Executive Summary:
The earnings announcement is a window into a firm's economic viability and future profitability. Recent billion dollar write-offs by financial firms, resulting from the sub prime mortgage meltdown, have shaken investor confidence. Are the earnings write-offs being reported by high-profile financial firms transparent enough to illuminate the depths of the problems, or are more surprise write-downs lurking? New research* by accounting professors Neil Bhattacharya and Hemang Desai and finance professor Kumar Venkataraman of SMU Cox provides hard evidence on the adverse long-term consequences for firms and their investors of reporting lower-quality earnings.
A Great Debate
What are the long-term implications of shaky balance sheet assets and unreliable reported earnings? The debate about earnings quality has been highly contentious among academics, regulators, and market participants. Although, several observers (for example, former SEC chairman Arthur Levitt) have argued that poor earnings quality lowers liquidity and increases the cost of raising capital, the empirical evidence from academic research on the association between earnings quality and cost of capital is inconclusive. This paper contributes to the debate by examining the impact of earnings quality on trading costs. Relative to the cost of firm's capital, trading costs are easy to measure. Moreover, lower liquidity is associated with higher costs of capital, as investors demand compensation for higher costs of completing their transactions.
But why should earnings quality impact trading costs? The authors argue that, to the extent that poor earnings quality causes opaqueness about a firm's true profitability and introduces uncertainty about future cash flows, it may provide the sophisticated investors with an information advantage over other market participants. The increased risk to a market maker (dealer) of trading against informed traders will result in a wider spread between the bid and ask prices and smaller quoted sizes. To compensate investors for the higher costs of completing transactions, firms have to offer a higher return on capital.
Venkataraman explains, "The cost of capital is the cost of raising money for a firm. It is the rate of return that investors demand for accepting the uncertainty of the firm's future performance. Investor's perception of risk is guided by the firm's disclosure policies. If a firm's policies are transparent, investors have a better understanding of firm's activities and a sense of confidence that the reported numbers indeed reflect the underlying economic profitability. In contrast, poor quality disclosures lower investor confidence and increases uncertainty about future performance. Thus, in addition to the economic uncertainty, the quality of firm's disclosure, particularly accounting disclosures, introduces an additional layer of uncertainty from an investor's perspective."
Author Desai explains that the stock price of any firm is the present value of its expected future cash flows. "Projections about future cash flows come from earnings, that is, how well do current earnings predict future cash flows," he says. "Earnings can be decomposed in two components: actual cash flows and accruals (accruals are estimates such as the expectation that outstanding receivables will be collected and whose impact is reflected in current earnings). However, managers have significant discretion over these estimates. For example, managers can be liberal about their estimate of receivables that are unlikely to be collected (underestimate uncollectibles) or they can spread depreciation expense over an unduly long period. Desai continues, "Some time down the road this [opportunism] will be revealed. Such interference by the managers results in poor earnings quality."
Bhattacharya points out that managerial discretion is not the only factor affecting earnings quality. When people consider earnings quality, they think about investors. But many firms with poor earnings quality "are not necessarily trying to change numbers and do malefic things. They can be derived from innate factors - factors which relate to the firm's business model or to the characteristics of the specific industry," Bhattacharya explains. Poor earnings quality in the construction industry is a norm with long lead times to complete projects and economic uncertainties running throughout the course of projects-recessions, macroeconomic shocks, etc. Firms with seasonal sales also fall prey to earnings quality challenges- the maker of skis, video games, and other firms with seasonal sales. Consequently, earnings quality can be influenced significantly by innate, firm-specific factors.
Parsing the Numbers
But the bottom line is that earnings quality impacts investor confidence-to what extent they can rely on the numbers, Venkataraman suggests. This lack of confidence in the reported earnings numbers induces investors to demand an additional premium in their returns. From prior research by Desai and Venkatarman, they found that sophisticated investors, such as short sellers and hedge fund types, were able to identify firms with poor quality earnings - even before a restatement, and capitalize on them.
In this study of a large sample of NYSE and NASDAQ firms for the period 1998 - 2005, the authors document that poor earnings quality exacerbates information asymmetry (the information gap between sophisticated and less sophisticated investors) in the financial markets, which in turn raises trading costs and ultimately cost of capital. Venkataraman states, "Trading costs are a way of quantifying the negative consequences of poor earnings quality." A higher transaction cost results from the trades of sophisticated investors, who often target firms with poor earnings quality. To protect their profits, the dealer has to increase the mark up between the ask and bid prices, thus increasing trading costs for all investors.
Transparency Matters
Ultimately, these information asymmetries can lead to adverse private market and social consequences, such as high transaction costs, thin markets, and decreased gains from trade. According to Bhattacharya, this study not only indicates that poor quality earnings affects investors and other market participants, there is an implicit message to managers of firms as well. "If your firm puts forth poor earnings, you may face higher cost of capital when going to the market to raise money, a real tangible cost, i.e., paying a premium to raise equity," Bhattacharya explains. Bhattacharya adds that managers should look into the factors related to firm and industry characteristics (innate factors), and those under the control of the management (discretionary factors).
With accounting scandals and corporate excesses still fresh in investors' minds, will the $112 billion in write-downs by big banks and brokerage firms thus far (as of January 18) be the final count? In summary, greater transparency in the earnings numbers reported by firms benefits both the firm and its investors.
The paper "Earnings Quality and Information Asymmetry: Evidence from Trading Costs" by Neil Bhattacharya, Hemang Desai and Kumar Venkataraman is under review.
Written by Jennifer Warren.
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