Transcript Earnings Management and Stock Repurchases

The Credibility of Stock
Repurchase Signals
Chao Chen
Min-Ming Wen
Information Hypothesis
Asymmetric information” or “signaling
story”:
A signal that the firm’s stock price is
significantly undervalued



Vermalen (1981, JFE)
Dann and DeAngelo (1983, JFE) document
that stock
Ikenberry, Lakonishok and Vermalen (1995,
JFE)
Alternative Observations
• Bartov (1991, JAE)
Jagannathan and Stephenes
(2003, FM)
• Grullon and Michaely (2003, JF)
• Huang, Liano, and Pan (2003)
• Zhou and Lin (2004)
• Kahle (2002, JFE)
Credibility of Repurchase Signals



Stock repurchase signals are cheap to make,
because firms do not need to follow up on
their announcements. (The Wall Street
Journal and Fortune)
Billett and Xue (2003), false signal with the
subsequent seasoned equity offerings
Kim, Schremper, and Varaiya (2004), the
least stringent regulation on execution and
disclosure of repurchase
Research Questions




Do firms really do what they announced?
Can it be a false repurchase signal sent by
managers who intend to benefit from it due
to their employee stock options ready for
exercise or other self motivated activities?
Is there any link between stock repurchase
and earnings management?
Do firms with earnings management have a
higher probability of leaving repurchase
program incomplete?
Measures of Credibility and
Earnings Management


This study uses whether a firm
completed its repurchase program as a
measure of the credibility of repurchase
announcement.
Following Teoh, Welch and Wong
(1998a, b), we use discretionary
accruals as a measure of earnings
management
Completed v.s Incompleted


Completed repurchase program-- if the
shares that the board wants to repurchase
under the authorization have been
repurchased.
Incompleted repurchase:
(i) Temporarily suspended by the board
(ii) the repurchase authorization is withdrawn
by the board
Incomplete Repurchase

A typical repurchase program lasts for three
years (Stephens and Weisbach 1998)

Incompleted status means that up to
January 2003, firms that had announced
repurchase programs between 1995 and
2000 did not complete the repurchase.
Hypothesis 1: Earnings
management neutral hypothesis


Based on the information hypothesis, if a
firm announces its intention to
repurchase stock, the firm should be
neutral on earnings management.
Thus, the discretionary current accruals
before and after the announcement of
stock repurchase will be indifferent.
Implications

A rejection of the null hypothesis:
(i) is in favor of the existence of earnings
management prior to the announcement of
stock repurchases
(ii) indicates that stock repurchase firms shift
future earnings prior to the announcement.
(iii) ROA will be negatively correlated with
pre-stock repurchase discretionary current
accruals
Hypothesis 2: Managerial
entrenchment hypothesis

If top managers decide to leave the
stock repurchase program incomplete,
the negative effect of earnings
management prior to repurchase
announcements on future earnings
changes will be more severe.
Implication
Following hypothesis 2 and the rejection
of hypothesis 1
=> if a firm has a greater incentive of
manipulating earnings, the credibility of
stock repurchase can be lower so that
the probability of leaving the repurchase
program incomplete is higher.

Data and Sample




The Securities Data Corporation’s (SDC)
Worldwide Merge and Acquisition database
Firms made the repurchase initial
authorization between 1995 and 2000.
COMPUSTAT data up to 2002
Non-financial firms
Data and Sample

Panel A of Table 1 presents the number of
firms initialized repurchase programs in each
sample year and the frequency and
percentage of completed v.s. incompleted
repurchase.
Table 1
1995
Completed(i)
Frequency Percent
75
44.4%
Incomplete(ii)
Total
Frequency
Percent
94
55.6%
169
1996
128
53.8%
110
46.2%
238
1997
124
46.4%
143
53.6%
267
1998
136
31.0%
303
69.0%
439
1999
83
29.1%
202
70.9%
285
2000
53
21.4%
195
78.6%
248
Methodology
(1) Earnings management model
Following Teoh, Welch, and Wong (1998a, JF,
1998b, JFE) methodologies.
(2) Logistic Model

Methodology

Cross-sectional regression of the change in return
on asset (∆ROA) in year 1 and year 2 on variables in
year –1:
∆ROAi, t+j=α1+δ1 DCAi, t-1 +δ2 NDCA i, t-1 +δ3
(OCF/TA) i, t-1 + δ4 (MV/TA) i, t-1 + e i, t+j
∆ROAi, t+j (j=1 or 2) = α1+ δ1TotalCAi, t-1 + δ3
(OCF/TA) i, t-1 + δ4 (MV/TA) i, t-1 + e i, t+j
Empirical results
Testing earnings management hypothesis
Table 2
I.
Table 2
Year
-2
NI
DCA
NDCA
OCF
1521
1454
1493
1519
NI
DCA
NDCA
OCF
6.562a
0.581
3.267a
11.198 a
NI
DCA
NDCA
OCF
6.980a
0.199
0.950a
10.543 a
-1
0
1
2
Observation
1625
1646
1540
1213
1574
1599
1500
1177
1609
1486
1534
1208
1625
1635
1540
1213
Mean
6.716 a 5.479 a 3.712 a 3.754 a
0.946b
1.101a
-0.207 -0.528b
2.796a
0.839a
0.899a 1.040a
10.458 a 10.108 a 10.155 a 9.923 a
Median
7.192 a 6.409 a 5.166 a 4.825 a
0.355a
0.353a
-0.101 -0.498a
1.059a
0.660a
0.511a 0.509a
11.254 a 10.676 a 10.419 a 10.337 a
Implications of Table 2


DCA > 0 if t =-1, 0; DCA < 0 if t =1,2
Consistent with Bartov (1991), Jagannathan
and Stephenes (2003), and Grullon and
Michaely (2004)
Results of Table 2 suggest the possibility that
earnings management exists among the
firms intended to buyback their shares.
Regression results:
Table 3 Panel A:
Intercept DCA
NDCA
OCF
MV
R2
ADJR2
N
F
∆ROAi,t+1
-0.01
(-1.35)
-0.04
(-1.21)
-0.11a
(-3.09)
-0.07a -0.04a 0.036
(-3.40) (-6.14)
0.033 1301 12.05 a
-0.15a -0.03 0.040
(-5.43) (-1.43)
0.036 1018 10.48 a
∆ROAi,t+2
0.01
(0.41)
-0.16a
(-2.92)
-0.23a
(-3.93)
Results Table 3


Non-discretionary current accruals, operating
cash flows, and size have a significantly
negative effect on the changes of returns on
asset one year after repurchase.
Discretionary current accruals inversely and
significantly affects the post-repurchase
performance of firms.
Results:
Complete v.s. Incomplete

Results of imposing equation (5) on the
completed and incompleted groups
Empirical Results


Comparisons of post-stock repurchase
announcement ROA of completed and
incompleted groups
Table 4A: the descriptive statistics of firm
size and repurchase contents (number of
shares and the percentage of targeted
shares) of completed and incompleted
firms
Table 4 Panel A
Descriptive Statistics of Repurchase Shares and Percentage of
Targeted Repurchase Shares
Group
Shares(i) Percent Total assets
(ii)
Mean
6.37
7.86
(iii)
Completed
Incomplete
3400386
3584094
Completed
Standard Deviation
Shares Percent Total assets
6854995
5.32
10973.93
Incomplete
8093569
6.52
2694.86
2222.50
11093.14
Intercept
Table 4 Pane B Regression Results
DCA
NDCA
OCF
MV
Completed
∆ROAi,t+1
a
0.03
-0.04
-0.35a
(3.08) (-0.84) (-4.45)
∆ROAi,t+2
0.03b
-0.11
-0.25a
(2.37) (-1.36) (-2.65)
Incomplete
∆ROAi,t+1
a
-0.02
-0.08c
-0.04
(-3.13) (-1.75) (-1.10)
∆ROAi,t+2
-0.01
-0.20a
-0.19b
(-0.90) (-2.82) (-2.32)
ADJR2
N
F
-0.18a
(-4.16)
-0.03
(-1.29)
0.07 492 10.78 a
-0.27a
(-4.79)
-0.08a
(-2.75)
0.08 428 10.37 a
-0.05b
(-1.99)
-0.03a
(-5.13)
0.03 809
7.35 a
-0.16a
(-3.05)
-0.01
(-0.38)
0.02 590
4.35 a
Results: Table 4B
(1) Incomplete firms: significant negative
effects of earnings management prior to
repurchase announcements on both
∆ROAi,t+1 and ∆ROAi,t+2
(2) Completed firms: discretionary current
accruals prior to repurchase announcements
have insignificant negative effects on both
∆ROAi,t+1 and ∆ROAi,t+2.
Table 5
Comparison of ROA of the complete and incomplete repurchase groups
ROA
(Complete)
% ∆ in
ROA(ii)
ROA
(Incomplete
)
%∆ in ROA
ROAGroup(i)
(t-2)
0.0871
(t-1)
0.0949
Median
t0
0.0880
t+1
0.0727
t+2
0.0660
0.0806
8.96%
0.0827
-7.27%
0.0680
-17.39%
0.0501
-9.22%
0.0396
2.61%
-17.78%
-26.32%
-20.96%
1.22%a
2.00%a
2.26%a
2.64%a
0.65%a
(t-2)
0.1025
(t-1)
0.1130
Mean
t0
0.0923
t+1
0.0826
t+2
0.0694
0.0968
10.24%
0.0606
-18.32%
0.0664
-10.51%
0.0416
-15.98%
0.0351
0.57%
(0.13)
-37.40%
5.24%a
(2.77)
9.57%
2.59%a
(2.88)
-37.35%
4.10%a
(4.75)
-15.63%
3.43%a
(3.18)
(i) ∆ ROAGroup = ROA (Complete) – ROA (Incomplete)
(ii) % ∆ in ROA = [ROA(t+i) – ROA(t+i-1)]/ROA(t+i-1), i = -1, 0, 1, 2.
Methodology-- Logistic model

To link the probability of leaving a
repurchase program incomplete and the
incentives of earnings management
Logit Model




Logit (p) = log (p/1+p) = α + ß’ x
p -- the probability of leaving a repurchase
program incomplete and defined as Pr (Y = 1
| x ), Y =1 if the repurchase program is
incompleted, Y = 0, otherwise
x is a vector of explanatory variables
(i) pre-stock repurchase discretionary current
accruals, (ii) the number of shares firms
intended to buyback, (iii) firm size, (iv) debt
ratio, (v) whether the firm disclose the
funding source of repurchase.
p = e ßX/(1+eßx).
Table 6 Logistic Regression Model
Variables
Parameters
Estimate
Chi-Square
Intercept
DCA(t-2)
DCA(t-1)
DCAt
DCA(t+1)
NDCA(t-1)
OCF(t-1)
0.020
-0.176
19.381c
-1.881
16.134
2.152
0.215
0.006
0.451
2.993
1.087
0.611
0.035
0.271
PercentShare
DE(t-1)
lnTA(t-1)
Dummy
0.052a
0.014
-0.041
0.470a
17.774
0.113
1.375
14.456
Empirical Results:
Logistic regression model
(1) firms with higher pre-stock repurchase
discretionary accruals tends to have
significantly higher probability leaving the
repurchase program incomplete.
(2) Higher discretionary accruals prior to the
stock repurchase suggest a greater incentive
of managing earnings.
(3) A linkage between the probability of
conducting earnings management and the
probability of leaving repurchase program
incomplete.
Conclusions
The earnings management
inversely and significantly affects
the post-repurchase performance
of firms with incomplete
repurchase programs.
 Stock repurchase may be a false
signal and the firm’s value may
actually be overvalued

Conclusions

firms with higher pre-stock repurchase
discretionary accruals tend to have
significantly higher probability leaving
the repurchase program incomplete.
Methodology

Current accrual (CA) model :
CAi,t = [ARi,t + INVi,t + OCAi,t ] - [APi,t + TPi,t + OCLi,t ] (1)

Discretionary and nondiscretionary
accruals for a given year,
CAi ,t
TAi ,t 1
= a0 ∙
1
TAi ,t 1
+ a1∙
Sales i ,t
TAi ,t 1
+ εi,t (2)
Methodology
CAi,t = the current accruals of firm i at year t,
ARi,t = accounts receivables,
INVi,t = inventory,
OCAi,t = other current assets,
APi,t = account payable,
TPi,t = tax payable, and
OCLi,t = other current liabilities.
Salesi,t = the change in sales from the
previous year (t-1) for firm i.
TA = Total Assets
Methodology
Nondiscretionary current accruals (NDCA) :
Sales  AR
1
a
NDCAi,t = a ∙ TA + ∙
(3)
TA

^
^
0
i ,t
i ,t
1
i ,t 1
i ,t 1
ARi,t = the change in account receivable in year
t for firm i.
a and a are the coefficients estimates from
equation (2)
^
0
^
1
Methodology
The scaled discretionary current accruals (DCA) :
CA
DCAi,t = TA
- NDCAi,t
(4)
i ,t
i ,t 1
DCAi,t is used for the proxy of earning
management
Equations for Accruals









Total Accruals = Changes in Net Operating Assets (NOA)
=(NOAt – NOAt-1)/NOAt-1
NOA = Operating Assets (OA) – Operating Liabilities (OL)
OA = Current Operating Assets + Non-current OA (NCOA)
OL = Current Operating Liabilities (COL) + Non-COL
(NCOL)
COA = Current Assets (CA) – Cash and Short Term
Investments (STI)
NCOA = Total Assets (TA) – CA – Investments and
Advances
COL = CL – Debt in Current Liabilities
NCOL = TL – Current Liabilities – Long-term debt
SG = sales growth = (Salest – Salest-1) - 1