17822 -0.60625 (17.100)* (-14.244)*

-0.16807 -2.14368 1.73736 (37.076)* (-46.700)* (42.537)*

0.65208 (17.138)*

1986

0.09493 -0.14939 (5.611)* (-3.478)*

-0.2509 (-4.081)*

0.15734 (2.894)*

15.73

1156

42.984*

1985

0.45343 -1.28564 -2.6103 -2.6135 2.75001 (10.143)* (-8.028)* (-18.516)* (-16.729)* (18.677)*

1.63162 (10.570)*

9.25

1125

59.41*

1984

-0.07757 -0.27608 (-8.298)* (-4.988)*

-0.18639 -0.28594 -0.13082 -0.15834 (-3.498)* (-6.266)* (-2.830)* (-3.873)*

4.56

1087

11387*

1983

0.22465 0.17436 (14.809)* (2.557)*

-0.30157 (-3.208)*

-0.15751 -0.09345 (-1.944)* (1.619)*

0.03652 (0.842)*

2.33

1053

4.997*

1982

0.21274 0.01594 (13.689)* (0.270)

-0.05577 (-0.735)

-0.11021 -0.22394 (-1.012) (-2.177)**

-0.1355 (-1.766)***

0.57

1044

1.199*

1981

-0.02949 -0.01469 (-2.265)* (-0.213)*

0.13962 (-2.110)*

-0.13305 -0.06059 (-1.529)* (-0.690)*

0.04813 (0.564)*

1.08

1017

2.200*

1980

0.24846 -0.1629 (16.412)* (-1.816)*

-0.41696 (-4.927)*

-0.74043 -0.75669 (-8.247)* (-8.169)*

-0.19651 (-2.347)*

11.53

990

26.825*

1979

0.30411 -0.28926 (16.540)* (-3.376)*

-0.69634 (-6.329)*

-0.2356 -0.5683 (-2.651)* (-7.017)*

-0.36051 (-5.300)*

9.12

973

19.426*

1978

0.10906 -0.13098 (8.572) (-1.630)*

-0.23046 -0.12412 -0.21359 (-2.847)* (-1.531)* (3.711)*

-0.03905 (-0.744)*

2.33

962

4.562*

1977

0.08743 -0.04306 (5.431)* (-0.418)*

-0.60884 -0.90345 -033141 -0.00078 (-7.268)* (-10.196)* (-0.012)* (-0.012)*

10.46

939

21.830*

Meani

-0.95301 0.13900 (13.717)* (1.8756)*

-0.21617 -0.52179 -0.62568 0.05102 0.09829 (-3.5364)* (-9.0595)* (-11.0522)* (3.58646)* (1.7966)***

(t statistics are provided in parentheses) * significant *t< « .01 *• significant at** • .05 ••* significant at* « .10 (1) The test statistics are ^-statistics because White's test for heteroskedasticity in the residuals revealed no significant heteroskedasticity. When there is (is not) significant heteroskedasticity, the test statistics reported for the intercepts and the slopes are z-statistics (^-statistics) appropriate for such cases. (2) This is the mean of the yearly coefficients, estimated to test for the effect of cross-sectional correlation in the error terms.

109

The Relevance of Earnings Levels

Exhibit 8.2 Explanatory Power of Current and Future Annual Changes in the Levels of Earnings for Current Annual Returns1

«*

«*

0.23545 (20.336)*

1.23040 (25.173)*

0.40718 (7.552)*

-3.97525 (-93.528)*

0.96725 (18.454)*

0.60277 (15.423)*

59.50

Sample F Size 10366 2481.26*

1986

0.07657 (20.336)*

0.28117 (4.452)*

0.81096 (10.587)*

-1.03642 (-9.881)*

0.04212 (0.624)*

0.23324 (4.36)*

15.74

1157

43.038*

1985

0.59036 (13.48)*

1.20992 (8.482)*

-0.1455 (-0.909)*

-5.42774 (-56.954)*

-0.25201 (-1.105)*

1.62430 (11.349)*

10.26

1127

78.71*

1984

-0.11406 (-11.959)*

0.44376 (7.78)*

0.29904 (5.317)*

-0.11346 (-2.297)*

0.13835 (3.816)*

0.02667 (0.63)*

13.32

1089

33.317*

1983

0.16875 (10.692)*

0.82406 (8.265)*

-0.09768 (-1.156)*

0.08975 (1.135)*

0.09604 (1.227)*

0.01600 (0.383)*

9.72

1053

22.557*

1982

0.12474 (7.619)*

037052 (4.851)*

0.34868 (3.097)*

0.11075 (1.069)*

0.09357 (0.959)*

0.18255 a.38)*

12.23

1045

28.996*

1981

-0.10347 (-7.049)*

-0.05214 (-0.874)*

0.54103 (5.395)*

0.26072 (2.603)*

-0.07735 (-0.845)*

0.22667 (2.763)*

11.60

1018

26.593*

1980

0.22785 (11.573)*

0.49333 (4.67)*

0.33920 (3.426)*

0.06518 (0.536)*

-0.52502 (-5.074)*

-0.18119 (-2.121)*

11.51

990

26.625*

1979

0.23507 (9.751)*

0.75752 (6.751)*

-0.14928 (-1.149)*

0.30426 (3.158)*

-0.09844 (-0.918)*

-0.24372 (-3.45)*

9.89

974

21.281*

1978

0.00950 (0.6)

0.38006 -0.00921 (5.755)* (-0.127)*

0.30618 (3.787)*

-0.12324 (2.252)*

0.15991 (3.134)*

10.88

962

23.376*

1977

-0.13889 (-7.079)*

1.63222 (16.886)*

-0.29199 (-3.38)*

-0.07614 (-0.79)*

0.13654 (2.419)*

30.33

940

81.419*

Year Jl Perioads

Meanu

•*

•n

0.15918 (3.158)*

*V

0.63404 0.20964 -0.57327 -0.07821 (6.7018)* (2-7639)* (-6.0224)* (-0.0146)*

•*

Adjusted

Rdf(a

0.21810 (2.1*47)*

(t statistics are provided in parentheses) * significant at v = .01 •* significant attf = .05 (1) The test statistics are ^-statistics because White's test for heteroskedasticity in the residuals revealed no significant heteroskedasticity. When there is (is not) significant heteroskedasticity, the test statistics reported for the intercepts and the slopes are ^-statistics (t-statistics) appropriate for such cases. (2) This is the mean of the yearly coefficients, estimated to test for the effect of cross-sectional correlation in the error terms.

110

Earnings Measurement, Determination, Management

Exhibit 8.3 Explanatory Power of Model A and Model B Cross-Sectional References Ratio of R2 Adjusted R2 for Model A t o Wilcoxon Model A

Model B

if for Model B

Signed Rank # t

15.74

15.73

1.0006

2.32

10.26

9.25

1.1092

2.42

13.32

4.56

2.9211

3.51

9.72

2.33

4.1717

3.23

12.23

0.57

21.4561

4.97

11.60

1.08

10.7407

3.5

11.51

11.53

0.9983

0.22

9.89

9.12

1.0844

2.38

10.88

2.33

4.6695

3.38

30.33

10.46

2.8996

2.52

cantly greater than the explanatory power of the changes model, Model B. The positive ^-statistic indicates that the squared residuals from Model A are greater than the squared residuals from Model B; moreover, this difference is statistically significant at the 0.01 confidence level for all cases but one. These results indicate that: (a) Model A, based on earnings level, and Model B, based on earnings change, are both relevant for explaining stock returns, and (b) Model A has a better association with stock returns than Model B. The findings provide evidence of a substantial lag in earnings recognition. They reveal a significant earnings lag for several periods and provide evidence that both future periods' earnings level and earnings change are significantly related to current returns and are often of greater explanatory power for current returns compared with current earnings level or current earnings change. These results are stronger when the returns are related to current and future earning level than for current and future earning change. SUMMARY AND CONCLUSION Previous studies demonstrated an association between the level of current accounting earnings divided by beginning-of-the-period price and stock re-

The Relevance of Earnings Levels

111

turns. O t h e r models provide theoretical support and empirically validate the association between future periods' level of earnings and current period's stock returns. Another model, M o d e l B, relates security returns to changes in the level of earnings. This study replicates empirical studies based on Model A and Model B. The results indicate that: (a) both earnings level and change in earnings play a role in security valuation, (b) both future periods' level of earnings and changes in earnings possess significant explanatory for the current period's stock returns, and (c) Model A has a better association with stock returns (based on R2) than Model B. Future research in this important facet in positive accounting is best served when current period stock returns are related to current and future level of earnings deflated by beginning-of-period price.

NOTES 1. W. Beaver, R. Lambert, and D. Morse, "The Information Content of Security Prices," Journal of Accounting and Economics (March 1980): 3-28. 2. D. W. Collins, and S. P. Kothari, "An Analysis of Intertemporal and CrossSectional Determinants of Earnings Response Coefficients," Journal of Accounting and Economics (July 1989): 143-181. 3. P. D. Easton and T. S. Harris, "Earnings as an Explanatory Variable for Returns," Journal of Accounting Research (spring 1991): 19-36. 4. T. D. Warfield and John J. Wild, "Accounting Recognition and the Relevance of Earnings as an Explanatory Variables for Returns," The Accounting Review (October 1992): 753-782. 5. These results fare better than previous results using variables regression of returns and the earnings levels and change variables. The R2 from the pooled regression based on the level model is 7.5 percent compared to the R2 of 4 percent from the equivalent regression for the changes model. The results in this study are better because of the higher number of independent variables. 6. Because of possible cross-sectional correlation in the regression error in the equation of each of the models, there is the potential for bias in statistical inferences regarding the earnings coefficient. Accordingly, an alternative procedure is used to test the significance of the earnings coefficients by using the mean and standard error of the coefficients obtained from the separate annual regressions (with the assumption that these annual regressions are independent). These calculations are shown in both Exhibits 8.1 and 8.2. All the coefficients are significant indicating the significance of earnings coefficients is unlikely to result from the potential crosssectional correlations. 7. To check if the results might be affected by collinearity among the variables, condition indices were computed for each regression reported in both exhibits. Mild collinearity exists if the maximum condition index is between 5 and 10, and potentially severe if it is over 30. The results in this study indicate a condition index with a highest value of 4. Collinearity, therefore, does not seem to affect our results.

112

Earnings Measurement, Determination, Management

SELECTED READINGS Beaver, W., R. Lambert, and D. Morse. "The Information Content of Security Prices." Journal of Accounting and Economics (March 1980): 3-28. Bernard, V. L. "Cross-Sectional Dependence and Problems in Inference in MarketBased Accounting Research." Journal of Accounting Research (spring 1987): 1-48. Belsley, D. A., E. Kuh, and R. E. Welsch. Regression Diagnostics: Identifying Influential Data and Sources of Collinearity. New York: Wiley, 1980. Collins, D. W., and S. P. Kothari. "An Analysis of Intertemporal and CrossSectional Determinants of Earnings Response Coefficients." Journal of Accounting and Economics (July 1989): 143-181. Easton, P. D., and T. S. Harris. "Earnings as an Explanatory Variable for Returns." Journal of Accounting Research (spring 1992): 19-36. Easton, P. D., T. S. Harris, and J. A. Ohlson. "Accounting Earnings Can Explain Most Security Returns: The Case of Long Return Intervals." Journal of Accounting and Economics (1992): 132-152. Warfield, Terry D., and John J. Wild. "Accounting Recognition and the Relevance of Earnings as an Explanatory Variable for Returns." The Accounting Review (October 1992): 753-782. White, H. A. "A Heteroskedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Heteroskedasticity." Econmetricka (May 1980): 817-838.

9 Accrual Accounting and Cash Accounting: Relative Merits of Derived Accounting Indicator Numbers One of the dominant characteristics in early views of the purpose of financial statements is the stewardship function. Under this view, management is entrusted control of the financial resources provided by capital suppliers. Accordingly, the purpose of financial statements is to report to the concerned parties so as to facilitate the evaluation of management's stewardship. To accomplish this objective the reporting system, favored and deemed essentially superior to others, is the accrual system. Simply the accrual basis of accounting refers to a form of record keeping which, in addition to recording transactions resulting from the receipt and disbursement of cash, records the amounts the firm owes others and others owe it.1 At the core of this system is the matching of revenues and expenses.2 The interest in the accrual method generated a search for the "best" accrual method in general and the "ideal income" in particular.3'4,5 For a long time, this accounting paradigm governed the evaluation of accounting alternatives and the asset valuation and income determination proposals. 6 ' 7,8 The approach was, however, constantly changed by cash flow accounting. The cash flow basis of accounting has been correctly defined as the recording not only of the cash receipts and disbursements of the period (the cash basis of accounting) but also the future cash flows owed to or by the firm as a result of selling and transferring title to certain goods (the accrual basis of accounting 9 ). The challenge by cash flow accounting is more evident in This chapter has been adapted with permission from: Ahmed Riahi Belkaoui, "Accrual Accounting and Cash Accounting: Relative Merits of Derived Accounting Indicator Number," Journal of Business Finance and Accounting 10(2) (summer 1983): 299-312.

114

Earnings Measurement, Determination, Management

some of the questioning of the importance and efficacy of accrual accounting and shift toward cash flow approaches and security analysis.10 The question of the superiority of accrual accounting over cash flow accounting is central to determination of the objectives and the nature of financial reporting. Consensus on criteria of superiority may be difficult to attain given the diversity of users and interests. It may be more practical to examine the relative merits of derived accounting numbers from both accruals and cash flow accounting. Thus, the main objective of this chapter is to examine empirically the relative merits of derived performance indicator numbers from both accrual and cash flow accounting in terms of both the persistence and the variability of such numbers. In the first section of this chapter, the conceptual differences and the controversy between accrual accounting and cash flow accounting are examined. This is followed by a discussion of the sample design. The next section then examines the impact of the choice of cash flow and accrual on accounting indicator numbers in terms of their persistency and variability. The final section presents a brief summary and conclusion. ISSUE: ACCRUAL VERSUS CASH ACCOUNTING As stated earlier, accrual accounting is deemed a superior system to facilitate the evaluation of management's stewardship, and essential to the matching of revenues and expenses so that effects and accomplishments are properly aligned. The efficacy of the accrual system has been, however, questioned. Thomas stated that all allocations are arbitrary and incorrigible and recommended the minimization of such allocations.11'12 Hawkins and Campbell reported a shift in security analysis from earnings-oriented valuation approaches to cash flow-oriented approaches. 13 Many decision usefulness theorists advocated cash flows.14'15'16,17'18 Finally, various authors recommended that financial statements be based upon a cash flow orientation because of limitations in accrual accounting.19'20-21'22'23'24'25'26 Most of these authors feel that the problems of asset valuation and income determination are so formidable that another accounting system should be derived and propose the inclusion of comprehensive cash flow statements in companies' annual reports. More recently Lee described how cash flow accounting and net realizable value accounting can be brought together in a series of articulating statements that provide more relevant information for the report user about cash and cash management than can be given by either system on its own. 27 Cash flow accounting is viewed by supporters as superior to conventional accrual accounting. Lawson argues that his system of cash flow accounting provides an analytical framework for linking past, present, and future financial performance. 28 Lee argues that investors could see from the projected cash flows both the ability of the company to pay its way in the

Accrual Accounting and Cash Accounting

115

future and also its planned financial policy.29 It is generally maintained that a "price/discounted flow" ratio would be a more reliable investment indicator than the present "price/earnings" ratio because of the numerous arbitrary allocations used to compute the earnings per share. Ijiri argues for the development of cash flow accounting to correct the gap in practice between the way in which an investment decision is made (generally based on cash flow) and the way the results are evaluated (generally based on earnings). 30 Finally, various authors are expressing doubt with regard to the relevance and utility of accrual accounting information for investors who are concerned mainly with decision making.31'32,33'34

Objective Given the issue of accrual versus cash accounting, the main objective in this chapter is to evaluate merits of accounting indicators derived from either an accrual accounting system or a cash flow accounting system. The accounting indicators derived from an accrual accounting system included both a balance sheet oriented number and an income statement oriented number. The indicators had two basic characteristics. First they are computed as per share numbers, and second, they are ratios whose dominator is the market price of share. The first characteristic is used to ensure the comparability between the indicators and the companies. The second characteristic is used to ensure that the indicator reflects both accounting based performance and market based numbers. A second argument for dividing the accounting based datum should be evaluated in terms of the impact on its relationships to the market price. The implied hypothesis is that of the accounting data derived from either an accrual accounting system or a cash flow accounting system. The one mode favored by the market and/or reflected in the market price will show less variability and a higher persistence than the other numbers. The rationale is that the nature of the association between the derived accounting numbers and the behavior of security prices will indicate which method the market perceives to be the most related to the information used in setting equilibrium prices. The method that produces accounting numbers having the association with the security prices, with the least variability and the highest persistence, is the most consistent with the information that results in an efficient determination of security prices. But as pointed out by Beaver and Dukes, the evidence on the nature of the association is also essential regardless of the efficiency of the market.35 It is an important factor in any accounting policy regardless of the nature of the policymakers' views about other issues, including market efficiency. The cash flow per share/stock price of security / for time period t is defined as:

116

Earnings Measurement, Determination, Management

where: P,,

=

CFO,,

=

CSO,,

=

price of security / at the end of period t adjusted for capital changes such as stock splits and stock dividends cash flows from operation calculated by adjusting net income for noncash charges (credits), and for changes in the current accounts exclusive of changes in the firm's cash position, of firm i in period t (COMPUSTAT variable No. 10) common shares outstanding of firm / in period t (COMPUSTAT variable No. 25)

T h e c o m m o n equity per share/stock price of security / for time period t is defined as:

where: CE,,

=

common equity of company / at the end of period t. Common equity (COMPUSTAT variable No. 11) represents common stock plus retained earnings, capital surplus, self-insurance reserves, and capital stock premium.

The earnings per share/stock price of security / for the time period t is defined as:

where: EPSif

=

earnings per share (primary), excluding extraordinary items, of company i for period t. EPS (COMPUSTAT variable No. 58) represents the primary earnings per share figure as reported by the company.

Each of these numbers, CFP, „ CEP, „ and EPSP, „ represents numbers derived from either an accrual or a cash flow accounting system and related to the stock price, and whose merits will be evaluated in terms of variability and persistence. They represent semiaccounting indices of ratio of return derived from either an accrual or a cash flow accounting system. 3 6

Accrual Accounting and Cash Accounting

117

THE SAMPLE DESIGN The study employs both accounting and market data. Market data were retrieved from the CRSP tape developed at the University of Chicago and accounting data were retrieved from COMPUSTAT tape. Two criteria were used for the selection of companies to be included in the sample. First, its accounting and market data were available on both the COMPUSTAT and the CRSP tape for a period of 19 years beginning in 1959 and ending in 1977. This criterion was necessary to allow for the computation of each of semiaccounting indices of rate of return. Second, the company must figure in the Fortune Magazine's list of the 500 largest American companies. This criterion was adopted to limit the size and profitability difference, which may affect the results of the study. Of these companies 66 met the sampling requirement. A list of these companies appears in Exhibit 9.1. The three semiaccounting indices of rate of return were used for a comparison of the relative merits of accrual and cash accounting. a. A cash flow per share/stock price ratio was used to represent the cash accounting-derived semiaccounting index of rate of return. b. A common equity per share/stock price ratio was used to represent the accrual accounting-derived and balance sheet-oriented semiaccounting index of rate of return. c. An earnings per share/stock price ratio was used to represent the accrual accounting-derived and income statement-oriented semiaccounting index of rate of return. RESULTS Variability of the Derived Accounting Indicator Numbers The three accounting indicators, namely the cash flow per share/stock price (CFP), the common equity per share/stock price (CEP), and the earnings per share/stock price (EPSP), were computed for the 66 companies for the years 1959 to 1977. The means, standard deviation, and coefficients of variation of these numbers are presented in Exhibit 9.1. In addition, Exhibit 9.1 includes a ranking of the coefficients of variations of derived accounting indicator numbers. An examination of Exhibit 9.1 shows a definite difference in the variability of these numbers. The variability of the EPSP numbers exceeds the variability of the CEP and CFP numbers. More precisely, the coefficients of variation of the EPSP numbers are higher than those of the CEP numbers in 42 cases or those of the CFP numbers in 45. The coefficients of variation

Exhibit 9.1 CEP, EPSP, and CFP's Means, Standard Deviations, and Coefficients of Variation for the Sample Companies, 1959-1977 CEP

Company 1 1. General Motors Corp 2. Lockheed Corp 1 3. EXTRA Corp 1 4. Honeywell Inc. j 5. Cities Service Co. 1 6. Allegheny Airlines Inc. j 7. NCR.Corp | 8. McDonnell Douglas Corp j 9. General Tire k Rubber Co. 10 Uniroyai Inc. 111. General Dynamics Corp 1 12.F.M.C.Corp 13. Westinghouse Electric Corp 14. R.C.A. Corp

30. 31. 32. 33.

Philip Morris Inc. | American Shores Co. Owens-Corning Fiberglu Corp Johnson k Johnson

| | 1

0 000528

1 0001338 0 000560 0 000546 1 0 001095 | 0.000888 j 0000670 1 0000851

1 | | 1

0001018 0 001388 0000965 0000654

0.000786 0000439 0000733 1 IS.VSICorp 16. Texacolhc. 0.000713 | 17. Owens-Illinois Inc. 0000762 0.000181 | 18. International Business Corp 1 19. Textron Inc. 0.000603 1 20. T.R.W. Inc. 0.000421 1 21. Republic Steel Corp 0 001923 j 22. Atlantic RichfieldCo. ] 0.000739 j 23.CelaneseCorp 0000810 0000724 j 24. Utah Power k Light | 25. Coca-Cola Co. | 0.000177 0000185 j 26. Minnesota Mining k Mfg. Co. 27. Wimet Lambert Co. 0000262 | 28. Republic of Texas Corp | 0000620 | 29. Ford Motor Co. | 0.000947

Co. of Variation

tandard Dev.

Mean |

EPSP

i

0000976 0001665 0.000616 0000533 0.000163 0.000696 0000453 0000575 0000655 0.000866 0.000593 0.000393 0.000467 0.000260 0.000422 0.000374 0.000388 0D0O09I 0D00297 0.000203 0000924 0.0003 52 0000376 0000332 0.000080 0.000083 00001II

1 |

0000440

1

0.001382 0.000423

| 1

0.000246

j

0.000262 0.000393 0.00018! 0000565 0.000172

0.000099

|

| 1 | |

.

i

| 1

1.848484849 1.244394619 1.1 0.976190476 0 879452055 0.783783784 0.676119403 0 675675676 0.643418468 0.623919308 0 614507772 0.600917431 0 594147583 0 592255125 0 575716235 0.S24S44I8 0.5091&6352 0.502762431 0492537313 0.482185273 0.48049922 0.47631935 0.464197531 0.458563536 0 451977401 0.448648649 0.423664122 0422580645

Mean 10.088996 0.097106 0083259 0.057101 0.097346 10.050166 0052659 0.121786 0.125968 0.094273 0078956 0.057844 0.072075 0.062512 0.103011 0.096196 0X179463 0.032806 0.098990 0084327 0.123040 0.072849 0.091250 0.079384 0.037553 | 0034273 | 0047978 | 0.079088 0.116545

1 |

i

Standard 1 Dev.

CFP

Co. of Variation

0038450 0.21719 0.104938 0.043605 0.028520 0.206859 0.063827

| .43204189 1 2.236628015 j 1.260380259 1 .763646871 | | .292975572 1 1 4.12349 | | 1.212081506 0.069912 .574056131 0078580 .623809221 0.053926 .57201956 0.164421 2.08243832 0052524 0.597923592 0.044888 0.6227956 0.031864 0.509726133 0067321 0.653532147 0.052297 < ' 0.543650464 0038722 0.487295974 0.017787 0.542187405 0.044234 0.446853218 0.046748 0.554363743 0.094391 0.767157022 ' 0.026904 0.369311864 ! 0.050207 0.5502136 0.033082 0.4167338 0J758954OI j 0.014116 0.013230 0J860I8I48 |

| 0.014925 0.042522 | 0.062840 0.418162619 0.014109 0.411363636 | 0.071162 0.408827786 | 0.109488 1 0.058236 0.406619385 | 0.048238 | 0.023777 0.402439024 | 0.03198! j 0.009834

1 0JI108 | 1 0.5376542 | | | 0.53919087 | 0.198265928 | 0.5318939 1 1 0.4929101 | | 0307495075 |

1

Rank-

1 ,n*

1

37 2 5

9

59

6

j

16 12 17 3 14 13

j

28 10 21 31 23 35 19 8 49

20 40 47 45 54

j | | j

26 24

j

67 27 30

5

|

Mean 0.000129 0.000390 0.000342 0.000183 0.000229 0.000421 0.000184 0.000180 0.000808 0.000261 0.000208 0.000162 0.000130 0.000IS9 0.000170 0.000156 0.000144 0.000066 D .000177

1

i

Standard | Dev.

Co. of Variation

0.000052 1 .403100775 0.000514 1.317948718 0.000278 0.812865497 j 0000203 1.109289618 j 0.000063 0.27510917 | 0.000375 j 0.890736342 1 0.000148 | 0.804347826 | 0.000106 1 0.588888889 0.000116 0.557692308 0.605363985 0.000158 0.000186 0.894230769 0.000101 0.62345679 0.000099 0.761538462 0.000110 0.691823899 0.000090 0.529411765 0.000081 0.519230769 0.000074 0.513888889 0.000030 j 0.4*545455 0.440677966 0.000078 0.552941176 0.000170 0.000094 0.000137 0.537254902 0.000255 0.000185 0.000051 0.275675676 0 569892473 0.0001S9 0.000279 0.364963504 0.000137 0.000050 0000017 0.000049 1 0.346938776 0.4375 0.000021 0.000048 0.000019 0.322033898 0.0000S9 0000065 0.476923077 0.000031 0 000190 | 0.452631579 0.000086 0.000021 j 0.230769231 0.000091 0.504 0.000126 0.000250 0.000086 0.000039 0.453488372 0.000047 | 0000016 j 0.340425532

Ranktn| 38 25 5 2 57

4 6 12 IS 71 3

9

7

8 18

19 22 25 89 16 17 56 14 46 48 31

50

24 27 61 83 26 49

CEP

Company

Mean

34. Aluminium Co. of America

| |

J 35 Gulf-OUCorp | 36. Greyhound Corp 1 37. Ray-theon Co. 1 38. Champion Intl. Corp 1 39. American Home Products Corp 1 40. Getty-Oil Co. 1 41. General Electric Company | 42. Emerson-Electric Co. 1 43. Allied Chemical Corp | 44. National Steel Corp j 45. Up John Co. 1 46. Union Oil Co. of California | 47. US.Steel Inc. j 48. Standard Oil Co. (Calif.) 1 49. Bethlehem Steel Corp 1 50. Borden Inc. [ 51. Armcolnc. j 52. Bowater Corp Ltd-Adr j 53. Shell-Oil Co. | 54. Standard Oil Co. (Ohio) | 55. Reynolds (RJ.)Inds 156. Tenneco Inc. 1 57. Inland Steel Co. | 58. Georgia Pacific Corp 159. Standard Oil Co. (Indiana) 60. Dow Chemical 61. Colgate Pilmolive Co. 62. 63. 64. 65. 66.

American Brands Inc. Kraft Inc. Catepillar Tractor Co. International Paper Co. Philips Petroleum Co.

1

0.000779 0.000923 0000494

|

1 0.000665 0.000805 0.000110 0.000966

0.000307 0.00004! 0.000360

0000306 0.000266 0.000735

0.000114

0.000594 1 0.000365 0.000665 0000667

|

0.360544218 0.352745424 0.344444444

0.000424 0.000093 0.000284 0.000497 0.000290 0.000467 0.000206 0.000393 0.000367 0.000226 0.000217 0.000145 0000174 |

0.000300 1 0.000100

|

0.00025! 1 0.000094

|

0.000119 1 0.000135 1 0.000132 1 0.000073

|

0.000130 1 0.000121

Co. of Variation

Mean

0.399229818 1 0064410 0396533044 1 0.109213 0.393858478 0.090411 0 384962406 0.026635 0.38136646 0.095903 0.372727273 0.039494 0.372670807 0.087845 0.047901 0.37254902 0.046987 0.36O9O2256

0.000096 0.000265

0.000831 0.001470 0.000870 0.001423 0.000628 0.00120! 0.00115 0.000718 0.000691 0000477 0.000601 0.001064 0.000362 0.000930 0.000367 0.000489 | 0.000589 |

EPSP

|

0000311.

1 0000366 1 0.000177 1 0.000256

0.001202 0.000270

| | | | |

i

Standard 1 Dev.

j

0J41756919 0.338095238 0.33333333 0.328179902 0.328015478 0.32641196 0.319130435 0.314763231 0.314037627 0.303983229 0.289517471 0.281954887 0.276243094 0.269892473 0.25613079 0.243353783 0.229202307 0.22222222 0.2 0.195488722 0.I814O929S

0.078056 0.101600 0043755 0.099550 0.101321 0.104958 0.077385 0.073927 0105100 0088466 0087232 0.064283 0.092009 0.091993 0.10207ft 0.055220 0.089009 0.056794 0.060901 0.101381 0.075648 0.062712 0.070480 | 0.070019 j

1

CFP

I

Standard Dev.

1

Co. of Variation

| Ranking

0.034966 0.058743 0.032712 0.027031 0.061573 0.009948 0.026303

|

0.542866015 0.537875528 0.361814381 0.352723951 0.642034139 0.251886362

22 25 50

0.299425124 0.432537943

0.020719 0.013029 0.030755

0.2772894 0.474723276 0.500836614 0.3249914 0.4071019 * 0.5834131 0.431524991 1.874277961 0.404317773 0.483491912 0.7746478 j 0.45368672 0.334847471 0.30900238 0.378876654 0.404102745 0.371079319 0.287667539

0.050885 0014220 0.040527 0.059112 « 0.045292 0.145041 0.029890 0.050815 0.068530 0039576 0.021525 0.028431 0.034*54 0.041250 0.020491 0.025605 0.024162 0013485 0.028532 0021650 0.015501 0.028830 0.021111

|

|

0.4254322 0.221424936 0.281433405 0.286193951 0.247177574 0.409052213 030J503878 |

51 11 64 58 36 63 33 29 S3 42 15 38 4 43 32 7 34 52 55 46 44 48 60 39 66 62 60 65 41

57 1

Mean 1

!

i

Standard Dev.

0.000153 I

0.000068

0.000203 0.000152 0.000140 0.000197 0.000045 0000153

0.000105 0.000065 0.000055

0.000078 0.000063 0.000184 0.000212 0.000057 0.000286 0.000231 0.000170 0.000218 0.000120 0.000208 0.000238 0.000188 0.000125 0.000120 0.000215 0.000202 0000113 0.000199 0.000116 0.000092 0.000131 0.000115 0.000096 0.000135 0.000146 j

Co. of Variation

1 0.4444 0.517241379 0.427631579 0.391857143 0.609137056 0.24444444

0.000120 0.000011 0.000034 0.000033

0.2222222 0.423076923 0.26984127

0.000017 0.000071 0.000086 0.000020 0.000116 0.000090 0.000069 0.000127 0.000049 0.000086 0.000123 0.000070 0.000055 0.000047 0.000065 0.000065 0.000033 0.000043 0.000039 0.000020 0.000048 0.000027 0.000020 0.000043 0.000028

0.385869565 0.405660377 0.350877193 0.405594406 0.38961039 0.405882353 0.582568807 0.408335333 0.413461538 0.516806723 0.372540426 0.44 0.591666667 0.502325581 0.32)782178 0.292055398 0.216080402 0.336206897 0.217511504

|

0.366412214 0.23478260! 0.208333333 0.318518519 0.191780822 |

1 Ranktal j 28 20 33 40 10 59 62 32 51 44 37 47 38 43 36 13 36 34 1 44 30 41 55 53 50 64 50 63 45 60 65 53 66

j

Source: Ahmed Riahi-Belkaoui, "Accrual Accounting and Cash Accounting: Relative Merits of Derived Accounting Indicator Numbers," Journal of Business Finance and Accounting (summer 1983): 304-305. Reprinted with permission.

120

Earnings Measurement, Determination, Management

of the CFP numbers are higher than those of the CEP numbers in 44 cases. Those differences are in most cases considerable (see Exhibit 9.1). For those cases where the variability of CEP and CFP numbers exceeds that of the EPSP numbers, the differences for more than 50 percent of the cases are EPSP numbers, as measured by their coefficients of variation, ranging from a high of 4.723 for Allegheny Airlines Inc. to a low of 0.19 for Philip Morris Inc. The variability of the CEP numbers ranges from a high of 1.84 for General Motors Corp. to a low of 0.18 for Philips Petroleum Co. Finally, the variability of the CFP numbers ranges from a high of 1.31 for Lockheed Corp. to a low of 0.19 for Philips Petroleum Co. Next, the relationship between the distributions of the coefficients of variation of EPSP, CEP, and CFP were examined by computing the Spearman's rank order correlation coefficients between these distributions. The computed correlation between the coefficients of variation of CEP and EPS is equal to 0.5 (ts = 4.6), which is significant at = 0.001. Finally, the computed correlation coefficient between the coefficients of variation of CEP and CFP is equal to 0.57 (ts = 5.65), which is also significant. Thus, it may be concluded that in spite of the differences in the variability of EPSP, CEP, and CFP numbers, there is some correlation between them. The main question created by these results refers to the possible reason(s) why the variability of income statement-oriented and accrual accounting based numbers (EPSP) exceeds for a large number of firms in the sample those of the cash accounting based numbers (CFP) and the balance sheetoriented and accrual accounting-based numbers (CEP). One reason may stem from the fact that EPSP numbers are based on accounting data, which are a likelier object of discretionary accounting income smoothing, as defined by Gordon 37 and others, and of the smoothing process inherent in the very definition of accounting income.38 As a result, the market is efficiently reflecting a "true" income figure different from the "reported" one, which may explain the variability of income statement-oriented and accrual accounting based numbers. A second reason may be that the market, very much aware of the smoothing process affecting income figures, is attaching more importance to the balance sheet position first and the cash flow second. The superiority of the balance sheet over cash flow may be due to a selection market response due either to the higher familiarity with balance sheet data than cash flow data or basically to a balance sheet fixation and a stronger interest in the financial position of the firms. Persistency of Derived Accounting Indicator Numbers The persistency of the derived accounting indicator numbers was determined by examining the median rank correlation between the accounting

Accrual Accounting and Cash Accounting

121

indicator number in the year of formation and the same number in subsequent years. Exhibits 9.2, 9.3, and 9.4 show consecutively the rank correlation of all the sample companies' CEP, CFP, and EPSP with the CEP, CFP, and EPSP in subsequent years. The median correlation of each column is reported at the bottom of the exhibits. The median correlation of the CEP numbers shown in Exhibit 9.2 decreases from 0.918 in the first year after formation to 0.250 in the fourteenth year after formation. Five years after formation the median correlation is 0.629 while 10 years after formation the median is 0.385. The median correlation of the CFP numbers shown in Exhibit 9.3 decreases from 0.835 in the first year after formation to 0.281 in the fourteenth year after formation. Five years after formation the median correlation is 0.452, while 10 years after formation the median is 0.281. The median correlation of the EPSP numbers shown in Exhibit 9.4 decreases from 0.666 in the first year to 0.182 in the fourteenth year. Five years after formation the median correlation is 0.385, while 10 years after formation the median is 0.182. The results show a good persistency in the CEP and CFP numbers and a low persistency in the EPSP numbers. Again the main question refers to the possible reason(s) why the persistencies of the balance sheet-oriented and accrual accounting based number (CEP) and the cash flow accounting based number (CFP) exceed that of the income statement-oriented and accrual accounting based number (EPSP). The two reasons given for the variability results may apply to the persistency results, namely the income smoothing distortion hypothesis and the selective market response hypothesis. SUMMARY AND CONCLUSIONS The purpose of this study was to evaluate merits of accounting indicators derived from either an income statement based on accrual accounting, a balance sheet based on accrual accounting, or a cash flow accounting. The hypothesis is that the number most favored by the market and/or reflected in the market price will show less variability and a higher persistency than the cash flow accounting based number and the income statement-oriented and accrual accounting distortion hypothesis and a selective market response hypothesis. One implication of these results is that the financial position of a firm is deemed more indicative of a firm's potential by the market than either cash flows or income statement numbers. A second implication for standardsetting bodies is to consider the fundamental measurement process as being the measurement of the attributes of assets and liabilities and changes in them rather than a matching process.39 In short, the evidence argues for an asset/liability view of earnings rather than either a revenue/expense view or a cash flow view.

Exhibit 9.2 Rank Correlations of All the Sample Companies' CEPs with CEPs in Subsequent Years Years Following Base Year Base Year 1

1959

2

3

4

5

6

7

8

9

10

0.825 0.733 0.670 0.592 0.431 0.468 0.304 0.288 0.207 0.310

11 0.226

0.374 0.329 0.457 0385" 0.364

12

13

0.106

0.215 j 0.250 0371 i 0.576

1960

0.878 0.801 0.720 0.632 0.599 -.443

1961

0.920 0.808 | 0.722 0.687 0.495 0.433 0.383 0.467 0.386 0.368

0335

1962

0.916 0.856 0.834 0.658 0.579 0.536 0.539 0.475 0.492 0.451 0.941 0.836 0.672 0.607 0.578 0.661 6.S66 0.56*0 0.5 22 0.298

0.175 0.364

0.350 0.122 0.242 0.398

0.567 0.352 0.465

0.482

0.559 0.584

0.322 0 3 3 4 , 0375

0.462

0.558

0.419 0.465 0.552

0.649

1963 1964 1965 1966 1967 1968 1969 1970 1971

0.858 0.702 0.652 0.630 0.665 0.637 0.611 0.894 0.839 0.782 0.737 0.655 0.681 0.665 0.936 0.925 0.813 0.723 0.729 0.735 0372 0.952 0.863 0.784 0.769 0.780 0.457 0.506

0.182 0.196 0.296 0.491

0.536 0.615 0.635

0509 0.855 0.825 0.812 0.506 0.507 0.542 0.622 0.650 0.945 0.893 0.879 0.671 0.602 0.657 0.714 0.655 0.946 0.907 0.752 0.644 0.683 0.743 0.656 0.946 0.731 0.536 0.615 0.695 0.705

1973 1974

0.806 0.521 0.596 0.681 0.688 0.492 0.531 0.618 0.512! 0.962| 0.927 0.636

1975

0.958 0.691

1976

0.833

1972

14

0.244 0.257

1977 Median Correlation 0.918 0.836

0.721 0.658 0.629 0.607

0.541 0.475 0.461

0.385

0.364

0.350 : 0.276 j 0.250

Source: Ahmed Riahi-Belkaoui, "Accrual Accounting and Cash Accounting: Relative Merits of Derived Accounting Indicator Numbers," Journal of Business Finance and Accounting (summer 1983): 307. Reprinted with permission.

Exhibit 9.3 Rank Correlations of All the Sample Companies' CFPs with CFPs in Subsequent Years j Base Year 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977

1 0.811 0.675 0.690 0.829 0.867 0.642 0.912 0.861 0.767 0.763 0.868 0.520 0.924 0.841 0.895 0.909 0.929 0.673

2 0.808 0.627 0.513 0.666 0.713 0.508 0.815 0.780 0.742 0.643 0.567 0.509 0.794 0.765 0.808 0.905 0.482

3 0.668 0.655 0.321 0.807 0.564 0.328 0.674 0.793 0.651 0.674 0.600 0.203 0.746 0.780 0.888 0.665

0.835

0.713

0.667

Years Following Base Year 7 1 8 9 5 ! 6 4 0.530 j 0.288 0.488 0.409 0.379 0.302 0.367 0.465 0.429 0.377 0.214 0.496 0.618 0.516 0.541 0.437 0.514 0.464 0.677 0.583 0.428 0.599 0.621 0.435 0.452 0.233 0.522 0.529 0.387 0.428 0.190 0.403 0.453 0.350 0.399 0.388 0.786 0.734 0.580 0.610 0.397 0.486 0.716 0.550 0.628 0.373 0.426 0.375 0.594 0.631 0.352 0.369 0.338 0.408 0.206 0.415 0.383 0.370 0.432 0.130 0.300 0.366 0.345 0.424 0.383 0.371 0.342 0.368 0.347 0.779 0.783 0.368 0.800 0.438 0.600

0.600

0.452

0.429

0.393

0.397

0.418

10 0.486 0.494 0.367 0.450 0.436 0.561 0.467 0.448 0.307

11 0.466 0.146 0.348 0.315 0.550 0.564 0.530 0.350

0.450

0.408

13 12 0.2991 0.302 0.187 0.196 0.220 0.273 0.420 0.380 0.466 0.562 0.557 0.477 0.383

0.383

0.341

14 0.223 0.271 0.281

0.478 1 0.688 1

0.181

Source: Ahmed Riahi-Belkaoui, "Accrual Accounting and Cash Accounting: Relative Merits of Derived Accounting Indicator Numbers," Journal of Business Finance and Accounting (summer 1983): 308. Reprinted with permission.

Exhibit 9.4 Rank Correlations of All the Sample Companies' EPSPs with EPSPs in Subsequent Years Years Following Base Year

Base Year 1959 1960 1961 1962 1963 1964 1965

10 5 6 1 3 9 12 13 7 8 11 14 0.574 0.545 j 0.394J 0.327 1 0.257j 0.37'J'( 0.296 1 0.148 0.200 0.428 j 0.208 j 0.292 j 0.181 1 0.179 0.576 0.360 0.262 lo.306 1 0.474| 0.358[-0.018 j 0.161 1 0.425 0/263 J 0.282 j 0.235 j 0.136[-0.020 j 0.536 [0.366 0.537 0.583 i 0.439 [0.409j 0.375 [ 0.473 0.005 0.456 1 0.307 j 0.165 0.133 0.260 1

2

4

0.900 0.738 0,655 0.504 0.342 0.291 j 0.168 [-0.243 0.442 [0.376 j 0.331 j 0.205 0.273 0.812 0.790 0.570 0.380 0.384 0.172[-0.278 0.492 0.500 1 0.481 0.349 0.391 0.444 0.819 0.710 0.424 0.549 0.407 -0.349 0.450 0.588 0.546 0.473 ! 0.369 0.391 0.012 0.880 0.567 0.664 0.612 -0.163 0.492 | 0.599 0.532 0.420 0.329 0.424 0.165 0.602 0.790 0.689 -0.141 0.540 0.715 0.507 0.412 0.271 0.292 -0.009 1966 0.626 0.441 -0.059 0.498 0.446 0.215 0.296 0.424 0.250 -0.232 1967 0.685 -0.111 0.651 0.693 0.479 0.384 0.371 0.274 -0.172 1968 0.016 0.537 0.592 0.350 0.530 0.153 0.136 -0.141 1969 -0.107 (-0.171 -0.265 u-0.363 ^0.261 -0.291 0.051 1970 1971 j 0.752 0.447 0.239 0.487 0.386 -0.091 0.717 0.554 0.463 0.492 0.127 1972 0.820 0.653 0.779| 0.395 1973 0.666 0.698 0.266| 1974 0.840 0.091 1975 0.490 1976 1

1977 j Median Correlation 0.666

0.545 0.500

0.487 0.385 0.215

0.296

0.412

0.395 0.376

0.319

0.235

0.158 1

0.324 j

6.182 j

0.182

Source: Ahmed Riahi-Belkaoui, "Accrual Accounting and Cash Accounting: Relative Merits of Derived Accounting Indicator Numbers," Journal of Business Finance and Accounting (summer 1983): 309. Reprinted with permission.

Accrual Accounting and Cash Accounting

125

NOTES 1. M. J. Gross, Jr., Financial and Accounting Guide for Nonprofit Organizations (New York: Ronald Press, 1972). 2. W. Paton and A. Littleton, An Introduction to Corporate Accounting Standards (Columbus, OH: American Accounting Association, 1940). 3. W. Paton, Accounting Theory (Chicago: Accounting Studies Press, Ltd., 1962; originally published in 1922). 4. J. Canning, The Economics of Accountancy (New York: Ronald Press, 1929). 5. S. Alexander, Five Monographs on Business Income (New York: Study Group on Business Income, AI[CP]A, 1950). 6. M. Edwards and P. Bell, The Theory of Measurement of Business Income (Berkeley: University of California Press, 1961). 7. R. Chambers, Accounting, Evaluation and Economic Behavior (Englewood Cliffs, NJ: Prentice-Hall, 1966). 8. R. Sterling, Theory of Measurement of Enterprise Income (Lawrence: University of Kansas Press, 1970). 9. B. E. Hicks, The Cash Flow Basis of Accounting, Working paper No. 13 (Sudburt, Ontario: Laurentian University, 1980). 10. D. Hawkins and W. Campbell, Equity Evaluation: Models, Analysis, and Implementations (New York: Financial Executive Institute, 1978). 11. A. R. Thomas, "The Allocation Problem in Financial Accounting Theory," Studies in Accounting Research No. 3 (Sarasota, FL: American Accounting Association, 1969). 12. A. R. Thomas, "The Allocation Problem: Part Two," Studies in Accounting Research No. 9 (Sarasota, FL: American Accounting Association, 1974). 13. Hawkins and Campbell, Equity Valuation: Models Analysis and Implications. 14. G. Staubus, "The Relevance of Cash Flows," in Asset Valuation, R. R. Sterling, Ed. (Houston: Scholars Book Co., 1971). 15. G. Staubus, A Theory of Accounting to Investors (Berkeley: University of California Press, 1961). 16. American Accounting Association, Committee on External Reports, An Evaluation of External Reporting Practices, a Report of the 1966-68 Committee on External Reporting, The Accounting Review (Supplement, 1969): 79-123. 17. L. Revsine, Replacement Cost Accounting (Englewood Cliffs, NJ: PrenticeHall, 1973). 18. American Institute of Certified Public Accountants, Study Group, The Objectives of Financial Statements (New York: American Institute of Certified Public Accountants, 1973). 19. J. Stern, "Let's Abandon Earning per Share," Barron's (December 18, 1972): 2. 20. Y. Ijiri, "Cash Flow Accounting and Its Structure," Journal of Accounting, Auditing, and Finance (summer 1978): 331-348. 21. R. Ashton, "Cash Flow Accounting: A Review and Critique," Journal of Business Finance and Accounting (winter 1976): 63-81.

126

Earnings Measurement, Determination, Management

22. T. A. Climo, "Cash Flow Statements for Investors," Journal of Business Finance and Accounting (autumn 1976): 3-16. 23. T. A. Lee, "A Case for Cash Flow Reporting," Journal of Business Finance (1972): 27-36. 24. T. A. Lee, "The Relevance of Accounting Information including Cash Flows," The Accountant's Magazine (January 1972): 27-32. 25. G. H. Lawson, "Cash-Flow Accounting I and II," Accountant (October 28 and November 4, 1971): 31-41. 26. G. H. Lawson, "Some Arguments for Cash-Flow Accounting," Certified Accountants (April-May 1973): 5-15. 27. T. A. Lee, "Reporting Cash Flows and Net Realizable Values," Accounting and Business Research (spring 1981): 163-170. 28. Lawson, "Cash-Flow Accounting I and II." 29. Lee, "A Case for Cash Flow Reporting." 30. Y. Ijiri, "A Simple System of Cash Flow Accounting," in Accounting for a Simplified Firm Owning Depreciable Assets, Robert Sterling and A. L. Thomas, Eds. (Houston, TX: Scholars Book Co., 1979): 57-71. 31. H. C. Edey, "Accounting Principle and Business Reality," Accountancy (November 1963): 998-1002 and (December 1963): 1083-1088. 32. Lawson, "Cash-Flow Accounting I and II." 33. T. A. Lee, "Good Will—An Example of Will-o-the-Wisp Accounting," Accounting and Business Research (autumn 1971): 918-928. 34. Lee, "The Relevance of Accounting Information including Cash Flows." 35. W. H. Beaver and R. E. Dukes, "Interperiod Tax Allocation, Earnings Expectations, and the Behavior of Security Prices," The Accounting Review (April 1972): 320-332. 36. B. Barlev and H. Levy, "On the Variability of Accounting Income Numbers," Journal of Accounting Research (autumn 1979): 305-315. 37. M. J. Gordon, "Postulates, Principles and Research in Accounting," The Accounting Review (April 1964): 221-263. 38. Barlev and Levy, "On the Variability of Accounting Income Numbers." 39. A. Belkaoui, Accounting Theory (New York: Harcourt Brace Jovanovich, 1981). SELECTED READINGS Alexander, S. Five Monographs on Business Income. New York: Study Group on Business Income, AI(CP)A: 1950. American Accounting Association, Committee on External Reports. "An Evaluation of External Reporting Practices. A Report of the 1966-68 Committee on External Reporting." The Accounting Review (Supplement, 1969): 79-123. American Institute of Certified Public Accountants, Study Group. The Objectives of Financial Statements. New York: American Institute of Certified Public Accountants, 1973. Ashton, R. "Cash Flow Accounting: A Review and Critique." Journal of Business Finance and Accounting (winter 1976): 63-81. Barlev, B., and H. Levy. "On the Variability of Accounting Income Numbers." Journal of Accounting Research (autumn 1979): 305-315.

Accrual Accounting and Cash Accounting

127

Beaver, W. H., and R. E. Dukes. "Interpreted Tax Allocation, Earnings Expectations, and the Behavior of Security prices." The Accounting Review (April 1972): 320-332. Beaver, W., and D. Morse. "What Determines Price-Earnings Ratios?" Financial Analysis Journal (July-August 1978): 65-76. Belkaoui, A. Accounting Theory. New York: Harcourt Brace Jovanovich, 1981. Canning, J. The Economics of Accountancy. New York: Ronald Press, 1929. Chambers, R. Accounting, Evaluation and Economic Behavior. Englewood Cliffs, NJ: Prentice-Hall, 1966. Climo, T. A. "Cash Flow Statements for Investors." Journal of Business Finance and Accounting (autumn 1976): 3-16. Edey, H. C. "Accounting Principles and Business Reality." Accountancy (November 1963): 998-1002 and (December 1963): 1083-1088. Edwards, E., and P. Bell. The Theory and Measurement of Business Income. Berkeley: University of California Press, 1961. Financial Accounting Standards Board. Statement of Financial Accounting Concepts No. 1. Stamford, CT: FASB, 1978. . "Tentative Conclusions on Objectives of Financial Statements of Business Enterprises." Stamford, CT: FASB, 1976. Gordon, M. J. "Postulates, Principles and Research in Accounting." The Accounting Review (April 1964): 221-263. Gross, M. J., Jr. Financial and Accounting Guide for Nonprofit Organizations. New York: Ronald Press, 1972. Hawkins, D., and W. Campbell. Equity Valuation: Models, Analysis and Implications. New York: Financial Executives Institute, 1978. Hicks, B. E. "The Cash Flow Basis of Accounting." Working paper No. 13. Sudbury, Ontario: Laurentian University, 1980. Ijiri, Y. "Cash Flow Accounting and Its Structure." Journal of Accounting, Auditing, and Finance (summer 1978): 331-348. . "A Simple System of Cash Flow Accounting." Accounting for a Simplified Firm Owning Depreciable Assets, R. Sterling and A. L. Thomas, Eds. Houston, TX: Scholars Book Co., 1979: 57-71. Lawson, G. H. "Cash-Flow Accounting I and II." Accountant (October 28 and November 4, 1971): 17-22. . "Some Arguments for Cash-Flow Accounting." Certified Accountant (April-May 1973): 21-32. Lee, T. A. "A Case for Cash Flow Reporting." Journal of Business Finance (1972): 27-36. . "The Contribution of Fisher to Cash Flow Accounting." Journal of Business Finance and Accounting (autumn 1979): 321-330. . "Good Will—An Example of Will-o-the-Wisp Accounting." Accounting and Business Research (autumn 1971): 318-328. . "The Relevance of Accounting Information Including Cash Flows." The Accountant's Magazine (January 1972): 16-23. . "Reporting Cash Flows and Net Realizable Values." Accounting and Business Research (spring 1981): 163-170. Paton, W. Accounting Theory. Chicago: Accounting Studies Press Ltd., 1962. Originally published in 1922.

128

Earnings Measurement, Determination, Management

Paton, W., and A. Littleton. An Introduction to Corporate Accounting Standards. Columbia, OH: American Accounting Association, 1940. Revsine, L. Replacement Cost Accounting. Englewood Cliffs, NJ: Prentice-Hall, 1973. Staubus, G. "The Relevance of Cash Flows." In Asset Valuation, R. R. Sterling, Ed. Houston: Scholars Book Co., 1971. . A Theory of Accounting for Investors. Berkeley: University of California Press, 1961. Sterling, R. "Earnings per Share Is a Poor Indicator of Performance." OMEGA (1974): 11-32. . Theory of the Measurement of Enterprise Income. Lawrence: University of Kansas Press, 1970. Stern. J. "Let's Abandon Earnings per Share." Barron's (December 18, 1972): 2. Thomas, A. L. "The Allocation Problem in Financial Accounting Theory." Studies in Accounting Research No. 3. Sarasota, FL: American Accounting Association, 1969. . "The Allocation Problem: Part Two." Studies in Accounting Research No. 9. Sarasota, FL: American Accounting Association, 1974. Whittington, G. "Accounting and Economics." In Current Issues in Accounting, B. Carsberg and T. Hope, Eds. New York: Philip Allan, 1977.

10 Cash Flow, Earnings, and Corporate Control INTRODUCTION A number of studies has investigated the characteristics that differentiate merger target firms using either selected financial variables,1'2,3'4'5 or Tobin's g, or other market-based measures.6'7'8 This chapter employs cash flow and earnings based measures of return to assess the differences in the characteristics of target firms compared to their industries, and to examine the association of these measures with target firms' abnormal returns during the takeover. In a sample of sixty-three completed takeovers over the period of 1977 to 1989, takeover targets have mean cash flow and earnings to total assets below their industry means in each of the three fiscal years preceding the year in which the takeover is completed. If these ratios are interpreted as measures of managerial performances the implication is that target firms were underperformers, which may have been taken over for a better use of their asset potential. A target firm's abnormal returns observed during the takeover period are significantly related to the difference between the target firm and target industry earnings to total assets ratios and to the difference in cash flow to total assets ratios. Abnormal returns are negatively related to the difference in the earnings to total assets ratio, suggesting that target industry cash This chapter has been adapted with permission from James W. Bannister and Ahmed RiahiBelkaoui, "Cash Flow, Earnings, and Corporate Control," Managerial Finance 18(5) (1992): 14-30.

130

Earnings Measurement, Determination, Management

flow to total assets is positively related to the target firm's abnormal returns, and that acquiring firms value the near-term cash flow of targets. The remainder of the chapter is organized as follows. The next section describes the link between cash flow, earnings, and takeover bids. Next the link between earnings, cash flow, and the target firm's abnormal returns is described. The data collection procedure and variable construction is discussed in the following section. Tests of target firm versus industry comparisons are reported next, followed by the results of tests of the relation between target firm abnormal returns and measures of cash flow and earnings. A summary and discussion conclude the chapter. CASH FLOW, EARNINGS, AND TAKEOVER For as long as it has existed, accrual accounting earning has been a matter of interest for managers, current and prospective owners of the firm, and financial analysis. Cash flow, a useful gauge of liquidity, has also been of interest and in recent decades has received greater attention from academics and accounting regulators. Its supporters view joint earnings and cash flow reporting as an improvement over the issuance of conventional accrual accounting alone. 9 ' 10,11 ' 12,13 A number of studies has examined, with mixed results, usefulness of cash flow versus earnings for the purpose of (1) predicting financial distress,14,15,16-17 or (2) determining the information content of financial statements. 18,19,20,21 If one adopts the view that takeover bids arise as a result of target firm undervaluation and/or managerial motives,22 then cash flow and earnings measures may be useful tools for the analysis of takeovers. Coffee23 identifies several potential reasons for target firm undervaluation, including the failure of management to efficiently manage the firm's assets, and the risk aversion of managers who may be extremely protective of their own authority. Under this scenario, motivation for a takeover bid stems from the bidder's desire to acquire an undervalued firm, displace current management, and exploit the disparity between the target's potential and current values. If firms become takeover targets due to undervaluation, then it is possible that the economic characteristics underlying this undervaluation (e.g., inefficient use of assets) are reflected in their accounting-based return measures. As such, the earnings and cash flow to total assets ratios, relative to the industry standard, provide an empirical prediction concerning the sources of value in takeovers and the characteristics of takeover targets. This possibility is addressed empirically by an examination of target firms' earnings to total assets and cash flow to total assets in comparison to the average of these performance measures for firms in the targets' industry. Let E/TA represent the earnings to total assets ratio, CF/TA represent the cash flow to total assets ratio, and D[E/TA] represents the difference be-

Cash Flow, Earnings, and Corporate Control

131

tween target firm E/TA (CF/TA) and industry average E/TA(CF/TA). The following hypothesis, stated in the alternative form, is tested: Ht: D[E/TA] and D[CF/TA] are less than zero. Takeover results in a gain in wealth for target firms' shareholders. 24,25,26 Rejection of the null for H a will provide some indication that target firms are indeed poor performers compared to their industries. However, this alone will not demonstrate that poor performance is associated with the magnitude of the bid in a takeover offer. The next section describes tests of the association between relative target/industry performance and the abnormal stock returns earned by target firm shareholders. CASH FLOW, EARNINGS, AND TAKEOVER ABNORMAL RETURNS If firms become takeover targets due to managements' failure to efficiently employ assets, and this underperformance can be remediated by a change in management, then, other things being equal, the lower the performance of the target in comparison to similar firms, the greater the gain to the acquiring firm. Further, if economic performance is proxied by the target's accounting measures of return, the abnormal returns earned by target shareholders during the takeover period should be associated with target firm cash flow and earnings to total assets relative to the industry standard. Under this scenario, D[CF/TA] and D[E/TA], should inversely proxy the extent to which an acquiring firm could better exploit the resources of the target firm and, consequently, should be negatively related to the share price increment that the bidding firm is willing to pay for the target. This leads to the second hypothesis: H2: D[E/TA] and D[CF/TA] are negatively related to target firm cumulative abnormal returns observed during the interval from the first announcement of a takeover offer to the date of takeover resolution. To analyze the extent to which D[CF/TA] and D[CF/TA] can explain abnormal returns to targets, the regression in equation (1) is estimated. Separate regression of CAR(t) on D[E/TA] and on D[CF/TA] is also reported in a later section.

CAR(T) is the cumulative abnormal return of the target over the takeover contest period; D[CF/TA] is the difference between target firm Ts industry;

132

Earnings Measurement, Determination, Management

and D[E/TA] is the difference between target firm T s earnings to total assets and average earnings/total assets for T's industry. A number of additional factors have been found to influence the magnitude of target firm abnormal returns in the course of a takeover contest. Huang and Walking 27 have found that returns to target shareholders are higher when the target's management opposes the takeover, and that more wealth is created in cash transactions than in takeovers conducted entirely or partly by the exchange of securities. Further, Servaes28 reports that multiple bidders in the contest increase the return to target shareholders. Finally, with the appearance of investment banking firms specializing in financing takeovers, and creation of anti-takeover devices, there has been a change in the overall merger environment that occurred about 1981. These factors may confound the results of the analysis shown in equation (2).

CAR(T), DJCF/TA], and D[E/TA] are defined above. The control variables have the following definitions: CASH is an indicator variable equaling 1 if takeover is primarily for cash and 0 otherwise; HF is an indicator variable equaling 1 if management's reaction to the takeover indicates that it is hostile and 0 if friendly; BIDS is an indicator variable equaling 1 if there is more than one bidder for the targets, and 0 if there is only one bidder; AFT80 is an indicator variable equaling 1 if the merger is the natural logarithm of market value of equity of the target firm at the beginning of the year in which the takeover announcement is made. The expectations for D[CF/TA] and D[E/TA] remain the same. Given the discussion above, the coefficients for CASH, HF, and BIDS are expected to be positive. Because AFT80 and SIZE are included as general control variables, there is no directional expectation for their coefficients. DATA COLLECTION A sample of completed takeovers was identified by examining the COMPUSTAT Annual Research file for firms delisted due to merger or acquisition over the period 1977 to 1988. The firms in this sample were candidate firms for another study involving value added and mergers. Firms in regulated industries were excluded from the sample. Specifically, firms with SIC codes starting with 4—transportation and utility companies, 6—financial institutions and insurance companies, and 9—public administration companies were excluded from the sample. Information on industry earnings, cash flow, and total assets were collected from the COMPUSTAT primary, secondary, tertiary, and research fees. Similar data for target firms

Cash Flow, Earnings, and Corporate Control

133

Exhibit 10.1 Frequent Distribution of Sample by Year of Takeover Resolution—Sample Period 1977-1989 Year of Takeover

Number of Targets

1977

4 6 6 7 7 6

1978 1979 1980 1981 1982 1983

3

1984

8 7 2 5 1 1 63

1985 1986 1987 1988 1989

Total

Source: Ahmed Riahi-Belkaoui, "Cash Flow, Earnings, and Corporate Control," Managerial Finance 18(5) (1992):14-30. Reprinted with permission.

were collected from the COMPUSTAT Annual Research file. Return data were collected from the CRSP Daily Return file. Other information collected includes the date of the first takeover offer for the target firm (the date of the first offer is the date on which the first bid for the firm was made; in a multifirm bidding contest, this date is not necessarily the date of the first bid by the firm that eventually acquired the target), the form of payment (cash, securities, or mixed cash and securities), the number of bidding firms, and the nature of the takeover (the takeover was viewed as friendly unless the Wall Street Journal Index reported the opposition of management to the offer). The Wall Street Journal Index and Merger and Acquisitions were the source of these information items. The final sample consists of sixty-three takeovers that were completed between 1977 and 1989. Due to insufficient industry data on COMPUSTAT, however, lack of coverage in the Wall Street Journal Index, or lack of coverage on the CRSP Daily Return file, fewer than sixty-three observations are available for some of the analyses. Exhibit 10.1 presents the distribution of the sample by year of takeover. Exhibit 10.2 subdivides the sample according to various merger characteristics. Due to incomplete coverage in either the Wall Street Journal or Merger and Acquisitions, how-

Earnings Measurement, Determination, Management

134

Exhibit 10.2 Sample Frequency of Takeover Classified by Form of Payment, Hostile or Friendly Offer, and Number of Bidders for the Target Form of Payment

Number of Firms

Percent

Cash Payment

28

44.4

Securities

13

20.6

Mixed cash and securities

10

15.9

Form ot* payment unknown

12

19.0

Total

63

100.0

Number of Firms

Percent

Hostile acquisition

15

23.8

Friendly acquisition

37

58.7

Management reaction to offer

Unknown

11

17.5

Total

63

100.0

Number of Firms

Percent

I bidder

37

58.7

2 bidders

10

15.9

3 bidders

3

4.8

4 bidders

2

3.2

Unknown Total

ll

17.5 100.0

Number of Bidders

63

j

Source: Ahmed Riahi-Belkaoui, "Cash Flow, Earnings, and Corporate Control," Managerial Finance 18(5) (1992):14-30. Reprinted with permission.

ever, one or more merger characteristics would not be determined for a number of firms. Construction of variables used for the tests of hypotheses is discussed next. Calculation of Earnings and Cash Flow to Total Assets Earnings to total assets (E/TA) is calculated as earnings available to common shareholders in year t (COMPUSTAT data item 20) divided by closing total assets from year t - 1 (COMPUSTAT data item 6). The calculation of cash flow for year t(CF) is shown in (3) below: CF = Earnings t + Depreciation t + Deferred taxes t — (Current assets t — Cash t — Current liabilities,) + (Current assets t_x — Cash,^ — Current liabilities,^)

(3)

Cash Flow, Earnings, and Corporate Control

135

where Earnings is defined as earnings available to common shareholders; Depreciation is current depreciation and amortization expense (COMPUSTAT data item 14); Deferred taxes are the current deferred tax effect on the income statement (COMPUSTAT data item 4 and 5, respectively); and Cash represents cash and short-term investments (COMPUSTAT data item 1). Cash flow to total assets (CF/TA) is calculated as CF t divided by total assets as of the end of year t-l. Estimation of Abnormal Returns CAR(T) is calculated as follows. Daily returns from the CRSP file are used to estimate market model parameters:

where Rjs is the daily return on security / on days s, Rms is the value weighted return on the market on days s, ejs is a normally distributed error term, and oc; and (3; are firm-specific parameters to be estimated. An estimation period from days - 2 0 9 to - 1 0 relative to the date of the first public announcement of a merger offer (day 0) is used. Day 0 is defined as the day prior to the day that the announcement of the offer was published in the Wall Street Journal. Daily abnormal returns for firm j(ARjd) are the market model prediction error for each day (d) in the cumulation period:

Finally, the Arjd are cumulated to form CAR(T). The cumulative period is from the date of the first announcement of a merger offer to the date of shareholder approval of the merger. In some cases, the target firm's stock was delisted prior to shareholder approval. In these cases, the cumulation of abnormal returns I terminated at the delisting date. Also, regressions were run using CAR(T) standardized by a factor to adjust for prediction outside the estimation period. 29,30 The results are not reported since they are similar to those reported below. THE CASH FLOW AND EARNINGS RATIOS OF TARGET FIRMS The cash flow and earnings to total assets ratios (CF/TA and E/TA, respectively) for cash of the target firms were computed for the three fiscal years preceding the resolution of the takeover. Average CF/TA and E/TA were also computed for the four-digit SIC code industries of the target firms. Industry average ratios were not computed for industries that had fewer than three nontarget firms with the necessary data. E/TA and CF/TA

136

Earnings Measurement, Determination, Management

for the target firms were then compared to those in their respective fourdigit industries. Exhibit 10.3 contains the comparisons of E/TA and CF/TA. Mean E/TA for the takeover targets in the three years preceding the resolution of the takeover are - 0 . 0 1 7 8 , -0.0224, and 0.0005. The comparative industry ratios are 0.0390, 0.0340, and 0.0396. The results of £-tests of differences between these ratios indicate that target firms have significantly lower mean E/TA ratios than the average for their industries in each of the three years. Mean CF/TA ratios of target firms are also significantly lower than those for their industries in the three years prior to resolution of the takeover. Target firm mean CF/TA is 0.0634 three years prior to takeover resolution. The related industry ratios are 0.1018, 0.0847, and 0.0910. Median target CF/TA is less than median industry CF/TA, and median target firm E/TA is larger than median industry E/TA but these differences are not statistically significant. These results suggest that many target firms exhibit lower performance than other firms in their industry over an extended period of time prior to the resolution of the takeover. CASH FLOW, EARNINGS, AND TARGET FIRM ABNORMAL RETURNS On average, target firm cash flow and earnings to total assets are lower than their industry average in the three years preceding the takeover completion. In this section, the difference between target firm and industry average CF/TA and E/TA from the last complete fiscal year prior to the resolution of the takeover (D[CF/TA and D[E/TA], respectively) is employed in an attempt to explain the abnormal returns that accrue to the shareholders of target firms during the period of the takeover contest. Cumulative abnormal returns realized on target firm shares are regressed on D[E/TA] and D[CF/TA]; if the value created in takeovers is greater when target firms have lower cash flow and earnings per dollar of total assets relative to their industries, then the coefficients on these variables should be negative. The results of regressions of CAR(T) on D[E/TA] and D[CF/TA], both individually and jointly, are reported in Exhibit 10.4. Panel A reports the first announcement of a merger offer. Panel B reports the results of regressions where CAR(T) is cumulated from one week (five trading days) prior to the first announcement of a merger offer. In column [1] of panel A, the regression of CAR(T) on D[E/TA] is insignificant. Similarly, in column [3], the coefficient for D[E/TA] is insignificant at a conventional level although, in both regressions, the sign agrees with H 2 . The coefficients are significantly different than zero, but the sign of the coefficients is positive, indicating that increasing cash flow per dollar of total assets relative to the industry average is associated with higher

Cash Flow, Earnings, and Corporate Control

137

Exhibit 10.3 Comparison of Target Firm and Industry Earnings to Total Assets (E/TA) and Cash Flow to Total Assets (CF/TA) Ratios Target Firm \

t-statisticb

Var

n

mean

median

mean

median

t-3a

E/TA

58

-0.0178

0.0635

0.0390

0.0563

CF/TA

56

0.0634

0.1028

0.1018

0.1122

-1.46*

E/TA

61

-0.0224

0.0559

0.0340

0.0448

-2.38***

CF/TA

59

0.0061

0.0865

0.0847

0.1090

-2.06**

E/TA

57

0.0005

0.0576

0.0396

0.0520

-1.74**

CF/TA

56

0.0458

0.0865

0.0910

0.1035

-1.91**

t-2 t-1 a

Target Industry

Year

" -2.01**

lh

Year t-i represents the i complete fiscal year prior to the resolution of the takeover. h Test of the null hypothesis that D[E/TAJ (D[CF/TAJ) equals zero. D[ ]is the difference (target ratio - target industry average ratio). Under the alternative hypothesis, the expected sign in each case is negative * " Significant at a = 0.10, one-tailed test. ** Significant at a = 0.05, one-tailed test. • *** Significant at a = 0.01, one-tailed test. Source: Ahmed Riahi-Belkaoui, "Cash Flow, Earnings, and Corporate Control," Managerial Finance 18(5) (1992): 14-30. Reprinted with permission.

abnormal returns for the shareholders. This result does not agree with H 2 , which hypothesized a negative relationship between CAR(T) and D[CF/ TA], but may be indicative of a desire by acquiring firms to quickly generate cash to cover the cost of the takeover. Alternatively, it may be related to Jensen's free cash flow theory of takeovers whereby times are taken over to distribute cash flow that the target management is retaining for investment in negative net present value projects.31 When abnormal returns are cumulated from one week prior to the first public announcement of a merger offer, similar, but quantitatively stronger, results are observed. The coefficients for D[E/TA] in columns [1] and [3] of panel B remain positive, and, in these regressions, are significant. D[CF/ TA] remains negatively correlated with CAR(T). This suggests that information, or speculation, about the merger offer was present in the market prior to the public announcement reported by the Wall Street Journal, and the abnormal returns were accruing to the target firm shareholders in advance of the offer. The results of similar regression, which include the control variables, are reported in Exhibit 10.5. In general, the control variables add no explanatory power to the regressions. The adjusted R1 of the regressions declines, and all of the regressions in panel A, along with the regression in column

,

Exhibit 10.4 Regression Results of Target Firm Abnormal Returns on D[E/TA] and D [CF/TA] Panel A: Regression Results

m

| Intercept0

[31

(21

0.228 1 (.01)*** 1 0.161 1 (.01)*** 1 0.189 1 (.01)*** 1 Dl E/TA) -1.371 -1.398 (-11) 1 (•11) piCF/TA| 1.148 1.156 (.05)** (.05)" 1 F-statistic 2648 3.620 (-04)" (.11) 4.277 | (.05)** (Adjusted R" 0.046 0.137 | 0.090 |n 35 34 34 Panel B: CAR(T) from one week prior to takeover offer date

[11 1 Intercept D|E/TA| D|CF/TA| 1 F-statistic [Adjusted R2

0.314

[21

(.01)*** j 0.230

(.01)***

j -1.788 1 (.04)** 1.521

(.01)"* (.01)***

[31 0.267 | (.01) ••* -1.774

(.03)**

1.511 6.977 0.266

(.01)*** (.01)***

| 4.369 1 (.04)** 7.784 | 0.090 0.171 34 j 35 1 34 a D[ E/TA| is the difference between target firm earnings to total assets and average earnings to total assets for the target firm's industry. D[CF/TA1 is the difference between targetfirmand average industry cash flow to total assets. D|E/TA] and plCF/TAJ are calculated from data from the last fullfiscalyear prior to takeover resolution. b The takeover offer date is the date of the first announcement of an offer for the target firm in the takeover contest; it is not necessarily the date of the first offer from the eventual acquirer. CAR(T) is cumulated from the offer date in panel A (one week prior to the offer date in panel B), to the date of targetfirmshareholder approval or exchange delisting, whichever is earlier. c Figures reported for regression variables are, coefficient (two-tailed p-value); for F-statistic, F-statistic (p- value); for n, observations. ** Significant at a = 0.05, two-tailed test. 1 * ^Significant at a = 0.01, two-tailed test. Source: Ahmed Riahi-Belkaoui, "Cash Flow, Earnings, and Corporate Control," Managerial Finance 18 (5) (1992):14-30. Reprinted with permission.

138

Exhibit 10.5 Regression Results of CAR(T) on D[E/TA] and D[CF/TA] with Control Variables related to Target Firm and Merger Characteristics

ni 0.110 -0.075 -0.195 0.089 0.128 -1.401

Intercept AFT80 HF CASH BIDS D[E/TA| D|CF/TA] SIZE F-statistic Adjusted R : n

0.027 0.694 -0.057 35

PI (.52) (.59) (.26) (.42) (.41)

-0.175 -0.185 -0.248 0.095 0.189

(-5) (.46) (.66)

1.582 0.076 1.591 0.097 34

PI (.33) (.17) (.13) (.36) (.20)

-0.107 -0.139 -0.263 0.093 0.192 -1.138 (.01)*** 1.515 (.05)** 0.064 (.19) 1.619 0.116 34

(-56) (.32) (.11) (.37) (.19) (.22) (.02)** (.10)* (.17)

+

[21

[1] Intercept AFT80 HF CASH BIDS D[ETA] D[CF/TA| SIZE F-statistic Adjusted R"

In

0.245 -0.038 -0.169 0.079 0.095 -1.875 0.015 0.0867 -0.024

(.16) (.79) (.33) (.48) (.54) (.06)*

[3]

-0.090 -0.152 -0.223 0.096 0.160

(.61) (.25) (.17) (.35) (.27)

1.922 0.070 2.046 0.160 34

(.01)*** (.07)* (.09)*

(.67) (.53)

35

139

0.009 -0.085 -0.245 0.094 0.165 -1.658 1.824 0.053 2.466 0.237 34

(-96) (.52) (.12) (.34) (.24) (.06)* (.01)*** (.15) (.04)**

140 a

Earnings Measurement, Determination, Management •

.

.

I

11

1

,

1

i

i

D[E;TA) (D[CF/TA|) is target firm earnings to total assets (cash flow to total assets) less average earnings to total assets (cashflowto total assets) for the target's industry calculated from data from the lastfiscalyear prior to takeover resolution. The indicator variables are: AFT80 = I if the merger takes place after 1980; HF = 1 if the merger is hostile; CASH = 1 if the merger is for cash; BIDS = 1 if there is more than one bidder for the target. SIZE is he natural log of the target's market value of equity at the beginning of the last year prior to thefirsttakeover offer. b

The takeover offer date is the date of the first announcement of an offer for the target firm in the takeover contcst/it is not necessarily the date of the first offer from the eventual acquirer. CAR(T) is cumulated from the offer date in panel A (one week prior to the offer date in panel B), to the date of targetfirmshareholder approval or exchange delisting, whichever is earlier.

c

Figures reported for regression variables are coefficient (two-tailed p-vaiue); for F-statistic, F-statistic (p value); for n, observations. ^'Significant at a = 0.10. ^'"Significant at a = 0.05. **^Significant at a = 0.01.

Source: Ahmed Riahi-Belkaoui, "Cash Flow, Earnings, and Corporate Control," Managerial Finance 18(5) (1992): 14-30. Reprinted with permission.

[1] of panel B have insignificant F-statistics. In the two significant regressions, reported in columns [2] and [3] of panel B, D[E/TA] and D[CF/TA] display the same relationship to CAR(T) as they did in the regressions without control variables (see Exhibit 10.4). Among the control variables in these two regressions, only SIZE has significant explanatory power.

DISCUSSION AND CONCLUSIONS This chapter examined the cash flow to total assets and earnings to total assets of a sample of sixty-three merger targets that were taken over in the period 1977 to 1989. The first result of the study concerns the ability of cash flow and earnings based measures of return to assess the differences between target firms and their industries. More specifically, the results corroborate the general premise in the literature that target firms are underperformers compared to other firms in their industries. They further indicate that this low performance is evident not only in an earnings based measure, but is also evident when a cash flow based measure is used. A second result indicates that cumulative abnormal returns accruing to target firm shareholders are significantly associated with these measures of the relative performance of targets versus their industries. As hypothesized, the target firm versus industry difference in earnings to total assets is negatively correlated with abnormal returns earned by target shareholders, indicating that target firms may be acquired to put their assets to a more efficient use. Contrary to the study's hypothesis, the target versus industry

Cash Flow, Earnings, and Corporate Control

141

difference in cash flow to assets is positively correlated to abnormal returns earned by target shareholders. One interpretation is that, while target firms underperform relative to their industry in terms of cash flow generation, acquiring firms value cash flow in merger targets and will pay a higher price to get it. This may result from a desire on the part of the acquiring firm to cover near-term costs of the merger. Alternatively, while Jensen's free cash flow theory 3 2 is not directly tested here, a possible interpretation of this result is that target firms are being acquired to release, or to better invest, cash flow that previous management retained to invest in negative net present value projects. NOTES 1. M. Simkowitz and R. J. Monroe, "A Discriminant Analysis Function for Conglomerate Targets," Southern Journal of Business (November 1971): 1-16. 2. D. L. Stevens, "Financial Characteristics of Merged Firms: A Multivariate Analysis," Journal of Financial and Quantitative Analysis 8 (1973): 149-165. 3. A. D. Castagna and Z. P. Matoley, "Financial Ratios as Predictors of Company Acquisitions," Journal of Security Institute of Australia (December 1976): 6 10. 4. A. Belkaoui, "Financial Ratios as Predictors of Canadian Takeovers," Journal of Business Finance and Accounting (spring 1978): 93-107. 5. K. G. Palepu, "Predicting Takeover Targets," Journal of Accounting and Economics 8 (1986): 3-35. 6. J. Hasbrouck, "The Characteristics of Takeover Targets: q and Other Measures," Journal of Banking and Finance 9 (1987): 329-345. 7. L. Lang, R. Stulz, and R. A. Walking, "Managerial Performance, Tobin's q and the Gains from Successful Tender Offers," Journal of Financial Economics 24 (1989): 137-154. 8. H. Servaes, "Tobin's q and the a Gain from Takeovers," Journal of Finance (March 1991): 409-419. 9. G. H. Lawson, "Cash Flow Accounting I and II," Accountant (October 28 and November 4, 1971). 10. T. A. Lee, "A Case for Cash Flow Reporting," Journal of Business Finance (1972): 27-36. 11. R. Ashton, "Cash Flow Accounting: A Review and Critique," Journal of Business Finance and Accounting (winter 1976): 63-81. 12. Y. Ijiri, "Cash Flow Accounting and Its Structure," Journal of Accounting Auditing and Finance (summer 1978): 331-348. 13. A. Belkaoui, The New Environment in International Accounting (Westport, CT: Greenwood Press, 1988). 14. W. F. Beaver, "Financial Ratios and Predictors of Failure," Empirical Research in Accounting: Selected Studies. Journal of Accounting Research 4(supplement) (1966): 71-111. 15. C. Casey, and N. Bartezack, "Using Operating Cash Flow Data to Predict Financial Distress: Some Extension," Journal of Accounting Research (spring 1985): 146-160.

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Earnings Measurement, Determination, Management

16. J. A. Gentry, P. Newbold, and D. T. Whitford, "Classifying Bankrupt Firms with Funds Flow Components," Journal of Accounting Research (spring 1985): 384-401. 17. J. A. Largey and C. P. Stickney, "Cash Flow, Ratio Analysis and the W. T. Grant Company Bankruptcy," Financial Analysis Journal (July/August 1980): 5 1 54. 18. J. Rayburn, "The Association of Operating Cash Flow and Accruals with Security Returns," Journal of Accounting Research (1986 Supplement): 112-133. 19. G. P. Wilson, "The Relative Information Content of Accruals and Cash Flows: Combined Evidence at the Earnings Announcement and Annual Report Release Date," Journal of Accounting Research (1986 Supplement): 165-200. 20. R. M. Bowen, D. Burgstahler, and L. A. Daley, "The Incremental Information Content of Accrual versus Cash Flows," The Accounting Review (October 1987): 723-747. 21. V. L. Bernard and T. L. Stober, "The Nature and Amount of Information in Cash Flows and Accruals," The Accounting Review (October 1989): 624-652. 22. B. Lev, "Observation on the Merger Phenomenon and a Review of Evidence," Midland Corporate Finance Journal (winter 1983): 6-28. 23. J. C. Coffee, "Shareholders versus Managers: The Strain in the Corporate Web," In Knights, Raiders, and Targets: The Impact of the Hostile Takeover, J. C. Coffee et al., Eds. (New York: Oxford University Press, 1988). 24. D. K. Dennis and J. J. McConnelly, "Corporate Mergers and Security Returns," Journal of Financial Economics 16 (1986): 143-187. 25. Y. Huang and R. A. Walking, "Target Abnormal Returns associated with Acquisition Announcements: Payment, Acquisition Form, and Managerial Resistance," Journal of Financial Economics 19 (1987): 329-345. 26. M. Bradley, A. Desai, and E. H. Kim, "Synergistic Gains from Corporate Acquisitions and Their Division between Stockholders of Target and Acquiring Firm," Journal of Financial Economics 91 (1988): 3-40. 27. Huang and Walking, "Target Abnormal Returns associated with Acquisition Announcements." 28. Servaes, "Tobin's q and the a Gain from Takeovers." 29. J. Patell, "Corporate Forecasts of Earnings per Share and Stock Price Behavior: Empirical Tests," Journal of Accounting Research (autumn 1976): 2 4 6 276. 30. Bowen, Burgstahler, and Daley, "The Incremental Information Content of Accrual versus Cash Flows." 31. M. C. Jensen, "Agency Costs of Free Cash Flow, Corporate Finance and Takeovers," American Economic Review 16 (1986): 323-329. 32. Ibid. SELECTED READINGS Ashton, R. "Cash Flow Accounting: A Review and Critique." Journal of Business Finance and Accounting (winter 1976): 63-81. Beaver, W. F. "Financial Ratios and Predictors of Failure." Empirical Research in Accounting: Selected Studies, Supplement to Journal of Accounting Research 4 (1996): 71-111.

Cash Flow, Earnings, and Corporate Control

143

Belkaoui, A. "Financial Ratios as Predictors of Canadian Takeovers." Journal of Business Finance and Accounting (spring 1978): 93-107. . The New Environment in International Accounting. Westport, CT: Greenwood Press, 1988. Bernard, V. L., and T. L. Stober. "The Nature and Amount of Information in Cash Flows and Accruals." The Accounting Review (October 1989): 624-652. Bowen, R. M., D. Burgstahler, and L. A. Daley. "The Incremental Information Content of Accrual versus Cash Flows." The Accounting Review (October 1987): 723-747. Bradley, M., A. Desai, and E. H. Kim. "Synergistic Gains from Corporate Acquisitions and Their Division between Stockholders of Target and Acquiring Firms." Journal of Financial Economics 91 (1988): 3-40. Casey, C , and N. Bartezack. "Using Operating Cash Flow Data to Predict Financial Distress: Some Extensions." Journal of Accounting Research (spring 1985): 146-160. Castagna, A. D., and Z. P. Matoley. "Financial Ratios as Predictors of Company Acquisitions." Journal of Securities Institute of Australia (December 1976): 6-10. Coffee, J. C. "Shareholders versus Managers: The Strain in the Corporate Web." Knights, Raiders, and Targets: The Impact of the Hostile Takeover. J. C. Coffee et al., Eds. New York: Oxford University Press, 1988. Dennis, D. K., and J. J. McConnelly. "Corporate Mergers and Security Returns." Journal of Financial Economics 16 (1986): 143-187. Gentry, J. A., P. Newbold, and D. T. Whiteford. "Classifying Bankrupt Firms with Funds Flow Components." Journal of Accounting Research (spring 1985): 384-401. Hasbrouck, J. "The Characteristics of Takeover Targets: q and other Measures." Journal of Banking and Finance 9 (1985): 351-362. Huang, Y., and R. A. Walking. "Target Abnormal Returns associated with Acquisition Announcements: Payment, Acquisition Form, and Managerial Resistance." Journal of Financial Economics 19 (1987): 329-345. Ijiri, Y. "Cash Flow Accounting and Its Structure." Journal of Accounting Auditing and Finance (summer 1978): 331-348. Jensen, M. C. "Agency Costs of Free Cash Flow, Corporate Finance and Takeovers." American Economic Review 16 (1986): 323-329. Lang, L., R. Stulz, and R. A. Walking. "Managerial Performance, Tobin's q and the Gains from Successful Tender Offers." Journal of Financial Economics 24 (1989): 137-154. Largay, J. A., and C. P. Stickney. "Cash Flow, Ratio Analysis and the W. T. Grant Company Bankruptcy." Financial Analysis Journal (July/August 1980): 5 1 54. Lawson, G. H. "Cash Flow Accounting I and II." Accountant (October 28 and November 4, 1971): 16-22. Lee, T. A. "A Case for Cash Flow Reporting." Journal of Business Finance (1972): 27-36. Lev, B. "Observations on the Merger Phenomenon and a Review of the Evidence." Midland Corporate Finance Journal (winter 1983): 6-28.

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Earnings Measurement, Determination, Management

Palepu, K. G. "Predicting Takeover Targets." Journal of Accounting and Economics 8 (1986): 3-35. Patell, J. "Corporate Forecasts of Earnings per Share and Stock Price Behavior: Empirical Tests." Journal of Accounting Research (autumn 1976): 246-276. Rayburn, J. "The Association of Operating Cash Flow and Accruals with Security Returns." Journal of Accounting Research (1986 Supplement): 112-133. Servacs, H. "Tobin's q and the Gain from Takeover." Journal of Finance (March 1991): 409-419. Simkowitz, M., and R. J. Monroe. "A Discriminant Analysis Function for Conglomerate Targets." Southern Journal of Business 8 (1971): 1-16. Stevens, D. L. "Financial Characteristics of Merged Firms: A Multivariate Analysis." Journal of Financial and Quantitative Analysis 8 (1973): 149-165. Wilson, G. P. "The Incremental Information Content of the Accrual and Funds Components of Earnings after Controlling for Earnings." The Accounting Review (April 1987): 293-322. . "The Relative Information Content of Accruals and Cash Flows: Combined Evidence at the Earnings Announcement and Annual Report Release Date." Journal of Accounting Research (1986 Supplement): 165-200.

11 The Information Content of Value Added, Earnings, and Cash Flow: U.S. Evidence

INTRODUCTION The information content of earnings components and nonearnings disclosures beyond earnings has been examined extensively in the accounting and finance literature. Because earnings have a central role in financial reporting, contracting, and valuation models, any challenge to get this role is subjected to incremental and relative information content tests. One serious challenge examined in the literature concerns the role of cash flows versus earnings information, especially since FASB 95 (effective July 1988) required the disclosure of cash flow statements with separate operating, investing, and financing components. Another challenge, still not fully examined, concerns the role of value added data when included in financial reports as suggested by the 1989-1990 American Accounting Association Committee on Accounting and Auditing Measurement 1 and most of the international accounting research literature.2'3 These suggestions for additional disclosures in U.S. annual reports of value added data in addition to both earnings and cash flow data raise the fundamental question of the incremental and relative information content of each of the three measures of accounting return: earnings, cash flows, and value added. This chapter has been adapted with permission of the editor from: Ahmed Riahi-Belkaoui, "The Information Content of Value Added, Earnings, and Cash Flow: U.S. Evidence," International Journal of Accounting 28 (1993): 143. Reprinted with permission.

146

Earnings Measurement, Determination, Management

VALUE ADDED VERSUS EARNINGS AND CASH FLOWS Value added represents the total return of the firm earned by all providers of capital, plus employees and the government. It can be computed by the following rearrangement of the income statement:

where R = retained earnings, S = sales revenue, B = purchases of material and services, W = wages, I = interest, DD = dividends, T = taxes, and DP = depreciation. Equation (1) expresses the gross value added; equation (2) expresses the net value added. In both equations, the left side (the subtractive side) shows the value added (gross or net), and the right side (the additive side) shows the disposal value among the stakeholders. The question is to know the incremental and relative role value added could play in the context of U.S. financial reporting. At present, the disclosure spectrum covers both earnings and cash flow data. The return/earnings research shows a limited usefulness of earnings (Lev, 1986). Studies that examined the informational contribution of earnings-related data, including cash flow data, show, however, an increase in R2 value added data representing earnings-related data. The examination of incremental and relative information content of value added data in the U.S. context could help assess whether this new information is useful, at the margin, in explaining the behavior of share prices. ESTIMATION MODEL A generally accepted return valuation model used is as follows:

where P = market price of the security, D = dividend, and AR = accounting return (earnings, value added, or cash flow based). The model depicted in equation (3) implies a linear relation between the relative changes in security prices and the relative changes in accounting return (as measured by the relative change in either earnings, value added, or cash flows). The model may be described by any of the following three equations:

The Information Content

147

Exhibit 11.1 Regression Results on Single Return Effects Model 1: Earnings based

Coefficient /

Intercept

RCE,

RCE,.,

F

B?

0.1111 14.15*

0.0015 2.334*

0.0022 1.460***

3.450**

0.0019

Model 2: Net value added based

Coefficient /

Intercept

RNVA,

RNVA,.,

F

R2

0.1064 15.89*

0.024 3.551

-0.002 -1.968**

8.374*

0.0049

Model 3: Cashflowbased

Coefficient /

Intercept

RCFt

RCE,.,

F

R2

0.110 13.99

0.004 2.456*

-0.0004 -0.434

3.106**

0.0017

RCE = Relative change in earnings RNVA = Relative change in net value added RCF = Relative change in cash flows significant at *a= 0.01; **a=0.05; ***a=0.10 Source: Ahmed Riahi-Belkaoui, "The Information Content of Value Added, Earnings, and Cash Flow: U.S. Evidence," International Journal of Accounting 28 (1993): 143. Reprinted by permission.

where R C M R = changes in security price return, RCE = changes in earnings, RNVA = changes in net value added, and R C F = changes in cash flow. The models depicted in equations (3a), (3b), and (3c) limit the impact of the relative changes in accounting returns on the changes in security prices to the present year and do not include the impact of at least the potential impact of the earlier years. A one-lag model that would include the impact of the preceding year would be as follows:

148

Earnings Measurement, Determination, Management

Exhibit 11.2 Regression Results on Combined Return Effects Model 4: Earnings and net added based

Coefficient t

R2

Intercept

RCE,

RCE,.,

RNVA,

RNVA,.,

F

0.11 15.99

0.001 2.888*

0.004 1.84**

0.024 3.527

-0.008 -0.989

6.777*

0.0025

Model 5: Earnings and cashflowbased

Coefficient t

F

R2

Intercept

RCE,

RCE,.,

RNVA,

RNVA,.,

0.11 14.22

0.0016 0.45*

0.0051 2.106**

-0.002 2.56

4.26* -1.816

5.56* 0.0047

Model 6: Value added and cashflowbased

Coefficient /

Intercept

RNVA,

RNVA,.,

RCF,

RCF,.,

F

0.108 16.01*

0.023 3.46*

-0.0003 -2.47*

0.0034 2.56*

-0.0009 -0.53

5.593*

R2 0.0067

significant at *o=0.01; **a=0.05; ***ct=0.10 Source: Ahmed Riahi-Belkaoui, "The Information Content of Value Added, Earnings, and Cash Flow: U.S. Evidence," International Journal of Accounting 28 (1993): 143. Reprinted by permission.

Exhibit 11.3 Tests for Relative Information Content for Net Income, Cash Flows, and Value Added Ranking Adjusted R2 p-value

Value added > 0.0049 > 0_1

Net income 0.0019

> > 03

Cash flows 0.0017

Source: Ahmed Riahi-Belkaoui, "The Information Content of Value Added, Earnings, and Cash Flow: U.S. Evidence," International Journal of Accounting 28 (1993): 144. Reprinted by permission.

The Information Content Exhibit 11.4 Incremental Comparisons 1. Information content (value added / income) 2. 3. 4. 5. 6.

information content (value added, income) -information content (income) -0.0025-0.0019 = 0.006 Information content (value added / cash flows) -information content (value added, cash flows) - information content (cash flows) =0.0067-0.0017 = 0.005 Information content (cashflows/ value added) -information content (cashflows,income) information content (income) = 0.0067-0.0019 = 0.0048 Information content (cashflows/ income) -information content (cashflows,income) information content (income) = 0.0067-0.0019 = 0.0048 Information content (cashflows/income) = information content (income, cash flows) - information content (income) = 0.0067-0.0019 = 0.0048 Information content (income / cash flow) = information content (income, cashflow)infonnation content (cash flow) = 0.0067-0.0017 = 0.0050

Source: Ahmed Riahi-Belkaoui, "The Information Content of Value Added, Earnings, and Cash Flow: U.S. Evidence," International Journal of Accounting 28 (1993): 143. Reprinted by permission.

Equation (4) depicting the one-lag valuation model will be used as the estimation model in this study for determination of the relative information content of each of the three accounting return measures considered in this study: earnings, value added, and cash flow. The model may be expressed by one of the following three equations:

W h e n examining the information content of t w o measures of accounting return, ARX and AR2, the following equation will be used:

150

Earnings Measurement, Determination, Management

This equation may be described by any one of the following three equations:

DATA AND SAMPLE SELECTION The accounting return variables used were based on the value added, earnings, or cash flow measure. More explicitly, these measures are defined from COMPUSTAT data items as follows.4 1. Net value added (NVA) — the sum of labor expenses, corporate taxes, dividends, interest expenses, minority shareholders in subsidiaries, and retained earnings. 2. Earnings (£) = income available to common equity. 3. Cash flow (CF) = cash flows generated from continuing operations, where cash flows are defined as income available to common equity plus depreciation, deferred taxes, and the changes in the noncash working capital. The firms examined in this study represent all the NYSE and AMEX firms that have available NVA, E, CF, and P data over the period 1981-1987 in COMPUSTAT. 5 The selection procedure resulted in a sample of 4,325 firm-year observations. RESULTS Exhibits 11.1 and 11.2 present, respectively, the results of the regression on sample and combined return effects. The six equations are significant at p = 0.05. Each of the measures of accounting return, value added, income, or cash flows is significant in explaining the changes in security returns. The tests for relative and incremental information content are presented, respectively, in Exhibit 11.3 and 11.4. Exhibit 11.3 presents the levels of significance for the relative information content comparisons. For the pooled sample and the period examined, value added exhibits greater relative information content than net income and cash flows (p < 0.01), and net income exhibits greater relative information content than cash flows (p = 0.03). Exhibit 11.4 presents the results for tests of incremental information content. It also shows the information content beyond both net income and cash flows. Similarly, net income dominates cash flows.

The Information Content

151

S U M M A R Y A N D DISCUSSION The study examined both the relative and incremental information content of value added, net income, and cash flows in the U.S. context. The findings show the value added concept to dominate both earnings and cash flows in terms of incremental information content. The results show that value added information can supply some of the explanatory power of security return beyond that provided by earnings or cash flow measures. It argues for disclosure of the underlying data needed to c o m p u t e value added variables. The cost of reporting this type of data is relatively immaterial given the availability of the data for payroll purposes and reporting to governmental agencies. It may constitute a definite improvement over the present U.S. reporting system and contribute to the international harmonization of accounting standards. It is also in line with the recommendations of the American Accounting Association Committee on Accounting and Auditing Measurement. NOTES 1. American Accounting Association, "Committee on Accounting and Auditing Measurement, 1989-1990," Accounting Horizons (September 1991): 81-105. 2. G. K. Meek and S. J. Gray, "The Value Added Statement: An Innovation for U.S. Companies?" Accounting Horizons (June 1988): 73-81. 3. F. D. S. Choi and G. G. Mueller, International Accounting (Englewood Cliffs, NJ: Prentice-Hall, 1992). 4. Each variable is defined using COMPUSTAT's annual industrial data definitions as follows:

5. The period 1981-1987 was used because it allowed us to generate a significantly higher number of firm-year observations than other periods. SELECTED READINGS Beaver, W., and R. Dukes. "Interperiod Tax Allocation, Earnings Expectations, and the Behavior of Security Prices." The Accounting Review (April 1972): 320332. Beaver, W., and W. Landsman. The Incremental Information Content of the FAS 33 Disclosures. Stanford, CT: Financial Accounting Standards Board, 1983. Beaver, W., A. Christie, and P. Griffin. "The Informational Content of SEC Accounting Series Release 190." Journal of Accounting Economics (July 1982): 127-157.

152

Earnings Measurement, Determination, Management

Beaver, W., P. Griffin, and W. Landsman. "The Incremental Information Content of Replacement Cost Earnings." Journal of Accounting and Economics (July 1982): 15-39. Beaver, W., R. Lambart, and D. Morse. "The Information Content of Security Prices: A Second Look." Journal of Accounting and Economics (July 1987): 139-157. Bernard, V., and R. Ruland. "The Incremental Information Content and Historical Cost and Current Cost Income Numbers: Time-Series Analyses for 19621980." The Accounting Review (October 1987): 707-722. Bernard, V., and T. Sober. "The Nature and Amount of Information in Cash Flows and Accruals." The Accounting Review (October 1989): 624-652. Biddle, G., and F. Lindhal. "Stock Price Reaction to LIFO Adoptions: The Association between Excess Returns and LIFO Tax Savings." Journal of Accounting Research (autumn 1982): 551-588. Bublitz, B., T. J. Frecka, and J. C. McKeown. "Market Association Tests and FASB Statement No. 33 Disclosures: A Reexamination." Journal of Accounting Research (1985 Supplement): 1-23. Choi, F. D. S., and G. G. Mueller. International Accounting. Englewood Cliffs, NJ: Prentice-Hall, 1982. Cox, B. Value Added: An Appreciation for the Accounts Concerned with Industry. London: Heineman, 1978. Foster, T., and D. Vickery. "The Incremental Information Content of the 10-K." The Accounting Review (October 1978): 921-934. Foster, T., D. Jenkins, and D. Vickery. "Additional Evidence on the Incremental content of the 10-K." Journal of Business Finance and Accounting (spring 1983): 56-66. Gray, S. J., and K. T. Maunders. Value Added Reporting: Uses and Measurement. London: Association of Certified Accountants, 1980. Harmon, W. "Earnings vs. Fund Flows: An Empirical Investigation of Market Reaction." Journal of Accounting, Auditing and Finance (fall 1984): 24-34. Hop wood, W., and T. Schaefer. "Incremental Information Content of Earnings and Nonearnings based on Financial Ratios." Contemporary Accounting Research (fall 1988): 318-342. Hoskin, R. E., J. S. Hugues and W. E. Ricks. "Evidence on the International Information Content of Additional Firm Disclosures Made Concurrently with Earnings." Journal of Accounting Research (1986 Supplement): 1-32. Karpick, P., and A. Belkaoui. "The Relative Relationship between Systematic Risk and Value Added Variables." Journal of International Financial Management and Accounting (autumn 1989): 259-276. Lang, M., and M. McNichols. "Earnings Quality, Financial Distress and the Incremental Information Content of Cash Flows." Working paper, Stanford University, Stanford, CA, July 1990. Lee, Tong-Kin, J. Livnant, and P. Zarowin. "Cash Flows and Accruals: Different Valuation Implications." Working paper, New York, March 1990. Lev, B. "On the Usefulness of Earnings Research: Lessons and Directions from Two Decades of Empirical Research." Journal of Accounting Research: Current Studies on the Informational Content of Accounting Earnings (1986 Supplement): 153-192.

The Information Content

153

Lipe, R. C. "The Informational Content in the Components of Earnings." Journal of Accounting Research (1986 Supplement): 37-64. Livnat, J., and P. Zarowin. "The Incremental Information Content of Cash-Flow Components." Journal of Accounting and Economics (May 1990): 25-46. Maunders, K. T. "The Decision Relevance of Value Added Reports." In Frontiers of International Accounting: An Anthology, F. D. Choi and G. G. Mueller, Eds. Ann Arbor, MI: UMI Research Press, 1985: 225-245. McLeary, S. "Value Added: A Comparative Study." Accounting Organization and Society Vol. 8(1) (1983): 31-56. Meek, G. K., and S. J. Gray. "The Value Added Statement: An Innovation for U.S. Companies?" Accounting Horizons (June 1988): 73-81. Morley, M. F. "The Value Added Statement in Britain." The Accounting Review (May 1979): 618-689. Rayburn, J. "The Association of Operating Cash Flows and Accruals with Security Returns." Journal of Accounting Research (1986 Supplement): 112-133. Renshall, M., R. Allan, and K. Nicholson. Added Value in External Financial Reporting. London: Institute of Chartered Accountants in England and Wales, 1979. Riahi-Belkaoui, A. Value Added Reporting: Lessons for the United States. Westport, CT: Greenwood Press, 1992. Rutherford, B. A. "Value Added as a Focus of Attention for Financial Reporting: Some Conceptual Problems." Accounting and Business Research (summer 1972): 215-220. Schaeffer, T., and M. Kennelley. "Alternative Cash Flow Measure and RiskAdjusted Returns." Journal of Accounting, Auditing, and Finance (fall 1986): 278-287. Sinha, G. Value Added Income. Calcutta: Book World, 1983. Stober, T. "The Incremental Information Content of Financial Statement Disclosures: The Case of LIFO Inventory Liquidations." Journal of Accounting Research (1986 Supplement): 138-164. Suojanen, W. W. "Accounting Today and the Large Corporation." The Accounting Review (July 1954): 391-398. Wilson, G. P. "The Incremental Information Content of Accrual and Funds Components of Earnings after Controlling for Earnings." The Accounting Review (April 1987): 293-322. . "The Relative Information Content of Accruals and Cash Flows: Combined Evidence at the Earnings Announcement and Annual Report Release Date." Journal of Accounting Research (1986 Supplement): 165-200.

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12 Earnings-Returns Relation versus Net-Value-Added-Returns Relation: The Case for a Nonlinear Specification INTRODUCTION Recent studies examining the functional specification relating unexpected earnings to market-adjusted returns suggests the existence of nonlinearities in the relationship. 1 ' 2 ' 3 This study differs on two counts. First, in addition to earnings, a known and conventional measure of accounting return, it examines net value added, a measure of wealth created and attributed to all stakeholders and advocated as an important European innovation worthy of inclusion in U.S. company annual reports. 4 ' 5 ' 6 Second, this study uses raw returns as variables in the analysis rather than expected returns. 7 ' 8 The results indicate a better explanatory power of the market and accounting returns relationship when (a) accounting returns are measured by the relative change in net value added, and (b) the relationship is modeled by a convex-concave, nonlinear model, an S-shaped model or S-curve. USEFULNESS OF NET VALUE ADDED The value-added statement reports on the return earned by a larger group of stakeholders: all providers of capital plus employees and government.9 It can be computed by the following rearrangement of the income statement: This chapter has been adapted with permission of the editor from: Ahmed Riahi-Belkaoui, "Earnings-Returns Relation Versus Net-Value-Added-Returns Relation: The Case for a Nonlinear Specification," Advances in Quantitative Analysis of Finance and Accounting 4(1996): 175-185.

156

Earnings Measurement, Determination, Management

or

where:

s

B DP W I D T R

= = = = = = = =

sales revenue bought-in materials and services depreciation wages interest dividends taxes retained earnings

Equation (1) expresses the gross value added, while equation (2) expresses the value added. In both equations, the left-hand side (the subtractive side) shows the value added (gross or net), and the right-hand side (the additive side) shows the disposal value among the stakeholders. The main advantage of the value-added approach is its ability to measure the total wealth created by the company before distribution to the various stakeholders. As such, it contains information beyond traditional bottomline earnings, which is useful in explaining the behavior of share prices. Three arguments may be used to support the thesis that shareholders would be interested in the total wealth created in the company. First, the expectation that the value-added variable contains more valuerelevant information than the earnings variable approach is based on prior research that indicates: (a) additional disclosure released concurrently with announcements of annual earnings has information content beyond that contained in earnings per se,10 and (b) components of earnings explain more of the variation in returns than is explained by earnings alone. 11 Second, although shareholders are interested in their share of the total wealth created, their primary concerns involve (a) a knowledge of what is the total wealth created, and (b) how it is going to be apportioned over time. Shareholders are basically competing with other members of the "team" (i.e., government, labor, and bondholders) for the distribution of total wealth. The higher the total wealth and the lower (or unchanged) the portion allocated to government, labor, and bondholders, the higher the profit accruing to shareholders. Third, accounting earnings are plagued with measurement and management problems that may hinder explanatory and predictive abilities. Value added was found to possess incremental information beyond both accrual

The Case for a Nonlinear Specification

157

earnings and cash flows in the context of explaining make risk.12 Similarly, takeover targets have lower value added to total assets ratios (both mean and median) than the average in their industries in the year preceding the resolution of the takeover. 13 In both contexts of prediction of systematic risk and takeover, earnings variables explain less than value-added variables. In sum, the value-added variable—which is computed by the addition to earnings of other components of earnings—explains more of the variation in returns than is explained by earnings alone. Thus the basic question is whether the more comprehensive disclosure of value-added variables will contain information relevant to the pricing of securities. This question can be addressed by examining potential nonlinearities with regard to the functional specification relating both earnings and net value added to market returns, as well as the explanatory ability of a nonlinear model based on either earnings or net value added. The examination of nonlinearity rests on two arguments. First, the time relation between market-adjusted returns and accounting returns is unobservable. Second, some empirical evidence suggests that the relation is not constant. For example, Chambers and Penman14 and Hughes and Ricks15 examined the timeliness of earnings announcement and indicated that the stock price reaction is greater for early versus late disclosures. A study of a sample of initial offerings, which suggested that the relation varies as investors learn about the earnings announcements, is also found to be symmetric for good and bad news, suggesting that the relation changes as a function of the sign of the earnings surprise.16 Finally, nonlinearities have been detected in at least two studies.17'18 VALUATION MODELS Linear Models A typical linear valuation model rests on expressing a relationship between relative changes in prices and earnings.19,20 One formulation of this model can be expressed as:

where: Fjt djt = Ajt = SIZEjt = LEVjt = MBjt -

market price of security j dividend accounting earnings natural logarithm of assets long-term debt over total assets ratio of market to book value

158

Earnings Measurement, Determination, Management

This model suggests there is a relationship between the relative change in security prices and the relative change in earnings. Three additional conditional variables are added to help explain the relative change in return given a certain level of earnings change: (1) the natural logarithm of assets (SIZE), (2) the ratio of long-term debt to assets (LEV), and (3) the ratio of market to book value (MB). These three variables are added to proxy for risk, size effects in the measurement of change in returns and growth, or persistence, respectively.21 Given the argument used earlier—that net value added contains informational content that is relevant to the pricing of securities—a second linear model is also investigated:

where NVA = net value added. This model suggests there is a relationship between the relative change in security prices and the relative changes in net value added. The three conditioning variables SIZE, LEV, and MB are also included in this model. Nonlinear Models Both equations (3) and (4) express the relationship between market and accounting returns found in the conventional linear model. Alternative nonlinear models may be proposed to test the potential nonlinear specification of the relationship.22-23 The convex-concave form (S-shaped or an S-curve) is proposed as the nonlinear expression of the relationship between market returns and accounting returns and accounting returns, measured by either earnings or net value added. The relationship between accounting earnings—as measured by either earnings or net value added—and market returns has a positive first derivative: it is convex for bad news and is concave for good news; that is, a convex-concave relationship exists between accounting and market returns. This convex-concave relationship is based on prior findings that (a) the ratio of permanent to transitory earnings declines as the absolute magnitude of unexpected earnings increases24, and (b) the transitory earnings surprises have significantly less impact on security prices than permanent earnings surprises.25'26 Accordingly, the nonlinear specification used in this study is a quadratic function, where quadratic term is allowed to depend on the sign of the relative change in either earnings or net value added. It is expressed as follows:

The Case for a Nonlinear Specification

159

D is an indicator variable taking a value of 1 when the relative change in either earnings or net value added is positive and —1 when the change is negative, thereby producing a convex-concave function. The prediction is that both b3t and b\t will be negative, based on the thesis that investors' perception of the persistence of the surprise is negatively correlated with its magnitude.

DATA AND SAMPLE SELECTION The analysis focuses upon security return and its relationship to either earnings or net value added. Security returns (Rjt) for security / in year t were defined as the security price at the end of the year plus cash dividends by security price at the beginning of the year. The use of Rjt rather than some form of residual returns follows from findings of prior studies that the correlation between security returns and earnings is essentially the same under either form of the security return metric.27'28'29'30 The accounting return variables used were based on either accounting earnings or net value added. They were defined from COMPUSTAT items as follows: 1. Net value added (NVA) = the sum of labor expenses, corporate taxes, interest expenses, minority shareholders in subsidiaries, plus retained earnings. 2. Earnings (A) = income available to common equity. Each variable was defined using COMPUSTAT's annual industrial data definition as follows:

The firms examined in this study represented all NYSE and AMEX firms that had available NVA, A, and R data over the period of 1981-1990 in COMPUSTAT. The selection procedure resulted in 4,660 firm-year observations after deleting 132 firm-year observations. The deletion affected those cases where AjJPt_1 is not between +1.5 and —1.5. This truncation rule was imposed to ensure that the results were not unduly affected by a few outlying (unusual) observations. However, the truncation did not change the substance of the results.31

Earnings Measurement, Determination, Management

160 Exhibit 12.1 Linear Regression Results

Panel A: Cross-sectional regressions based neton value added Year

N

1990 480 1989

499

1988 484 1987 1986 1985 1984

473 462 478 477

1983

448

1982

431

1981

418

aV

a2

-0.287* ' 0.0360* -5.2290

33060

0.2700

0.0000

3.8960

0.2260

-O.3500 -0.201 • -O.6060 -3.7970

ay 0.0060 1.0390

a4*

a2

F

0.2142

30.53*

0.0291

3.73*

0.0660

4.34*

0.0595

5.547*

0.1320

17.212*

0.0120

0.506*

aS

0.3870* 4.8610

-0.0006* -8.9480

-0.0130*" 0.0600 -1.6890 0.6890 0.1060** *-0.9450

0.0002* -3.2520 -0.0005

1.5150

-1.0850

0.4820

-0.0390

0.0086'

-0.0103

0.1330

-0.0010*

-0.4840

0.6330

-1.0620

1.1170

-3.9900

-0.1210 -0.0040

0.0120

0.8090*

-0.0060*

-1.2540 -0.2160

1.0700

5.8990

-4.2550

0.2490

0.0010*

0.0030

0.0040

0.0020

3.0910

0.1220

0.3140

0.0420

1.1470

-0.220* -3.6910 0.1110 1.0490

0.0990* 2.4850 0.1800* 3.3520

0.0300*

0.1560** 1.8960 -0.299** -2.1440

-0.0020**

0.0782

6.422*

3.9120 0.0190 1.4110

-2.2660 -0.0003 -0.1840

0.0840

4.595

0.3820* 0.1880*

-0.0130

0.1360

-0.0040*

0.0880

8.134

4.1180

3.4230

-1.1180

1.0950

-2.6610

0.0390 0.4920

0.3620* 5.570

-0.0150*** 0.4040* -1.4970 3.9130

0.650

12.831*

0.0010 1.4650

Panel B: Pooled cross-sectional time series regressions based on earnings Range of relative change in return (RCR) IRCRI IRCRI < .1

N

a1

4660

0.036 0.513 2317 -0.236* -11.987

IRCRI <.05

32

a3

0.0068** 0.007 1.9750 0.894 0.0070* 0.007* 7.4330

3.055

0.137 1.415 0.070*

a5

R2

F

-0.0040* 0.0030 4.14* -3.1220 -0.0003* 0.0701 46.30*

2.394

-10.7360

0.027 0.517 0.033

-0.0003*0.0762 41.79 -10.5310 -0.0002*0.0823 40.78*

1.095

-10.3070

IRCRI <.01

2032 -0.255* -12.789 1811 -0.295*

IRCRI <.005

1790 -0.295*

0.0070* 0.006*

0.030

-0.0020*0.0821 40.29*

-14.617 1770-0.292* -14.426 4660 0.037 0.521

6.9440 2.805 0.0060*0.006* 6.8560 2.463 0.000 0.007 -0.319 0.871

1.007 0.030 0.978 0.137 1.414

-10.2650 -0.0002*0.0818 39.39* -10.2260 -0.0004* 0.0031 3.19* -3.1630

-14.646

IRCRI <.001 IRCRI

0.0070*0.005* 7.0810 2.465 0.0070*0.007*

a4

6.9570

2.957

161

The Case for a Nonlinear Specification Range of relative change in return (RCR)

IRCRI < .1 IRCRI < .05

N

a/

2317 -0.239* -12.003 2032 -0.257* -12.762

IRCRI < .01

1811 -0.298-14.830

a2

a3

a4

0.013* 3.337

0.007*

0.007*

2.928

0.013* 3.335

0.005* 2.294

2379 0.028

0.011*

F

-0.0030* 0.0767 34.70* -9.8550 -0.0002* 0.0785 31.40* -9.6360

0.006*

0.035

-0.0002* 0.0823 29.97*

2.775

2.818

1.164

-9.4250

0.033 1.084

-0.0002* 0.0829 29.47*

1790 -0.298*

0.011*

0.006*

2.730

2.673

IRCRI < .001

-14.586 1770 -0.294*

0.010* 2.543

0.005* 2.335

Notes:

ff2

0.935

IRCRI < .005

-14.397

a5

0.033

-9.3910 -0.0002* 0.0829 28.64*

1.078

-9.3750

The test statistics are r-statistics because White's (1980) test for heteroscedasticity in the residuals revealed no significant heteroscedasticity. When there (is not) significant heteroscedasticity, the test statistic reported for the intercepts and the slopes cues the z-statistics (r-statistics) appropriate for such cases. 'Significant at a = . 0 1 .

••Significant at a = .05.

•••Significant at a » .10.

Source: A. Riahi-Belkaoui, "Earnings-Returns Relation versus Net-Value-Added-Returns Relation: The Case for Nonlinear Specification," Advances in Quantitative Analysis of Finance and Accounting (1996): 180-181. Reprinted with permission.

RESULTS Three important results emerged. First, the net-value-added-returns relationships offer slightly more explanatory power than the earnings-returns relationships when the relationships are expressed by a linear model. Regression results on linear models are presented in Exhibit 12.1. Panel A includes the cross-sectional regressions, while panel B includes the pooled cross-sectional time series regression. The adjusted R2 for 9 of the 10 cases in panel A and the 6 cases in panel B is slightly higher for the net value added data-based linear model than the earnings-based linear model. The coefficient of earnings (a2) is significant for 7 out of 10 cases in panel A and 5 out of 6 cases in panel B. This influence of conditioning variables is significant, particularly for SIZE and MB in most cases. Second, the net-value-added based returns relationships still offer better explanatory power than the earnings-returns relationships, when the relationships are expressed by a nonlinear, convex-concave function. In addition, the convex-concave function is more pronounced in the net-value-added than the earnings-based functions and cases. Regression results on nonlinear models are presented in Exhibit 12.2. Panel A includes the cross-sectional regressions, while panel B includes the pooled crosssectional time series regressions. In each case, the adjusted R2 for the 10 cases in panel A and the 6 cases in panel B is slightly higher for the value-

162

Earnings Measurement, Determination, Management

Exhibit 12.2 Nonlinear Regression Panel A: Cross-sectional regressions based on earnings Year

N

a3

a4

a1

a2

1990 480 -0.285

0.014 3.254

-0.0001**0.007

0.015 1.892

-

-1.601

a5

1.204

#

a6

0.381* 4.818 0.066 0.663 -0.892 -1.007 0.1504

-0.006* -9.107

0.2185 26.55

-0.002* -3.116 -0.004

0.0503

5.232

0.006

0.592

0.079

8.08

-5.236 1989 499 0.285 3.743 1988 484 -0.217

-0.01

0.001* -0.011 3.285 -1.459 0 0.086

-0.36 1987 473 -0.071

-0.31 0.033

-0.248 1.218 -0.0007*-0.005

-0.891 1986 462 -0.11 -1.147

4.229 0.018 1.799

-3.189 -0.592 -0.002** 0.011

1.285 0.827* -0.005*

-1.538

0.927

5.99

1985 478

0.253

0.025

0.0004

0.002

3.153 -0.192 -3.33 -0.109 1.088 0.348 3.751 -0.075 0.922

2.021

0.306 -0.005* -3.27 -0.003* -5.04 0.006 0.298 0.001 0.985

0.249 0.027 3.661 0.013 1.019 -0.008 -0.716 -0.013 -1.277

0.026 0.241 1.125 0.147*<• -0.001

1984 477 1983 448 1982 431 1981 418

0.079 5.507 0.137 7.362 0.075 4.337 0.038 2.955

F

-0.385 -0.001* -4.024 -3.11 0.002

0.1326 14.47 1.227

0.012 0.098

10.32

1.838 -0.166

-1.405 0.004** 0.1343 13.74

-1.251 0.238** 1.943 0.377* 3.521

2.115 -0.004* -2.822 0.003* 2.811

0.0886

8.282

0.0681

6.033

Panel B: Pooled cross-sectional time series regressions based on earnings Range of relative change in return N IRCRI IRCRI < .1 IRCRI <.05 IRCRI < .01 IRCRI <.005 IRCRI <.001

4659

d

0.039 0.549 2317 -0.237 -12.009 2032 -0.255 -12.802 1811 -0.296 -14.658 1790-0.296 -14.628 1770-0.292 -14.436

c2 0.011 2.783 0.01 5.051 0.009 4.54 0.086 4.37 0.008 4.339 0.008 4.205

c3

c4

0.000**0.007 2.128 0.871 -0.000 0.007 -1.349 3.099 -3E-05 0.006 -0.962 2.497 0 0.007 -0.889 2.987 0 0.006 -0.864 2.833 0 0.006 -0.78 2.792

c5

c6

R2

F

0.132 -0.0004 0.004 4.22 1.363 -3.091 0.07 -0.0003 0.075 37.4 2.431 -10.788 0.028 -0.0003 0.076 33.61 0.946 -10.564 0.034 -0.0002 0.083 32.78 1.125 -10.327 0.031 -0.0002 0.083 32.37 1.035 -10.294 0.03 -0.0002 0.082 31.63 1.003 -10.251

163

The Case for a Nonlinear Specification Range of relative change in return

(RCR)

IRCRI

N

CV

0.03 -0.05 0.043 -4.829 2317 -0.247 0.07 7.764 -12.51 0.066 -0.265 2032

4659

IRCRI < .1 IRCRI < .05

-13.28 IRCRI < .01

1811 -0.306 -15.14

IRCRI <.005

1790 -0.305

IRCRI < .001

1770 -0.303 -14.95

-15.1

Notes:

cZ

cJ

c4*

4E-05* 0.009 4.819 1.057 0.000** 0.007 -6.997 3.006 -0.004* 0.005

R2

F

0.138

-O.005 0.005

7.22*

1.495 0.094*

-3.628

cS

3.819 0.055*

c&

-0.000 0.085 38.2 -9.164

1.823

-0.000 0.086 34.7* -8.927

0.065 -0.003* 0.007 7.254 -6.717 2.893 0.64 -0.003* 0.006 7.154 -6.63 2.75

0.063*

-0.000 0.091 33.6*

2.053 0.06** 1.962

-8.651 -0.000 0.085 32.9* -8.619

0.064 -0.003* 0.006 7.012 -6.561 2.452

0.061** -0.000 0.086 32.7* -8.56 1.985

7.489 -6.687

2.386

The test statistics are f-statisties because White's test for heteroscedasticity in the residuals revealed no significant heteroscedasticity. When there is (is not) significant heteroscedasticity, the test statistics reported for the intercepts and the slopes are the z-statistics (f-statistics) appropriate for such cases. •Significant at a » . 0 1 .

"Significant at a = .05.

"••Significant at a » .10.

Source: A. Riahi-Belkaoui, "Earnings-Returns Relation versus Net-Value-Added-Returns Relation: The Case for Nonlinear Specification," Advances in Quantitative Analysis of Finance and Accounting 4(1996): 182-183. Reprinted with permission.

added-based nonlinear model than the earnings-based nonlinear models. The convex-concave function, stipulating that b3 or b\ will be significant and negative, is verified for all the cases in panels A and B for the netvalue-added-based nonlinear models. It is verified for only some cases for the earnings-based nonlinear models. Finally, comparison of the results presented in Exhibits 12.1 and 12.2 for all the cases shows that in general: (a) the nonlinear models have better explanatory power than the linear models, and (b) the net-value-addedbased nonlinear models have the best explanatory power. CONCLUSION The use of value-added reporting is on the increase worldwide. 32 ' 33 Calls have been made for its adoption by domestic corporations. 34 ' 35 The results of this study make a favorable case for the adoption of value-added reporting in the United States. The models relating accounting and market returns have more explanatory power because (a) the accounting returns are expressed by the relative changes in net value added, and (b) the relationship is a nonlinear, convex-concave function. The important policy implication of this study is that the value-added

164

Earnings Measurement, Determination, Management

accounting information can supply additional explanatory power for market returns beyond that provided by earnings. Thus an important accounting policy issue is whether firms should be required to disclose the underlying data needed to calculate value-added variables. The current disclosure system does not m a n d a t e the disclosure of some of the information needed to compute the value-added metric. The cost of reporting this additional data should be relatively immaterial given the general availability of such information; firms already process this information for payroll purposes and report it to governmental agencies. Given the low cost relative to the potentially much greater benefit shown in this study, releasing value-added reports or disclosing the underlying data needed to calculate the value added appears to be an improvement over the present U.S. reporting system.

NOTES 1. M. D. Beneish and C. R. Harvey, "The Specification of the Earnings-Returns Relation," Working paper. (Durham, NC: Duke University, 1993). 2. C. S. A. Cheng, W. S. Hopwood, and J. C. McKeown, "Nonlinearity and Specification Problems in Unexpected Earnings Response Regression Model," The Accounting Review (July 1992): 579-598. 3. R. N. Freeman and S. Y. Tse, "A Nonlinear Model of Security Price Responses to Unexpected Earnings," Journal of Accounting Research (fall 1992): 157185. 4. M. J. Barrett, W. H. Beaver, W. W. Cooper, J. A. Milburn, D. Solomons, and D. P. Tweedie, "Report of the American Accounting Association Committee on Accounting and Auditing Measurement, 1989-1990," Accounting Horizons (September 1991): 81-105. 5. P. Karpik and A. Belkaoui, "The Relative Relationship between Systematic Risk and Value Added Variables," Journal of International Financial Management and Accounting (spring 1989): 259-276. 6. G. K. Meek and S. J. Gray, "The Value Added Statement: Innovation for U.S. Companies?" Accounting Horizons (June 1988): 73-81. 7. W. Beaver, R. Lambert, and D. Morse, "The Informational Content of Security Prices," Journal of Accounting and Economics (March 1980): 3-28. 8. P. D. Easton and T. S. Harris, "Earnings as an Explanatory Variable for Returns," Journal of Accounting Research (spring 1991): 19-36. 9. S. J. Gray and K. T. Maunders, Value Added Reporting: Uses and Measurement (London: Association of Certified Accountants, 1980). 10. R. E. Hoskin, J. S. Hughes, and W. E. Ricks, "Evidence on the Incremental Information Content of Additional Firm Disclosure Made Concurrently with Earnings," Studies on Alternative Measures of Accounting Income, Supplement to Journal of Accounting Research 6 (1986): 1-3. 11. Robert C. Lipe, "The Information Contained in the Components of Earnings," Studies on Alternative Measures of Accounting Income, Supplement to Journal of Accounting Research 6 (1986): 1-3.

The Case for a Nonlinear Specification

165

12. Karpik and Belkaoui, "The Relative Relationship between Systematic Risk and Value Added Variables." 13. J. W. Bannister and A. Riahi-Belkaoui, "Value Added and Corporate Control in the U.S." Journal of International Financial Management and Accounting (Autumn 1991): 941-957. 14. A. E. Chambers and S. H. Penman, "Timeliness of Reporting and the Stock Price Reaction to Earnings Announcements," Journal of Accounting Research 22 (1984): 21-47. 15. J. S. Hughes and W. E. Ricks, "Association between Forecast Errors and Excess Returns Near to Earnings Announcements," The Accounting Review 62 (1987): 158-175. 16. A. R. Abdel-Khalik, "Specification Problems with Information Content of Earnings: Revisions and Rationality of Expectations, and Self-Selection Bias," Contemporary Accounting Research (fall 1990): 142-172. 17. Beneish and Harvey, "The Specification of the Earnings-Returns Relation." 18. Freeman and Tse, "A Nonlinear Model of Security Price Responses to Unexpected Earnings." 19. W. Beaver, R. Lambert, and D. Morse, "The Information Content of Security Prices," Journal of Accounting and Economics (March 1980): 3-28. 20. D. Collins and S. Kothari, "A Theoretical and Empirical Analysis of the Determinants of the Relation between Earnings Innovations and Security Returns," Journal of Accounting and Economics (July 1989): 143-181. 21. Ibid. 22. Beniesh and Harvey, "The Specification of the Earnings-Return Relation." 23. Freeman and Tse, "A Nonlinear Model of Security Price Responses to Unexpected Earnings." 24. R. Freeman, J. Ohlson, and S. Penman, "Book Rate-of-Return and Prediction of Earnings Change: An Empirical Investigation," Journal of Accounting Research (autumn 1982): 639-653. 25. P. D. Easton and M. Zmijewski, "Cross-Sectional Variation in the Stock Market Response to Accounting Earnings Announcements," Journal of Accounting and Economics (July 1989): 117-24. 26. R. Kormendi and R. Lipe, "Earnings Innovation, Earnings Persistence, and Stock Returns," Journal of Business (July 1987): 37-64. 27. W. Beaver, P. A. Griffin, and W. R. Landsman, "The Incremental Information Content of Replacement Cost Earnings," Journal of Accounting and Economics 4 (1982): 15-39. 28. W. Beaver, R. Lambert, and D. Morse, "The Information Content of Security Process," Journal of Accounting and Economics (March 1980): 3-28. 29. W. Easman, A. Falkenstein, and R. Weil, "The Correlation between Sustainable Income and Stock Returns," Financial Analysis Journal (September-October 1979): 44-48. 30. P. D. Easton and T. S. Harris, "Earnings as an Explanatory Variable for Returns," Journal of Accounting Research (spring 1991): 19-36. 31. Ibid. 32. C. Deegan and A. Hallam, "The Voluntary Presentation of Value Added Statements in Australia: A Political Cost Perspective," Accounting and Finance (May 1991): 1-29.

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33. B. A. Rutherford, "Value Added as a Focus of Attention for Financial Reporting: Some Conceptual Problems," Accounting and Business Research (summer 1977): 73-81. 34. M. J. Barret, W. H. Beaver, W. W. Cooper, J. A. Milburn, D. Solomons, and D. P. Tweedie, "Report of the American Accounting Association Committee on Accounting and Auditing Measurement, 1989-1990," Accounting Horizons (September 1991): 81-105. 35. Meek and Gray, "The Value Added Statement: Innovation for U.S. Companies?"

SELECTED READINGS Abdel-Khalik, A. R. "Specification Problems with Information Content of Earnings: Revisions and Rationality of Expectations, and Self-Selection Bias." Contemporary Accounting Research (fall 1990): 142-172. Bannister, J. W., and A. Riahi-Belkaoui. "Value Added and Corporate Control in the U.S." Journal of International Financial Management and Accounting (autumn 1991): 241-257. Barrett, M. J., W. H. Beaver, W. W. Cooper, J. A. Milburn, D. Solomons, and D. P. Tweedie. "Report of the American Accounting Association Committee on Accounting and Auditing Measurement, 1989-1990." Accounting Horizons (September 1991): 81-105. Beaver, W., P. A. Griffin, and W. R. Landsman. "The Incremental Information Content of Replacement Cost Earnings." Journal of Accounting and Economics 4(1982): 15-39. Beaver, W., R. Lambert, and D. Morse. "The Information Content of Security Prices." Journal of Accounting and Economics (March 1980): 3-28. Beneish, M. D., and C. R. Harvey. "The Specification of the Earnings-Returns Relation." Working paper, Duke University, Durham, NC, 1993. Chambers, A. E., and S. H. Penman. "Timeliness of Reporting and the Stock Price Reaction to Earnings Announcements." Journal of Accounting Research 22 (1984): 21-47. Cheng, C. S. A., W. S. Hopwood, and J. C. McKeown. "Nonlinearity and Specification Problems in Unexpected Earnings Response Regression Model." The Accounting Review (July 1992): 579-598. Collins, D., and S. Kothari. "A Theoretical and Empirical Analysis of the Determinants of the Relation between Earnings Innovations and Security Returns." Journal of Accounting and Economics (July 1989): 143-181. Deegan, C , and A. Hallam. "The Voluntary Presentation of Value Added Statements in Australia: A Political Cost Perspective." Accounting and Finance (May 1991): 1-29. Easman, W., A. Falkenstein, and R. Weil. "The Correlation between Sustainable Income and Stock Returns." Financial Analysis Journal (September-October 1979): 44-48. Easton, P. D., and T. S. Harris. "Earnings as an Explanatory Variable for Returns." Journal of Accounting Research (spring 1991): 19-36. Easton, P. D., and M. Zmijewski. "Cross-Sectional Variation in the Stock Market

The Case for a Nonlinear Specification

167

Response to Accounting Earnings Announcement." Journal of Accounting and Economics (July 1989): 117-141. Freeman, R., J. Ohlson, and S. Penman. "Book Rate-of-Return and Prediction of Earnings Change: An Empirical Investigation." Journal of Accounting Research (autumn 1982): 639-659. Freeman, R. N., and S. Y. Tse. "A Nonlinear Model of Security Price Responses to Unexpected Earnings." Journal of Accounting Research (fall 1992): 157185. Gray, S. J., and K. T. Maunders. Value Added Reporting: Use and Management. London: Association of Certified Accountants (1981). Hoskin, R. E., J. S. Hughes, and W. E. Ricks. "Evidence on the Incremental Information Content of Additional Firm Disclosures Made Concurrently with Earnings." Studies on Alternative Measures of Accounting Income. Supplement to Journal of Accounting Research 6(Supplement) (1986): 1-3. Hughes, J. S., and W. E. Ricks. "Association between Forecast Errors and Excess Returns Near to Earnings Announcement." The Accounting Review 62 (1987): 158-175. Karpik, P., and A. Belkaoui. "The Relative Relationship between Systematic Risk and Value Added Variables." Journal of International Financial Management and Accounting (spring 1989): 259-276. Kormendi, R., and R. Lipe. "Earnings Innovation, Earnings Persistence, and Stock Returns." Journal of Business (July 1987): 37-64. Lang, M. "Time Varying Stock Price Responses to Earnings Induced by Uncertainty about the Time-Series Properties of Earnings." Journal of Accounting Research (fall 1991): 229-260. Lipe, Robert C. "The Information Contained in the Components of Earnings." Studies on Alternative Measures of Accounting Income, Supplement to Journal of Accounting Research (1986): 37-68. Meek, G. K., and S. J. Gray. "The Value Added Statement: Innovation to U.S. Companies?" Accounting Horizons (June 1988): 73-81. Rutherford, B. A. "Value Added as a Focus of Attention for Financial Reporting: Some Conceptual Problems." Accounting and Business Research (summer 1977): 215-220. White, H. "A Heteroskedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Heteroskedasticity." Econometrica (May 1980): 817-838.

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13 Accrual Accounting, Modified Cash Basis of Accounting, and Loan Decision: An Experiment in Functional Fixation

Calls for some form of cash flow accounting have taken an international dimension.1'2,3 The trend is to either increase the amount of cash-flow based disclosures in the financial statements whenever possible or encourage the adoption of other comprehensive bases of accounting (MCBOA).4'5 The reaction of potential users to the modified cash basis of accounting versus accrual accounting is of interest to the standard-setting bodies and to the profession. Because users have been conditioned to react to accrual-based information, they may be fixated on accrual accounting rather than the modified cash basis of accounting (or any other form of MCBOA). Accordingly, the experiment reported in this study constitutes an investigation of the actions and perceptions of users confronted with either accrual accounting information or information based on the modified cash basis of accounting. The functional fixation hypothesis is used to explain the potential conditioning of users of accounting information. The next section introduces the issues associated with the user of other comprehensive bases of accounting. The next section elaborates on the hypothesis of the study, followed by a section that introduces the major aspects of the experimental design: the task, the variables, and the data analysis. Finally, the results and discussion are presented.

This chapter has been adapted with permission from: Ahmed Riahi-Belkaoui, "Accrual Accounting, Modified Cash Basis of Accounting and Loan Decision: An Experiment in Functional Fixation," Managerial Finance 18(5) 1992: 3-13.

170

Earnings Measurement, Determination, Management

O T H E R COMPREHENSIVE BASES OF A C C O U N T I N G The growing concern with accounting problems of small firms has generated interest in financial statements prepared on the basis of M C B O A . T h e motivation to switch to M C B O A came from: a. the changes in the tax laws made by the Economic Recovery Act of 1981, b. the increasing separation of tax accounting from GAAP accounting, c. the increase in the number of partnerships, subchapter S corporations, and other entities that prefer to present tax or cash basis financial statements, and finally, d. the tentative conclusions of the AICPA accounting standards overload special committee in favor of MCBOA. 6 ' 7 Guidance to practioners faced with M C B O A statements is provided in the 1976 AICPA statement on Auditing Standards N o . 14, Special Reports.8 Of the four types of reports identified, one is based on M C B O A . T o be classified as an M C B O A , a basis must meet one of four criteria: a. A basis of accounting necessary to meet regulatory requirements. It is basically a GAAP for regulated companies. b. A basis of accounting that may be used for income tax requirements. It is basically the tax basis of accounting. c. A basis of accounting based on cash receipts and disbursements with or without some accrual support. It is basically the cash basis or the modified cash basis of accounting (MCBOA). d. A basis of accounting resulting from the application of a definite set of criteria. Current value statements or price-level adjusted financial statements art good examples. As one of the criteria indicates, the cash basis, or the M C B O A , is classified as acceptable M C B O A . The pure cash basis is, however, rarely used. The M C B O A is favored if it has substantial support. The AICPA provides the following clarification. Modification of the cash basis of accounting to record depreciation and equipment and to accrue income taxes were recognized in SAS No. 14. Ordinarily, a modification would have substantial support, if the method is equivalent to the accrual basis of accounting (such as, recording revenue on the accrual basis and recording purchases and other costs on the cash basis). If modification to the cash basis of accounting does not have substantial support, the auditor should include an explanatory paragraph and modify the recommended language.9

An Experiment in Functional Fixation

171

The MCBOA has not been well defined. In fact, modification arose through common usage in practice. The following examples of modification are recognized in practice as having substantial support: • • • •

Property, plant and equipment purchased for cash. Material amounts of inventory purchased for cash. Liabilities arising from the receipt of borrowed cash. Employee Federal Insurance contributions and withholding taxes not deposited with the Internal Revenue Service. • Federal income taxes accrued on current year's cash income.10 The use of MCBOA, or any other MCBOA, by small business is not, however, without an explanatory paragraph: 1. States, or preferably refers to the note to the financial statements that states, the basis of presentation of the financial statements on which the auditor is reporting. 2. Refers to the note in financial statements that describes how the basis of presentation differs from GAAP. (The monetary effect of such differences need not be stated.) 3. States that the financial statements are not intended to be presented in conformity with GAAP.11 Second, SAS No. 14 requires a third paragraph that expresses the author's opinion (or disclaims an opinion) on whether the financial statements are presented fairly in conformity with the basis of accounting described and whether the basis of accounting used has been applied in a manner consistent with that of the preceding period. Third, SAS No. 14 recommends that the financial statements not be captioned or otherwise referred to as "balance sheet" or "income statement" without appropriate modification. Fourth, a 1980 auditing interpretation, "Adequacy of Disclosure in Financial Statements Prepared on Comprehensive Basis of Accounting Other than Generally Accepted Accounting Principles," offers general guidance on MCBOA disclosures. It generally states that the criteria the auditor should apply are essentially the same as those applicable to financial statements prepared in conformity with generally accepted accounting principles. These criterias are discussed in SAS No. 5, the meaning of "Present Fairly in Conformity with Generally Accepted Accounting Principle" in the independent auditor's report, paragraph 4. It also states that the auditor's opinion should be based on his judgment regarding whether the financial statements, including the related notes, are informative of matters that may affect their use, understanding, and interpretations.

172

Earnings Measurement, Determination, Management

Given the special way in which MCBOA is presented to users, it may well be that they will react to it with less confidence than when faced with accrual based information. This study investigates specifically the users' reactions to MCBOA in an experimental setting. HYPOTHESIS The potential reactions of the primary users of the financial statements of small business to the basis of accounting is of great importance to standard setters and the professions. The question considered in this study is whether there would be any differences in the reactions of bank loan officers examining financial statements based on either accrual accounting or MCBOA. The reactions of bank loan officers focus on both action and perception differences. More specifically, this study simultaneously examines financial statement perception and action differences. The primary research questions of this study are the following. Action Differences Does the use of an MCBOA rather than accrual accounting influence the banker's decision regarding: 1. the acceptance or rejection of a company loan application? 2. the determination of the interest rate premium? Perception Differences Does the use of MCBOA rather than accrued accounting influence the banker's confidence ratings that the financial statements are: 1. overall reliable? 2. free from the effect of fraud? 3. free from clerical errors? The differences are predicted to show a preference for the case using accrual based information because of a functional fixation effect. Functional fixation, a psychological phenomenon, is used in accounting to suggest that under certain circumstances a decision maker may be unable to adjust his/her decision process to a change in the accounting process that supplied him/her with the input data. 12 Basically, in this study, if the loan officers, because of better familiarity, experience, or socialization with accrual accounting, are cognizant of the fact that reported accounting earn-

An Experiment in Functional Fixation

173

ings provide better measures for the assessment of dividend and debt paying ability as compared to the information provided by MCBOA, we hypothesize that loan officers shall become conditioned and fixated on using reported earnings and show more preference to the same firm analyzed when it uses accrual accounting information than when it uses MCBOA. EXPERIMENTAL DESIGN This section elaborates on the task and the research instrument presented to the subjects in this experiment, the variables to be used in the analysis, and the methods used. Task Thirty-eight expert loan officers from a large commercial bank of a metropolitan city served as subjects after a discussion with a senior officer at the bank. The project and the subject need were discussed. (The participants ranged in age from twenty-five to thirty-four years and had been employed as lending officers from two to four years. Thirty percent had either a business or accounting undergraduate degree while the rest had a degree in liberal arts. Twenty percent of the respondents had MBA degrees and the rest were pursuing studies toward an MBA in various evening programs.) Each of the loan officers was presented with a research instrument and asked to review a set of financial statements and background information for a hypothetical loan applicant. The basis of accounting used in the financial statements was either accrual accounting or MCBOA. Therefore, two forms of the instrument were used, either accrual accounting or MCBOA, with eighteen loan officers responding to the accrual instrument. (No significant difference was found between the two groups in their familiarity with either accrual or modified cash basis of accounting.) The loan officers were rai/ domly assigned by the senior officer at the bank to answer one of the forms of the instrumeA_j. After examining the financial statements and the background information the loan officers were requested to: a. indicate the ability of the firm to repay the loan, b. accept or reject the loan, c. if the loan is accepted, indicate the interest rate premium that would be charged to this loan applicant, d. if the loan is rejected, indicate the interest rate premium that could be charged by other lending institutions willing to accept the loan application, e. indicate their confidence that the statements are (1) overall reliable, (2) free from the effects of fraud, and (3) free from clerical errors.

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Earnings Measurement, Determination, Management

Development of the Research Instrument The material provided to the subjects included: 1. Covering instructions about the nature of the project and background information about the loan applicant identified as the "Riverboat Excursions." 2. Two years of audited financial statements of the firm. These financial statements were based on either accrual accounting or MCBOA. 3. A questionnaire that asked the loan officers to perform the tasks described in the previous section. 4. A questionnaire that asked the loan officers to provide background and feedback information. To construct the financial statements to be used as stimuli, the local office of one of the Big Eight CPA firms was contacted for a "live example" of the financial statements of a small company using modified cash accounting. The example provided by the accounting firm was of a two-year-old partnership that was originated to renovate, develop, own, and operate a riverboat excursion vessel and related facilities as a family entertainment facility moored on the X river. The first two years' audited financial statements based on a modified cash accounting of the firms were made available to the author. They were used as MCBOA stimuli after deleting all information that could be used to identify the company and then substituting the fictional name of "Riverboat Excursions." These MCBOA statements contained a footnote disclosing the necessary adjustments that needed to be made to concert them to the accrual basis. These adjustments were made resulting in the accrual accounting stimuli. Variables and Data Analysis One independent variable and six dependent variables are used. The independent variable is the basis of accounting: either an accrual basis or an MCBOA basis. The six dependent variables represent the actions and perceptions of the loan officers. They are the loan decision, the interest rate premium decision, the confidence decision that the financial statements were reliable, free of the effects of fraud, and free of clerical errors. Given that the set of five research questions were inherently correlated, the research questions were exclaimed on the basis of one-way multivariate analysis of variance. RESULTS AND DISCUSSION The questions on potential actions and perception differences examined whether the use of MCBOA rather than accrual accounting influenced the loan officers' decision regarding:

An Experiment in Functional Fixation

175

1. 2. 3. 4. 5.

the ability of the firm to repay the loan, the acceptance or rejection of the company loan application, the determination of the interest rate premium, the perception of overall reliability of the financial statements, the perception of freedom from the effects of fraud of the financial statements, and 6. the perception of freedom from clerical errors of the financial statements.

When the impact of these six dependent variables was examined simultaneously, the results indicate that there were action and perception differences that depend on whether accrual or MCBOA is used in the financial statements. When the impact of each of the dependent variables was examined, two important results emerged. First, the form of accounting used, accrual accounting versus MCBOA, affected significantly the loan officers' decisions on 1. 2. 3. 4. 5.

the the the the the

ability of the firm to repay the loan, acceptance or rejection of the company loan application, interest rate premium, perception of reliability of the financial statements, and perception of freedom from clerical errors of the financial statements.

Second, the perception of the freedom from the effects of fraud was not affected by the form of accounting used. The direction of these differences was in favor of accrual accounting as the loan officers believed that the loan applicant presenting accrual accounting financial statements a. b. c. d.

was was was had

more able to repay the loan, more likely to be granted the loan, given a different and more favorable interest rate premium, and statements more reliable and free from clerical errors.

In short, the loan officers showed a net preference for accrual accounting versus modified cash accounting in evaluating the financial statements of the same company applying for a loan—especially given the evidence of no significant difference in the familiarity of the two groups of respondents with modified cash accounting and accrual accounting. The result may be explained by both the conditioning and functional fixation hypothesis. In other words, the loan officers cognizant of the fact that accrual accounting provides better measures for the assessment of dividend and debt-paying

176

Earnings Measurement, Determination, Management

ability become conditioned and fixated on using reporting earnings numbers and show more preference to the same firm analyzed when the firm presents them with accrual financial statements than when it presents them with MCBOA. Various implications are raised by the results: First:

If informed and intelligent bank officers are unable (or unwilling) to use financial data that is buried in the footnotes of a relatively simple company, one may wonder about the ability (or willingness) of a potential investor reading through the financial statements of a complex Fortune 500 company. A loan officer focusing on one specific entity has a "functional fixation." Is it possible that the marketplace as a whole has a similar fixation? These findings argue against indiscriminate reliance on the predictive approach in analysis of the capital market. This study suggests that users individually or in the aggregate react because they have been conditioned to react to accounting data rather than because the data have any informational content.

Second: The findings may also indicate that the risk aversion of bank lending officers is higher than their drive for profit maximization, which make them more cautious when faced with "unconventional" accounting practices. That suggestion has significant implications for bank managers as well as for borrowers. CONCLUSION Functionally fixated users are considered unlikely to readily adapt to changes in methods of measuring indicators. The effect of such behavior may lead to different and sometimes incorrect decisions because the change in variables in general and in the measurement base in particular (in this study) are not recognized with the result that only the familiar information is adequately used in the analysis. This study verified the above hypothesis by showing that loan officers examining the financial statements of the same company using either accrual information or MCBOA showed clear preference for the company when faced with accrual information. A conditioning factor is used to explain these results. APPENDIX Significant effects with the multivariate analysis of variance (MANOVA) were explored by examination of the univariate F-ratios and related uni-

177

An Experiment in Functional Fixation Exhibit 13.1 Univariate Analysis of Various Tables

HO:

I Sum of Mean Square \ Square \ F Value \Prob>F

DF

| (A) Ability of the Firm to Repay the Loan Accounting Methods

1

Error

36

54.0000

Total

37

| 63.4736 |

| 9.4736 | 9.4736 1

632 1 0.0166*

lJOOO

(B) Percentage Accepting the Loan (Yes/No) Accounting Methods Error Total

1 36 37

0.2631

02631

.2J000

0.0694

3.79

0.0594*

3.18

0.0831* 1

2.7631 |

(C) Interest Rate Premium (Points in Eccess of Prime) Accounting Methods Error Total

1 36 37

3.0123 1 3.1231 34.1340

0.9481

37.1463

1(D) Reliability (Degree of Confidence) Accounting Methods Error

1 . 36

31.0748

31.0748

17.09

| 0.0002

65.4777 1 1.8188

Total

37

Accounting Methods

36.8494

Error

1 36

Total

37

|942105

|96J526 1 (E) Freedom from Clerical Errors (Degree of Confiidence)

36.8494 57.3611 1.5933

l

23.13

0.0001*

1.96

0.17

| (F) Freedom from Fraud 1 3.4739 1 3.4379

Error

1 36

Total

37

| 673584

Accounting Methods

I 63.8944

'significant at a=0.05

Source: Ahmed Riahi-Belkaoui, "Accrual Accounting, Modified Cash Basis of Accounting and Loan Decision: An Experiment in Functional Fixation," Managerial Finance 18(5) (1992): 3-13. Reprinted with permission.

178

Earnings Measurement, Determination, Management

variate procedures. T h e decision was based on the argument that when one is interested in determining on which dependent variables the experimental design groups differ (in a M A N O V A ) , regardless of the interrelationship between the variables, A N O V A , and not discriminant analysis, is able to give this information. 1 3 The alpha level for all statistical tests is set at a = 0.05 level of significance. Both M A N O V A and A N O V A are performed using the programs developed by the Statistical Analysis System Institute. 1 4 Results from the M A N O V A showed significant results at the 0.0001 level, using as test criterion Wilk's lamda, the Hotelling-Lawley Trace, Piklau's Trace, or Roy's M a x i m u m Root. 1 5 Results from the univariate analyses of variance are shown in Exhibit 1 3 . 1 . With the exception of freedom of fraud, all the other dependent variables are significant. NOTES 1. Ahmed Belkaoui, The New Environment in International Accounting: Issues and Practices (Westport, CT: Greenwood Press, 1988). 2. Ahmed Belkaoui, Multivariated Financial Accounting (Westport, CT: Greenwood Press, 1991). 3. T. A. Lee, "Reporting Cash Flows and Net Realizable Values," Accounting and Business Research (spring 1981): 163-170. 4. Wayne C. Alderman, Dan M. Guy, and Dennis R. Meak. "Other Comprehensive Bases of Accounting: Alternatives to GAAP?" Journal of Accounting (August 1982): 32-41. 5. Ahmed Belkaoui, Public Policy and the Problems and Practices of Accounting (Westport, CT: Greenwood Press, 1985). 6. Alderman, Guy, and Meak, "Other Comprehensive Bases of Accounting: Alternatives to GAAP?" 7. C. Charzen and Benjamin Benson. "Fitting GAAP to Smaller Businesses," Journal of Accounting (February 1978): 46-51. 8. American Institute of Certified Public Accountants, Statement on Auditing Standards No. 14, Special Reports (New York: American Institute of Certified Public Accountants, 1976). 9. American Institute of Certified Public Accountants, AICPA Technical Practice Aides, Vol. 1 (Chicago: Commerce Clearing House, Inc., 1985). 10. Alderman, Guy, and Meak, "Other Comprehensive Bases of Accounting: Alternatives to GAAP?" 11. American Institute of Certified Public Accountants, AICPA Technical Practice Aides, Vol. 1. 12. N. A. Wiener and J. G. Birnberg, "Methodological Problems in Functional Fixation Research: Criticisms and Suggestions," Accounting Organizations and Society (February 1986): 71-83. 13. P. E. Spector, "What to Do with Significant Multivariate Effects in Multiple Analysis of Variance," Journal of Applied Psychology 62 (1977): 62. 14. Statistical Analysis System Institute, SAS User's Guide (NY: SAS Institute Inc., 1979).

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15. M. M. Tatsuoka, Multivariate Analysis: Techniques for Educational and Psychological Research (New York: Wiley, 1971). SELECTED READINGS Alderman, Wayne C , Dan M. Guy, and Dennis R. Meak. "Other Comprehensive Bases of Accounting: Alternatives to GAAP?" Journal of Accounting (August 1982): 32-41. American Institute of Certified Public Accountants. AICPA Technical Practice Aids. Chicago: Commerce Clearing House, Inc., 1985. . Statement on Auditing Standards No. 14. Special Reports. New York: American Institute of Certified Public Accountants, 1976. Belkaoui, Ahmed. Behavioral Accounting. Westport, CT: Greenwood Press, 1991. . Multivariated Financial Accounting. Westport, CT: Greenwood Press, 1991. . The New Environment in International Accounting: Issues and Practices. Westport, CT: Greenwood Press, 1988. . Public Policy and the Problems and Practices of Accounting. Westport, CT: Greenwood Press, 1985. Charzen, C , and Benjamin Benson. "Fitting GAAP to Smaller Businesses." Journal of Accounting (spring 1981): 46-51. Lee, T. A. "Reporting Cash Flows and Net Realizable Values." Accounting and Business Research (spring 1981): 163-170. Spector, P. E. "What to Do with Significant Multivariate Effects in Multiple Analysis of Variance." Journal of Applied Psychology 62 (1977): 62. Statistical Analysis System Institute. SAS User's Guide. NY: SAS Institute Inc., 1979. Tatsuoka, M. M. Multivariate Analysis: Techniques for Educational and Psychological Research. New York: Wiley, 1971. Wilner, N. A., and J. G. Birnberg. "Methodological Problems in Functional Fixation Research: Criticism and Suggestions." Accounting Organizations and Society (February 1986): 71-83.

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Index Accounting changes and errors, 17 Accounting smoothing, 90 Accrual accounting: accounting indicators derived from, 15; defined, 1, 113; efficacy of, 114-15 Accrual accounting vs. cash flow accounting, and derived accounting indicator numbers, 115-25; and persistency of accounting indicators, 120-21; and semiaccounting indices of rate of return, 117; and variability of accounting indicators, 117-20 Accrual accounting vs. modified cash basis of accounting (MCBOA), 16976; experimental design, 173-74; functional fixation hypothesis, 17273; study results and implications, 174-76 Accrual and cash flow based valuation study: findings and implications, 6 4 68; hypothesis, 59; methodology, 6 1 64; multinationality and reputation effects and measures in, 60-64 Accruals: calculation of, 61; and corporate reputation, 81-88; nondiscretionary, estimation of, 72-73

Allocation criteria, 9-10 ANOVA, 178 Articulation, 2 Asset-valuation base, defined, 23 Asset-valuation and incomedetermination models, 23-39; attributes measured in, 24-25; comparison and evaluation criteria in, 26-28; expressed in units of money, 28-34; expressed in units of purchasing power, 34-39; illustrations of, 28-39 Capital maintenance concept of income, 1; asset-valuation base used in, 23 Capital structure, and earnings per share computation, 18 Cash flow accounting: defined, 113; usefulness and reliability of, 114-15, 130. See also Accrual accounting vs. cash flow accounting Cash flows: and corporate reputation, 81-88; data, informational contribution of, 146; preference for, over accruals, 59; statement, FASB requi-

182 rements, 145; vs. value added, informational content of, 146-51 Command of goods (COG), 27, 28 Comprehensive income, FASB definition of, 11 Constant-dollar data disclosures, 4 0 42 Corporate reputation: attributes and measures of, 62; effect of earnings management on, 81-88; and market value of equity, 60-68; regression analysis of, 83; related to accruals and cash flows, 81-88; value of, 81 Cost: definitions of, 6-8; unexpired vs. expired, 8 Cost attach concept, 9 Current operating concept of income, 10-11 Current-cost data requirements, 4 0 42 Current-value accounting, and pricelevel changes, 25 Discontinued operations, gain or loss from, 15-16 Dual economy, stratification and income smoothing in, 90-92 Earnings: articulation principle and, 2; asset/liability view of, 3, 124-25; revenue/expense view of, 3; vs. value added, informational content of, 14649 Earnings data vs. value added data, comparative information content, 146-51 Earnings determination, role of net value added and previous level of earning in, 49-56 Earnings management: contextual accruals and cash flow based valuation in, 59-68; in high vs. low multinationality firms, 71-80; and incomereducing accruals in high multinationality firms, 71, 72; and market value of equity, 60-68; process, 49; and reputation building, 8 1 88

Index Earnings measurement: alternative models of, 24-25; asset-valuation base used in, 23; attributes and units of measure in, 24-26; and measuringunit errors, 27; and price-level changes, 25-26, 39-45; relevance and interpretability criteria in, 27-28; and reputation building, 81-88; and timing errors, 26 Earnings per share, 18 Earnings-returns relations: book valuation model of, 106-7; and change in net-value added, 155-64; empirical analysis, 107-10; nonlinear specification of, 158-59; relevance of earnings level and earnings changes to, 105, 110-11 Earnings-returns relations vs. net-valueadded-returns relations: analysis of, 157-64; and linear vs. nonlinear valuation models, explanatory power of, 161-62 Expenses: creation of, accounting techniques in, 8; definitions of, 7, 8; distinguished from cost, 6-7 Extraordinary items, defined, 12-13 Financial Accounting Standards Board: and articulation (Statement No. 5), 2; cash flow statement requirements, 145; definition of revenue, 3; on financial reporting and changing prices (Statement No. 33), 39-45 Financial reports, comparative roles of value added, earnings, and cash flow in, 145-51 Financial statement: allocations in, 10; articulation in, 2; gains in, 4; and modified cash basis of accounting (MCBOA), 169, 170-72; stewardship function of, 113 General price-level accounting, 24, 45; expressed in units of general purchasing power, 34-39 General price-level net-realizable-value accounting, 24, 38-39

Index General price-level present-value accounting, 24, 26 General price-level replacement-cost accounting, 24, 36-38 Historical cost, defined, 24 Historical-cost accounting, 23, 25, 2 8 31,40 Income: capital maintenance concept of, 1, 23; current operating vs. allinclusive, 10-11; transactional approach to, 1 Income smoothing: in core vs. periphery sector, 89-103; defined, 89; and organizational characterizations, 90; process and motivations, 49, 89-90; and theories of economic dualism, 90-92 Income statement preparation: accounting changes in, 17; articulation and earnings concepts in, 1-3; discontinued operations in, 15-16; earnings per share in, 18; expenses and losses in, 6-10; extraordinary items in, 12-15; income concepts in, 1, 10-11; prior period adjustments in, 16; revenues and gains in, 3-6; single- vs. multiple-step format, 1 1 12 Inflation disclosure requirements, 40, 42-45 Interpretability of accounting models, 27 Losses: and cost, 6-7; definitions of, 7-8 Market and accounting returns relations. See Earnings-return relations vs. net-value-added-returns relations Market valuation models, 59. See also Accrual and cash flow based valuation study Matching and allocation, 8, 9-10 Mergers. See Takeover analysis Modified cash basis of accounting (MCBOA): vs. accrual accounting,

183 research study on, 169-78; motivations for use of, 170; and SAS No. 14, Special Reports, 170-71 Multinationality: arbitrage benefits, 72; attributes and measures, 62; levels of, and political costs/political risk, 71-72, 79-80 Multinationality and earnings management: level of multinationality in, 7 1 80; and market value of equity, 6 0 68 Multivariate analysis of variance (MANOVA), 176-78 Net realizable value, defined, 24 Net-realizable-value accounting, 23, 3 2 34 Net value added: computation of, 15556; defined, 155; and total wealth, 155-57; usefulness of, 155-57 Nondiscretionary accruals, estimation of, 72-73 Number of dollars (NOD), 27, 28 Political costs/political risk, and high multinationality firms, 71-72, 7 9 80 Present (capitalized) value, 24 Present-value accounting, 24, 26 Price-level changes: accounting models based on, 34-39; and changes in earnings, linear model of, 157-58; and FASB Statement No. 33 reporting requirements, 3 9 ^ 5 ; types of, 25 Price-level-adjusted net realizable value, 28 Price-level-adjusted replacement cost, 28 Prior period adjustments, 16 Real smoothing, 90 Relative price-level changes, 25 Relevance of accounting models, 2 7 28 Replacement cost, defined, 24 Replacement-cost accounting, 23, 3 1 32

184 Return valuation models, 146-49, 15758 Revenue: definitions of, 3; and gains, 4; inflow and outflow concepts of, 3 Revenue recognition: critical event approach to, 4-6; deferred, and installment and cost-recovery methods, 6; percentage-of-completion and completed contract methods of, 5 Security price determination, and accrual vs. cash flow accounting, 115-25 Security returns and earnings relations. See Earnings-returns relations Specific price-level changes, 25 Takeover analysis: and abnormal returns during takeover period, 12930, 131-32, 136-40; cash flow and earnings measures in, 129, 130-32; and low performance preceding

Index takeover, 129, 130-31, 135-36, 14041 Timing errors, 26 Transactional approach to income determination, 1 Value added: computation of, 146; concept, 50-51; cost of reporting, 149 Value added vs. earnings and cash flows: and behavior of share prices, 146; estimation model of, 146-49; financial reporting role, compared to earnings and cash flows, 146-51 Value added-earnings policy model, 51 Wealth, total, and net value added, 155-57 Wealth generation, and earnings determination, 56

About the Author AHMED RIAHI-BELKAOUI is CBA Distinguished Professor of Accounting in the College of Business Administration, University of Illinois at Chicago. Author of more than 40 Quorum books, published or forthcoming, and coauthor of several more, he is also a prolific writer of articles for major scholarly and professional journals, and has served on numerous editorial boards that oversee them.