by
Sonia Wasan
B.Com (Honors), Delhi University, 1990
C.A., Institute of Chartered Accountants of India, 1994
M.Com, Delhi University, 1998
August, 2006
A Dissertation
Submitted to the Graduate Faculty of the
Louisiana State University and
Agricultural and Mechanical College
in partial fulfillment of the
requirements for the degree of
Doctor in Philosophy
In
The Department of Accounting
ABSTRACT
A considerable body of evidence, both archival and experimental, suggests that accounting accruals are heterogeneously interpreted by investors. In this study, I examine whether the information asymmetry among investors arising from this heterogeneous interpretation, implied in these empirical results, affects transactions costs in the form of the bid-ask spread and its adverse selection component. I examine this impact both, in general, for all trading activity occurring for a firm over a continuous flow of information during the year and around the first release of accrual information for each quarter. The results of the study provide empirical evidence of a positive association between the adverse selection component of the bid-ask spread and accruals in the yearly analysis. The results of the quarterly event tests conducted both around earnings announcements and the 10-Q/K filing dates indicate that the increase in the adverse selection component of the spread is positively linked to the absolute magnitude of total accruals. Documenting the existence of such a real cost of accruals provides a transactions cost basis for understanding why cost of capital increases with accrual activity (Dechow et al. 1996, Francis et al. 2005) as well as suggesting that the information asymmetries associated with such activity merit serious attention of accounting policy makers.
INTRODUCTION
In this study, I investigate whether accounting accruals are linked with higher transaction costs in the form of bid-ask spread and its adverse selection component. My enquiry stems from considerable empirical evidence that suggests that accruals are heterogeneously interpreted across investors. Recent studies on the accrual anomaly first documented by Sloan (1996) have given conflicting results on whether different groups of investors can comprehend the pricing implications of accruals. While the presence of the accrual anomaly indicates that investors, on average, do not fully comprehend the lack of persistence of accruals, empirical evidence on exploitation of the anomaly by certain sets of informed investors such as, legally-defined insiders (Beneish and Vargus 2002), institutional investors (Lev and Nissim 2004), and short-sellers (Zhang and Cready 2003) suggests heterogeneous interpretation of accruals across investors resulting in exacerbated information asymmetry in the market. Since market microstructure literature (O’Hara 1995) states that higher information asymmetry leads to high transactions costs, I investigate whether high magnitudes of accruals are associated with higher transaction costs as evidenced in the bid-ask spread and its adverse selection component.
The accrual anomaly documented by Sloan (1996) has spawned considerable research among academicians. Specifically, Sloan (1996) demonstrates that the market, failing to anticipate the lack of persistence of accruals, tends to over-value (under-value) stocks with high (low) accruals, thereby, causing the accruals to be mispriced in the current period. This mispricing corrects itself in the subsequent periods so that the future period stock returns are negatively related to current period accruals. Consequently, he demonstrates that a hedge portfolio formed by taking a long (short) position in stocks with low (high) accruals yields significant positive abnormal returns for a period of up to three years.
Extant literature on the accrual anomaly has investigated the anomaly from two perspectives – first, the nature of the anomaly and the firm-specific factors to which the anomaly may be attributable, and second, the capital market consequences of accruals. While the literature on the capital market consequences of the anomaly mainly focuses on the pricing implications of accruals and investigates whether different sets of investors comprehend the accrual information, the impact of accruals on the information environment and consequently, on the transaction costs incurred by investors while dealing in securities, has generally remained a neglected area of research. This study investigates whether the heterogeneous interpretation of accruals documented in prior research manifests itself in exacerbated information asymmetry in the market as evidenced in wider bid-ask spread and its adverse selection component.
The research on the nature of the anomaly documents several firm-specific factors that may be responsible for the mispricing of accruals. Xie (2001) finds that much of the accrual mispricing is attributable to abnormal accruals. Collins and Hribar (2000) demonstrate that the anomaly holds not just for the annual data but also for the quarterly data. Furthermore, they find that it is different from the post earnings announcement drift documented in prior literature (Bernard and Thomas 1989). Desai et al. (2002) suggest that the accrual anomaly may be a manifestation of the glamour anomaly depicted by Lakonishok (1994). While Fairfield et al. (2003) indicate that the accrual anomaly may not be distinct from the well documented growth anomaly characterized by the negative relation between return on assets and the growth in long-term operating assets, Richardson et al. (2003) contend that it is the growth anomaly that may be an extension of the accrual anomaly, since the long-term operating assets used to measure the growth anomaly can also be categorized as accounting accruals. Chan et al. (2001) document that much of the accrual mispricing can be explained by the changes in inventories and the discretionary component of accruals. Zach et al. (2003) find that though a significant portion of the accrual mispricing may be ascribed to corporate events, book-to-market ratios and the stock exchange listings of the firms, much of the anomaly still remains unexplained.
The research on the capital market consequences of accruals has provided conflicting evidence on whether different categories of market participants comprehend the valuation implications of accruals. DeFond and Park (2001) find that the market only partially comprehends the accounting information contained in accruals. Bradshaw et al. (2001) demonstrate that neither the auditors nor the analysts signal to the investors the future declining performance of firms reflected in the current period accruals. Richardson (2003) finds no conclusive evidence on whether the short-sellers manage their trading activity based on the knowledge of the mispricing of accruals. However, Zhang and Cready (2003) depict that the speculative short-sellers take short positions for firms with large income-increasing accruals and profit from their mispricing. Beneish and Vargus (2002) provide evidence suggesting that insiders use their superior knowledge of extreme accruals to exploit the accrual anomaly profitably.
Studies on the analysts behavior vis-ā-vis accruals generally suggests that the analysts fail to account for the economic information contained in high levels of accruals in their forecasts. Ali et al. (2001) find that accrual mispricing is more pronounced for firms that have a high analyst following and a large percentage of institutional holdings. Teoh and Wong (2002) show that the analyst failure to account for the decreasing future earnings implied in the current period accruals contributes to the mispricing of stocks by investors. Abarbanell and Lehavy (2003) demonstrate that the analyst failure to comprehend the accounting information contained in extreme accruals partially explains the bias and the inefficiency in their forecasts. Barth and Hutton (2004) also find that the analysts fail to comprehend or convey the lack of persistence of accruals in their forecasts. Empirical evidence on institutional investor behavior suggests that institutional investors do comprehend and react to the knowledge of future declining performance contained in accruals. Balsam et al. (2002) show that the presence of institutional ownership leads to quicker comprehension of accruals in the market. Collins et al. (2003) find that the institutional investors comprehend and trade on their superior knowledge of accruals and help mitigate some of the accrual mispricing. Lev and Nissim (2004) document that not only do the institutional investors trade in a timely manner to the mispricing of accruals, their magnitude of accrual-related trading also is increasing with time.
While the presence of accrual mispricing indicates that investors, on average, do not fully comprehend the lack of persistence of accruals, empirical evidence on exploitation of accrual mispricing by certain sets of informed investors such as, legally- defined insiders (Beneish and Vargus 2002), institutional investors (Collins et al. 2003, Lev and Nissim 2004), and short-sellers (Zhang and Cready 2003) suggests heterogeneous interpretation of accruals across investors resulting in exacerbated information asymmetry in the market. To the extent these better-informed investors are trading on the basis of superior insights on accruals that are not shared by other investors, their profit-making imposes trading losses on specialists and other suppliers of liquidity. Market microstructure literature (O’Hara 1995) suggests that the specialists, being relatively uninformed, tend to price-protect themselves by widening the spread in response to the losses suffered in dealing with these better-informed investors. In summary, if empirical evidence suggests that the accrual anomaly represents a form of mispricing that is profitably exploited by a subset of sophisticated traders, such exploitation should manifest in the form of wider bid-ask spreads and their adverse selection component.
I study whether accruals exacerbate information asymmetry by examining whether accruals are positively linked to the bid-ask spread and its adverse selection component. Market microstructure directly links the adverse selection component to the perceived level of information asymmetry in the market. Furthermore, I examine the association between accruals and spreads both in a long-term, non-event setting and around the point in time when the quarterly accrual information is first released to the investors. While the long-term association study examines whether firms with high magnitudes of accruals are associated with wider spreads, the quarterly event study investigates whether the increase in spreads around the first release of accrual information is positively related to the magnitude of accruals. Since it is not clear when the information is first released, I structure the event study tests both around earnings announcement and the filing of 10- K/10-Q report.
Using a sample of 5,377 firm-year observations for the sample period 1994-2001, I find empirical evidence suggesting that the adverse selection component of the spread is increasing in the absolute magnitude of total and abnormal accruals. The total spread also is also found to be positively related to abnormal accruals after controlling for the endogeneity between accruals and spreads (Richardson 2000). The results of the event study are quite consistent with those of the yearly study. Empirical evidence in the quarterly event study indicates that the increase in the adverse selection component of the spread both around earnings announcements and the 10-Q/K filling dates is significantly positively related to the absolute magnitude of total accruals. The association between the abnormal adverse selection component and abnormal accruals is positive but insignificant in the event study.
However, contrary to the main hypothesis of the study, I find a negative association between total accruals and the total spread both in the yearly analysis and the quarterly event study. One interpretation of these results is that the other two components of the spread, namely, the order processing cost and the inventory holding cost, move in a direction opposite to the adverse selection component and subdue the information asymmetry effect of accruals on the total spread. Krinsky and Lee (1996) document that while the adverse selection component of the spread is found to increase during earnings announcement, the other two components of the spread, namely, the order processing cost and the inventory holding cost, decline during the same period. They conclude that the total bid-ask spread may not be an accurate measure of information asymmetry in the market.
An alternative explanation to the negative association between accruals and the bid- ask spread may lie in the overall decline in the total spreads resulting from the reduction in tick size introduced in 1997. Goldstein and Kavajecz (2000) document that spreads have declined by a total of 14.3% after the NYSE passed a rule to bring down the minimum variation in the spreads from 1/8th to 1/16th of a dollar per share. If total spreads decline and adverse selection costs remain constant then adverse selection costs as a percentage of total spread would increase and thus the correlation between total spread and its adverse selection component is likely to be negative. It is plausible that an increase in the magnitude of accruals stimulates an increase in the adverse selection component of the spread. But the negative correlation between the total spread and its adverse selection component dominates or overshadows the positive impact of accruals on the adverse selection component, i.e., accruals and the adverse selection component may be positively linked to each other but both these variables may be negatively related to the total spread.
This study contributes to the existing literature on capital market response to accruals by demonstrating that high magnitudes of accruals exacerbate information asymmetry as evidenced in higher adverse selection component of the spread.
Documenting the existence of such a real cost of accruals provides a transactions cost basis for understanding why cost of capital increases with abnormal accrual activity (Dechow et al. 1996, Bhattacharya 2002, Francis et al. 2005). Francis et al. (2005) interpret this association as arising from non-diversifiable information risk (Easley et al. 2002) but they acknowledge that the association could arise from non-information sources of priced risk. The empirical evidence of a positive association between accruals and the adverse selection component of the spread suggests that some measure of the positive linkage between accruals and cost of capital may be attributable to the informational inequalities resulting from heterogeneous interpretation of accruals.
Furthermore, the information asymmetries associated with the accrual activity merit serious attention of accounting policy makers. According to Lev (1998, p.1), “information asymmetries across investors lead to adverse private and social consequences: higher transaction costs, thin markets, lower liquidity of securities, and in general decreased gains form trade. Such adverse consequences of inequity can be mitigated by a public policy mandating the disclosure of financial information in order to reduce information asymmetries.”
The remaining sections of the paper are organized as follows: Section 2 describes the prior literature on accruals and the spreads. Section 3 explains the development of the hypotheses. Section 4 discusses the sample selection and the descriptive statistics of the data. The research methodology adopted to test the hypotheses is described in Section 5. Section 6 documents the empirical results and Section 7 concludes the paper.
No comments:
Post a Comment