3 LA ORGANIZACIÓN INTERNACIONAL DEL TRABAJO.

As described in the literature review, managers are extremely interested in maintaining growth in income because their compensation is often linked to their firms’ profits (Chan et al., 2006). The research also shows that if a firm has fallen short of earnings expectations, this can immediately affect its stock price, while firms that beat expectations are attractively rewarded by investors. The focus on earnings is so strong that is suggested that the market focus on firms’ bottom line income is to the detriment of other indicators of operating performance.

Chan et al. (2006) examine the power of accruals regarding stock returns by considering three steps. First, they test the operating performance of firms with high and low accruals. Their research follows whether the timing of changes in accruals coincides

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with the timing of changes in underlying profitability, by applying methods with indicators such as sales turnover. Second, they test the individual components of accruals, such as accounts receivable and inventories. Some items offer an opportunity for managers to have more discretion (e.g. relating to the timing of revenue recognition). Therefore, focusing on such items may highlight the effects of manipulation.57 Third, they decompose accruals into discretionary and nondiscretionary components and examine the information in each component for returns. Their findings show that accruals are negatively related to future stock returns, as documented by Sloan (1996). In addition, Chan et al. show that the nondiscretionary component of accruals, constructed by assessing past trends in sales and accruals, cannot predict future returns. Sloan (1996) finds that stocks with large positive accruals (increases in net income) in a given year tend to have low returns in subsequent years; these stocks have an average size-adjusted return of 5.5% in the following year. Collins and Hribar (2000) repeat these results with quarterly accruals. One important interpretation of these results is that large positive accruals are a sign of earnings management, but investors are not aware of this and are misled into believing that future profitability will stay at a high level. A large number of researchers examine whether mispricing can be linked to the portion of accruals that reflects opportunistic managerial behaviour, defined as discretionary accruals. Jones (1991) provides a model to identify the discretionary and nondiscretionary components of accruals. With regard to this model, Subramanyam (1996) and Xie (2001) show that discretionary accruals predict returns, but they do not find evidence that nondiscretionary accruals predict returns. Thomas and Zhang

57_{Hribar (2000), and Thomas and Zhang (2002), for instance, focus on the relation between inventory}

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(2002) examine the importance of the different components of working capital changes. Teoh et al. (1998a, 1998b) demonstrate a negative relationship between discretionary current accruals and subsequent stock returns for companies issuing new stock, as well as all non-issuing companies.

Chan et al. (2006) provide a method to predict returns using earnings by considering accruals as a measure of the quality of earnings. They classify stocks at the end of each April over the sample period into one of five categories on the basis of earnings surprises, and at the same time, stocks are independently classified into quintile groups on the basis of accruals. Afterwards, they make an intersection of these two classifications, prepared across 25 categories58; stocks are equally weighted within each group.

6.8 Summary

This chapter describes a model to test hypotheses. The regression model provides the link between stock returns and other relevant variables. Furthermore, this chapter, discusses two

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They provide annual buy-and-hold returns in the first year after portfolio formation. Size and book-to- market adjusted abnormal returns are computed as follows: each April, Chan et al. (2006) calculate quintile break points for size (market value of equity) on the basis of NYSE stocks. Since the bottom quintile of firms contains a disproportionately large number of firms (mostly NASDAQ stocks), they divide this group into two subgroups (the first and second deciles of the distribution of firm size). Accordingly, there are six categories by firm size. Furthermore, Chan et al. (2006) calculate quintile break points for the ratio of book- to-market value of equity. The intersection of these two classifications gives 30 groups, and buy-and-hold returns are calculated for equally weighted portfolios of the stocks within each group. Underlying where a stock falls given the size and book-to-market break points, one of these portfolios is assigned as a control. Chan et al. then compute abnormal returns for a stock as the difference between its raw return and the return of the control portfolio.

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hypotheses that result from the research questions. According to these hypotheses the relevant independent variables are sales growth, discretionary accruals, standard unexpected earnings. Also, control variables are size and book-to-market. In addition, this chapter gives an explanation of the regression models and the variables employed in the study.

The next chapter (Chapter 7) includes the results of testing the relation between returns and earnings management. In addition, the chapter discusses a comparison of the results with those from prior studies. Finally, the limitations and implications of the research are given, and the potential for further research.

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Chapter 7