Persistence of Firms Earnings - Report Example

Persistence of Earnings Student’s Name Subject Professor Date Persistence of Earnings Introduction Persistent of earnings refers to an income that flows continuously in a year and the next. This is an income that a firm can forecast about its inflow as well as plan for its expenditure. Persistent earning are said to be sustainable and of higher quality as compared to transitory earnings. Moreover studies show that persistent earning makes it very easy for batter inputs to discounted cash flow valuation (Chen, Folsom, Paek & Sami 2013). This is because it is possible to forecast for the persistent earnings in future with a lots of precision than other forms of earnings such as the transitory earnings. In addition persistent earnings are also positively associated with areas such as equity valuation and compensation among others. There has been a lot of literature about persistent earnings as well as different stands taken by the researchers concerning these earnings; however only a few studies that have considered the macroeconomic aspect of the persistence of earnings in this field of study. (Clinch, Fuller,Govendir & Wells 2012) The above phenomenon and others that relate to persistence of earnings will be discussed in this paper as well as various literatures that have been put in place by different researchers concerning persistence of earnings. Moreover this paper will identify several motivations and reasons for examining earning persistence as well as the various factors that affect the persistence of a firm’s earnings. The paper will also shine some light on the methods that are employed in determining the persistence of earnings for a firm and the relationship between earnings persistence and earnings quality. (Clinch, Fuller,Govendir & Wells 2012) Literature review Studies show that there is a strong association between the macroeconomic cycles in the business world and the firm’s persistence of earnings. During expansion or booms earnings are normally very persistent while during recession the earnings are not persistent at all. During intermediate growth period the persistent on earnings is also moderate (Choi, Lin, Walker & Young, 2007). Therefore it has been found that the persistence of earnings is determined by macroeconomic cycles in the economy for any given firm. According to this study persistence of earning is therefore dependant on such factors as the accounting system and the fundamentals of the firm. The accounting system on one hand depends on the components of financial reporting. The participants of financial reporting vary depending on the methods used in the calculation process of the accounts. On the other hand fundamentals in most cases are in one way or the other linked to macroeconomic factors. Thus the two factors are key determinants of the persistence observed in the earnings of a firm. (Dechow et al. 2010) Further studies on persistence of earnings indicate that cash and accrual components in a firm also lead to a difference in terms of how income flows within the firm (Karahan & Ozkan 2013). This is because the concept that a firm will employ depending on the two components will lead to very different results. If a firm employs the accrual accounting concept it means the firm will consider the revenues periodically. The accrual accounting concept considers the revenues of the firm depending on the transactions that take place within a given specified period of time. This concept ensures that revenues and expenses are recognized within the period in which they have been accrued; therefore the persistence of earnings can easily be monitored. Cash flow concept is quite different from the accrual in that it does not recognize the different times when the revenues earned and expenses incurred. For this reason it may not be easy for a firm to be able to follow the exact persistence depicted by through its earnings. Researchers therefore conclude that accrual concept is the best for showing the persistence of earnings in a firm. (Clinch, Fuller,Govendir & Wells 2012) In other studies researchers have sought to find out what factors that affect the persistence of earning. Among them is Lev and Thiagarajan (1993) who put posited that one of the major components of a firm that has effects on the persistence of earnings is the tax system. This researcher states that, “A significant change in the company’s effective tax rate which is not as a result of transitory tax change is generally considered temporary by the analysts. Similarly, an unusual decrease in the effective tax rate is normally considered a negative sign as far as earnings persistence is concerned.” According to him even if the firm’s effective tax rate is equal to the persistence of its pre-tax earnings the tax change component would still be less than any other earning. This is because the tax change component always reflects the relationship or the interaction of two or more persistence parameters (Clinch, Fuller,Govendir & Wells 2012). For this reason the researcher concludes that the effective tax rate of any firm directly determines the responsiveness of the earnings that flows into that particular firm. Hence, whenever there are changes in the effective tax rate from one period to the other the persistence of earnings will equally be affected and thus there will not be any uniformity in the earnings. Another researcher put across that the persistence of earnings is affected by changes in the managerial incentives (Doukakis 2010). This researcher’s argument is closely related to the fact that persistence of earnings depends on the macroeconomic cycles within the economy. This is because the managerial incentives are said to vary with the business cycles over time. The study noted that managerial incentives are a very key component in the financial reporting of any firm. Therefore any change in the incentives leads to a similar change in the earnings of the firm. The punch line of this study is that the changes in the level of managerial incentives does not change equally in different periods and hence results to varying periodic firm performance. On the same notch, there are other participants that affect financial reporting and consequently affect earnings persistence (Dichev & Tang 2009). These include auditors, investors, regulators as well as analysts who normally affect the operations of the firm in one way or the other. Motivations for examining earnings persistence In several studies, persistence of earnings has been used as a measure of the firms’ quality of earning. For this reason firms’ persistence of earnings have been emphasized in order to offer inferences and support to such areas as equity valuation, annual report readability and compensation contracts. A survey on the applicability of this measure in delivering support to such fields as the ones mentioned above indicate that firms persistence of earnings play a vital role in enhancing the ability to deliver good results as far as these fields are concerned. Theory on valuation indicates that most of the long term investors are motivated by sustainable earnings of a firm. In terms of stock prices, it has been noted that those firms that have higher and sustainable earnings persistence, they also have a higher responsiveness to their stock prices. This is because persistent earnings are associated with good equity returns as well as predictable compensation contracts. Persistent earnings are also very important in encouraging investors in the bond market as well as ensuring good annual report readability. Market participants such as investors and analysts are also dependants of the persistence of earnings in order for them to attain their goals. These participants are normally involved in making decisions based on predictions about the future conditions of a business or a firm. For them to be certain with their predictions they always have to ensure that the information depicted by the firm under consideration is quite reliable especially in terms of persistence. The major element for analysts and investors while carrying out their duties is the trend of a firm’s earnings. This makes it easy for the valuation processes on the firm. However it should be noted that sustainable and predictable persistence of earnings of any given firm do not always guarantee similar results in the future. This is due to unexpected changes in the macroeconomic cycles which entail expansions and recessions. Hence in order to ensure wide-ranging reliability on the persistence of earnings macroeconomic conditions have to be put into consideration. By so doing the investors or analysts will be able to take care of any eventuality in their operations as far as changes in the earnings are concerned. You must also identify factors that impact on the persistence of a firm’s earnings. As discussed in the literature review section some of the factors that impact persistence of earnings are the accounting system and the firm’s fundamental performance. These two factors affect the persistence of earnings in quite diverse aspects. For instance the accounting systems affect the financial reporting system which in return affects the persistence. The effects on the accounting systems may result from change in the incentives or other financial reporting participants. Firm’s fundamental performance depends on the prevailing business cycles. Most of the industries’ productivity is normally affected by their future uncertainty about the business trends as far as the macroeconomic conditions are concerned. Such economic cycle whimsies, cause firms to operate with lots of susceptibility; hence results into earnings that are not persistent at all. Other participants of financial reporting such as auditors, investors, regulators and analysts; also affects persistence of earnings of a firm. This is because they affect the business management that results to influences on the firm’s earnings. For instance regulators may pop in during the normal functioning of the business and enact a law that require every firm to implement. For example, regulators may put in place price ceilings to all firms or to firms in particular production line. Such a regulation may affect the firm’s earnings thus impact on the persistent of earnings. (Chen, Folsom, Paek & Sami 2013) Another major factor that impacts the persistent of earnings in a firm is the action of the firms in the market. According to Rotemberg and Saloner (2009) collusion of oligopolies especially during periods of expansion or high demand the firms are likely to engage in price wars. This competitive business behaviour may affect the earnings of the individual firms thus resulting to lack persistence in the firm’s earnings. Cash flows and accruals may also impact the flow of the firm’s income. As discussed earlier it was noted that accruals enhances more persistence than the cash flows as far as the earnings are concerned. The error component associated with the accruals may cause negative impacts on the persistence of earnings. This is because the error term in the accruals is estimated using various formulas, therefore depending on the choice of the formulae different accounting results may be obtained thus resulting to impacts on the persistence of earnings. Empirical methods employed by researchers to determine the persistence of earnings The methods that are employed in determining the persistence of earnings ought to be reliable and relevant. This means that the methods should be freely verifiable, without error or biasedness and should also accurately represent the transition. The methods should have metrics that are timely and whose predictive power is undisputable. Under this section we will discuss two common methods that companies employ in order to determine the persistence of earnings. These methods are the cash accounting and the accrual accounting. (a) Cash accounting This method involves taking records of every cash inflow and outflow in the firm. This method of keeping an eye on the performance of the firm’s operations mainly concentrates on the finances more than any other factor in the firm. This method ensures that the transactions have been carried out in reality and the amounts that are involved are certain. However the only disadvantage of this method is that the measurement of the earnings may sometimes be unstable. For example, when new equipment which is to be used over a long period of time is obtained, recording it in the following periods may make earnings volatile due to the depreciation nature of the equipment. Therefore this makes the method a little bit irrelevant. (Dechow & Ge 2006) (b) Accrual accounting Accrual accounting method introduces the aspect of periodicity in determining the performance of the firm’s operations. This aspect requires that each transaction is assigned given specified period of time and is divided accordingly depending on the periods it covers. This helps in eliminating the volatility of earnings caused by the recording of equipment that are obtained and used continuously over a given period of time. The advantage of this method is that it considers revenues in the period in which they have actually been earned and also relates the expenses to the period in which they have actually been acquired. Moreover the metrics that result from this method are more relevant than those that result from the cash accounting method. (Chen, Folsom, Paek & Sami 2013) Comparing the reliability and the relevance of cash and accrual accounting in measuring the persistence of earnings - Relevance Reliability Cash Accounting Low, due to instability of earnings measurement High, because deals with completed transactions Accrual Accounting High, due to periodicity Low, because it relies on management\'s expectations Empirical evidence of an association between earnings persistence and earnings quality As it has been discussed earnings persistence is associated with the earnings quality. This is because when the earnings are persistent they are employed in offering inferences or support to such fields as the compensation contracts, debt covenant, equity valuation and report readability among others. Earnings persistence is associated with such fields because they provide reliable and sustainable persistence that is required in order to make proper predictions about the firm’s future operations. (Chen, Folsom, Paek & Sami 2013) Market participants such as investors and analysts are also dependants of the persistence of earnings in order for them to attain their goals. These participants are normally involved in making decisions based on predictions about the future conditions of a business or a firm. For them to be certain with their predictions they always have to ensure that the information depicted by the firm under consideration is quite reliable especially in terms of persistence. The major element for analysts and investors while carrying out their duties is the trend of a firm’s earnings. This makes it easy for the valuation processes on the firm. However it should be noted that sustainable and predictable persistence of earnings of any given firm do not always guarantee similar results in the future. (Chen, Folsom, Paek & Sami 2013) References Booms. The American Economic Review 76(3), 390-407. Chen, L H, Folsom, D M, Paek, W, & Sami, H, 2013: Accounting Conservatism, Earnings Persistence, and Pricing Multiples on Earnings Accounting Horizons, 282, 233-260. Choi, Y S, Lin, S, Walker, M, & Young, S, 2007: Disagreement over the persistence of earnings components: evidence on the properties of management-specific adjustments to GAAP earnings Review of Accounting Studies, 124, 595-622. Clinch, G, Fuller, D, Govendir, B, & Wells, P., 2012: The accrual anomaly: Australian evidence Accounting & Finance, 522, 377-394. counting Research 18(2), 524-550. Dechow, P M, & Ge, W, 2006: The persistence of earnings and cash flows and the role of special items: Implications for the accrual anomaly Review of Accounting Studies, 112-3, 253-296. Dichev, I D, & Tang, V, W, 2009: Earnings volatility and earnings predictability Journal of accounting and Economics, 471, 160-181. Dichev,I.D., Graham, J., and Rajgopal, S., 2012. Earnings Quality: Evidence from the Field. Doukakis, L, C, 2010: The persistence of earnings and earnings components after the adoption of IFRS Managerial Finance, 3611, 969-980. Karahan, F, & Ozkan, S, 2013: On the persistence of income shocks over the life cycle: Evidence, theory, and implications Review of Economic Dynamics, 163, 452-476. Lev,B., 1993. On the use of index models in analytical reviews by auditors. Journal of Ac- Rotemberg, J.J. and Saloner, G., 2009. A Supergame-Theoretic Model of Price Wars during Working paper July, 2012. Read More