La Finca de La Concepción

Managers use accruals to manipulate earnings if the underlying economic earnings are not in a desirable trend. The opportunity to manipulate exists if managers have incentives and if investors do not fully incorporate the earnings manipulation into the stock price.

Moreover, if fundamental business conditions affecting economic earnings growth are better than anticipated for winner firms over the one to six month period, then the earnings growth will be expected to be excessive which leads stock prices to go up. This seats winner firms among ‘return momentum winners’. On the other hand, disappointing growth that is potentially negative for a firm over the one to six month period leads to earnings falling in the next period. Loser firms among ‘return momentum losers’ continue over the seven to twelve month period to manipulate earnings towards accruals to maintain losers. In addition, the managers of winners experiencing mean reversion may manipulate earnings upward to create positive earnings surprises. In contrast, in loser firms experiencing mean reversion option compensation motivations may make management manipulate earnings downwards to continue their status as losers. Thus, they defer earnings gains to take their benefit in the next compensation cycle period.

Two main empirical assumptions follow the hypotheses mentioned above. First, there is a relationship between returns and earnings, and it is expected that past returns

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are positively correlated with future earnings management. This implication comes straightforwardly from the existing hypotheses that winner and loser firms attempt to keep the return pattern from the one to six month period in the seven to twelve month period using discretionary accruals. The other assumption is that returns over the seven to twelve month period are positively related to current discretionary accruals for return momentum firms. The expectation is that positive or negative earnings management is used to create positive or negative earnings surprises. These surprises guide positive and negative returns so that a positive correlation between earnings management and returns is expected. In general, accruals can drive returns where the motivations are considered to continue the returns through earnings management.

In Chapters 5 and 6 empirical tests are performed to test these hypotheses. The tests focus on whether the data support the assumption that earnings for momentum firms provide the motivation to manage earnings in the seven to twelve month period. Earnings management is not reflected in earnings surprises and investors cannot use other measures like the return on asset (ROA) ratio to distinguish the use of earnings management. However, these variables are used as control variables in further analysis and empirical tests.

In Chapters 6 and 7, some methods for testing the hypotheses will be used. The first method employs linear regression. To test the hypothesis, a regression is run between discretionary accruals and past returns and other independent variables. According to the main regression, if the returns are explained by earnings management, then it is expected that a positive relation will be found between accruals and earnings.

The second method is presented in Chapter 7. Past returns are categorized and then analysed by looking at whether returns of winner or loser firms have higher or lower discretionary accruals over the seven to twelve month period. For testing the hypothesis,

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dependent classification is used. First, tests are run on past returns to identify winners and losers, and then on consecutive discretionary accruals. Subsequently, it is seen whether there is a positive correlation between firms engaging in earnings management and their returns over the seven to twelve month period.

As stated in the literature review, there is less supporting argument for the motivation for earnings management by losers than by winners. The results are expected to be less supportive for the loser hypothesis than for the winner hypothesis. This research does show linear relations between discretionary accruals and stock returns.

The conservative view in accounting is that profits should be more persistent than losses, because financial statements do not recognise unverifiable increases in profits when they occur; rather they are recognised over future periods as and when the cash flows generating those increases are realised. For example, if an asset value increases because it is expected to throw off more future cash flows, then the profit will be recognised over the next several years. This implies that gains tend to be persistent. Otherwise, firms with positive earnings or earnings changes are likely to have recognised gains, and positive earnings and increasing earnings are also likely to be persistent.

Companies with negative or decreasing earnings are more likely to have recognised losses. According to Watts (2003), these losses do not recur in future periods; negative earnings and earnings decreases are less likely to be persistent compared with positive earnings and earnings increases, because those negative earnings and earnings decreases are transitory. The amount that persistence or transience of earnings and earnings changes are considered provides a measure of conservatism.

Skewness and variability are defined as two measures of conservatism of earnings distribution. Distribution of returns on assets, whether derived from a time-series of

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individual firms or the cross-section of firm-years, is skewed negatively for most of the periods that have been examined by Givoly and Hayn (2000). They demonstrate that there is a significant increase in firms reporting losses on and a decline in the accounting rate of return on assets with increased skewness which indicates increased conservatism over time.