Persistence of Earnings - Essay Example

Student Name: Tutor: Title: Persistence of Earnings Course: Persistence of Earnings Introduction Corporate managers show discretion in using generally accepted accounting principles. Firms with persistent earnings overtime have demonstrated better quality earnings (GAAP). Persistence is driven both by the firm fundamentals and by the accounting system and getting the difference between the impact of the two has been a challenge to researchers. The accounting system is influenced by participants to the process of financial reporting (Dechow, Ge & Schrand, 2010). Earnings persistence reduces gradually when moving from one expansion to a slow growth episode and then eventually to recession. The persistence of accrual and cash components of earnings follows the cycle of persistence in earnings. Sloan demonstrates that invests in a manner to suggest that they do not expect the lower persistence of earnings accrual component occasioning important security mispricing (Sloan et al, 2005). An interesting discovery is the prevalently documented feature of cash flows possessing more persistence relative to accruals is predominantly true in expansionary times. Both incentives and fundamentals can have an impact on earnings persistence. Higher quality earnings represent faithfully the features of the firm’s process of fundamental earnings that are relevant to a particular decision made by a particular decision-maker. Analysis of persistence of earnings literature Persistence of earnings describes the likelihood of that an earnings component or number will be repeated in the future. Persistence is a component of earnings that is permanent. Since investors have to have to predict future earnings for decisions about investment, earnings’ predictability is a desirable property. Predictability of earnings is measured using the estimated error variance obtained from the earnings persistence regression (Hee, 2008). The perception of earnings quality was conceived in the setting of growing evidence of management of earnings being documented by researchers. Earnings quality intuitively is high when earnings are not managed. Several earnings attributes like those based on the time-series properties such as predictability, persistence and variability constitute high quality. Since earnings can be differentiated into accruals and cash flows, some researchers apply accruals quality to draw meaning concerning earnings quality and conceptualize earnings quality as an increasing function of quality of accruals (Barron, Stanford & Yu, 2009). Some researchers refer to earnings to be of high quality when earnings are persistent. Some earnings are regarded to be of higher quality when the past earnings of a firm are strongly linked to its future cash flows. Earnings are also regarded as of high quality when bad news is detected in a timely manner and management of earnings is low. Bigger values of error variance translate to earnings that are less predictable (Sloan et al, 2005). Consistency within the time series shows the application of same accounting policies over time. Less reliable accruals result into lower earnings persistence. Earnings’ accrual component is less persistent as compared to the earnings’ cash flow component and this difference is attributed to more subjectivity of accruals. Less reliable accruals lead to less earnings persistence. Previous research has demonstrated that earnings volatility leads to the decline of predictability of earnings. Earnings are termed as high quality when they are anticipated to recur. This is when the present level of earnings is a good indication for the earnings to be expected in the years to come (Walker & Wang, 2003). This explanation does not exempt earnings from showing volatility over-time but it shows that such volatility has to be connected to predicted changes in future earnings. Stability defines high quality earnings showing low volatility over time. High quality earnings are often predictable. High quality earnings comprise of relatively small accruals or possess accruals that are strongly connected to the current, past or future cash flows. Whereas some of the views are related, they are distinct from one another and usually contain contradictory implications (Francis et al, 2004). For instance, fair value accounting: measuring liabilities and assets at fair value with unrecognized losses and gains contained in income can enhance the accuracy of earnings being a measure of change in value, but is likely to lead to reduction in the predictability and persistence of earnings. When firm managers smooth earnings over time they enhance the predictability and persistence of earnings but on the other hand weaken the correlation between cash flows and earnings because earning management is often achieved through accruals’ management. Smoothing of earnings over-time is a wide spread form of earnings management (Dechow, Ge & Schrand, 2010). The theoretical work relating to earning quality has explained earnings quality as being the precision of an accounting signal regarding fundamental or described high quality earnings as those earnings that are relatively permanent. Where earnings persistence is high the correlation is positive and stock returns drift in the same course as the changes in earnings. When persistence of earnings is low the correlation is negative and the stock returns change in the opposite direction as changes in earnings. This evidence shows that stock prices underreact to persistence earnings that are high and overreact to persistence earnings that are low (Sloan et al, 2005). One determinant of earnings statistical reliability is earnings persistence since earnings persistence dictates the revision in the anticipated future earnings that is suggested by present earnings innovations. Academics and practitioners have equated quality of earnings with the sustainability or persistence of earnings. This is owing to partly to the extensive application of multiple-based valuation whereby equity value is often estimated using a multiple on some measure of earnings like Earnings Per Share (EPS). A basic determinant of multiples for earnings is the perceived earnings’ persistence. The larger the multiple means higher the persistence. Higher earnings persistence shows that valuation that is multi-based is likely to occasion precise valuations since current earnings are a good indicator of earnings in future and hence a good demonstration of intrinsic value (Choi, O'Hanlon & Pope, 2006). High earning persistence alleviates uncertainty and assists in mitigating of information asymmetries between investors and insiders. There may be a reduction in the capital cost and an increase in the multiple. Investors and other market players are attentive to recurring expenses and revenues as compared to one-time occurrence items. This can prompt firms to equate one-time gains as being recurring revenues to offset expenses against gains. Whereas recurring expenses can be categorized as one-time losses. The disparity in return is huge for the low accrual firms but reduces and even reverses for firms with high accrual. High accrual firms will exhibit lower future earnings while firms with special items tend to exhibit higher future earnings (Bergstresser & Philippon, 2006). Hence for few firms reporting high special items and high accruals the two influences on future earnings could offset each other. When special items are associated with negative accruals they appear to be more useful for the prediction of future stock returns that are positive. The broad perception of earning quality that is often known as accounting quality is crucial since many choices in accounting that do not influence bottom-line earnings still provide a glimpse into future earnings, risk or cash flows (Hee, 2008). While measures of historical-cost of income emphasize on realized earnings from persistent key operating activities, gains and losses fair value are broadly uncorrelated over-time. Hence fair value income is not more informative concerning future income than historical-cost earnings. In extreme circumstances within the perfect fair value accounting, the market-to-market changes recognizes and anticipates in present earnings the entire value implications of present operations, hence future earnings reflect only future shocks affecting profitability hence not related to current earnings. Firms possess adequate discretion in measurement of earnings (Givoly & Hayn, 2000). In this regard a crucial determinant of earnings quality is the level to which earnings have been managed. Motivations for examining earnings persistence The informativeness of earnings is enhanced by firms that have smooth earnings. Smoother income help the reader in evaluating the firm’s future prospects through improving the significance of the information passed across for predictive purposes. For instance, if a firm previously demonstrated trend of erratic earnings, the ready may not be willing to rely on an income increase in the present year understanding that can be immediately be flowed by a decline in future (Givoly & Hayn, 2000). Low-type firms’ managers do not abandon their first best reporting strategy reflecting under-reporting income since their compensation would be diminished by the impact of taxation hence lowering the firm’s value. The cost of over-reporting present period income in the model is prompted by increased taxes. Firms exhibiting high-type characteristics can bear the higher taxes owing to their superior taxes (Barron, Stanford & Yu, 2009). Managers in charge of high-type firms are therefore motivated to lower asymmetry of information in order to raise expectations of the future value of the firm and consequently, their compensation. Studying a firm smoothing over a period of time is likely to enhance the capacity of participants in the market to infer the quality of the firm since smoothing over a long term is costly to lower quality firms. Managers furthermore smooth earnings in order to eliminate transitory items hence permitting investors to be in a better position to predict future cash flows and earnings. Firms in environments exhibiting huge economic shocks are likely to possess volatile earnings and less predictive earnings. The volatility of earnings that is reporting also reflects significant aspects of the accounting income determination that offers a link to predictability of earnings. Economic theory holds that shareholders can gain from earnings smoothness. Earnings smoothness declines the observed earnings variance that lowers the bankruptcy likelihood. This is importance to shareholders since it decreases the cost of borrowing and enhances the terms of trade of the company with its suppliers, customers, and employees. The consistent application of accounting policies is associated with higher, predictability, persistence, and smoothness of earnings together discretionary accruals estimates and accrual quality. Some earnings quality proxies are importantly influenced by accounting consistency. Consistency in the time series shows the application of same accounting policies over a period of time. Persistent earnings are usually sustainable earnings and are considered to be a higher quality. Persistent earnings can be projected with more accuracy than transitory earnings they form better inputs to valuation of discounted cash flow. Persistence earnings and its correlation to areas like compensation and equity valuation has been broadly studied in previous research. The literature has however disregarded the impact of macroeconomic factors on persistence of earnings. Changing incentives of firm managers and other participants to the process of financial reporting can also influence the earnings persistence behavior. Managerial incentives play an important role in influencing features of financial reporting and it is believable that these incentives alter over the business cycle (Walker & Wang, 2003). The significance of earnings prediction to financial statement analysis assumes that earnings would remain consistent if not for the economic problems and shocks in the determination of accounting income. Factors affecting the persistence of a firm’s earnings The mechanisms by which economic cycles influence the value relevance of earnings are disparities in persistence of earnings and they have been the subject of immeasurable scrutiny. High accrual firms possess high earnings persistence as compared to that of cash flows, and accruals and cash flows are negatively correlated (Dichev & Vicki, 2008). Low accrual firms possess low earnings persistence as compared to that of cash flows, and accruals and cash flows are positively correlated. Special items play a critical role in substantiating the lower persistence of earnings within low accrual firms. The persistence of both earnings and cash flows varies depending on the magnitude of accruals indicating that firms having extreme accruals are operating in business environments that are more volatile. Persistence of earnings is affected by the sign and magnitude of accruals (Hee, 2008). Accruals enhance the persistence of earnings in relation to cash flows within high accrual firms, but decrease earnings persistence within low accrual firms. This is true to investors’ misconception of the transitory nature of the special items. Further evaluation divulge that special item-low accrual firms exhibited poor performance, were financially distressed and shows declining recognition by investors (Francis et al, 2004). Investors do not have faith the possibility of special item-low firms successfully turning themselves around. Variations in persistence of earnings along the business cycle can be attributed to changing incentives and firm fundamentals. The population of firms with negative earnings increases in the course of a recession. A basic reason for misrepresenting earnings by CEOs is to meet targets. Management and executives are largely governed as well as rewarded by their ability to meet targets. Some of these targets maybe earnings associated with stock prices, compensation, or debt covenants. Targets are not easily achieved in the course of transition from expansion to recession (Bergstresser & Philippon, 2006). Incentives for management of earnings are high in the course of the transition from expansion to recession for a firm. Conclusion Persistence of earnings dictates the quality of earnings. Earnings that show persistence over-time tend to be of high quality and more trusted by investors and other stakeholders. The predictability of the performance of a firm increases with the level of persistence of earnings. There is much literature concerning the persistence of earnings and its bearing on the quality of earnings. Whereas there are dissenting views with the regard to factors that affect the persistence of earnings. However, it is agreed investors’ confidence is enhanced by persistent earnings which indicate high quality earnings. It is easy and clearer to project into the future performance of the firm that exhibits persistent earnings as compared to a low accrual firm that shows fluctuating earnings. It is important for earnings to remain persistence and that is why managers look for ways to smooth earnings to ensure consistency. References Barron, O., Stanford, M., & Yu, Y., 2009, Further Evidence on the Relation between Analysts’ Forecast Dispersion and Stock Returns, Contemporary Accounting Research 26 (2), 329-357. Bergstresser, D., & Philippon, T., 2006, CEO incentives and earnings management, Journal of Financial Economics 80 (3), 511-529. Choi, Y., O'Hanlon, J. F., & Pope, P F 2006, Conservative accounting and linear information valuation models, Contemporary Accounting Research, 23(1), 73-101 Dechow, P., Ge, W., & Schrand, C., 2010, Understanding earnings quality: A review of the proxies, their determinants and their consequences, Journal of Accounting & Economics 50 (2/3), 344-401. Dichev, I.D., & Vicki W. T., 2008, Matching and The Changing Properties Of Accounting Earnings Over The Last 40 Years, The Accounting Review 83: 1425-1460. Francis, J., LaFond, R., Olsson, P., & Schipper, K., 2004, Cost of equity and earnings attributes, The Accounting Review 79, 967-1010. Givoly, D., & Hayn, C., 2000, The changing time-series properties of earnings, cash flows and accruals has financial reporting become more conservative?, Journal of Accounting and Economics 29, 287–320. Hee, K.W., 2008, Earnings Persistence of Restating Firms: Should All Earnings Restatements be Treated Equally? ProQuest, New York. Sloan, R.G., Richardson, S.A., Soliman, M.T., and Tuna, I., 2005, Accrual reliability, earnings persistence and stock prices, Journal of Accounting and Economics 39(3), 437-485. Walker, M., & Wang, P., 2003, Towards an understanding of profitability analysis within the residual income valuation framework, Accounting and Business Research, 33(3), 235-246. Read More