The Quality of Eranings, Governance and Future Stock returns in Europe. An Empirical Study

VI 
 
Abbreviations and Notations 
 
 
AP Accounts Payble t Current period
AR Accounts Receivable t-1 Prior period
BMK Benchmark E ( ) Expectational (forecasted) value
CA Current Assets αi,t Intercept in a regression analysis
CEO Chief Executive Officer ßi,t Beta
CFA Chartered Financial Analyst ∆ Change
CFI Investing Cash Flow ∑ Summation
CFO Operating Cash Flow Var Variance
CL Current Liabilities εit Error term
COGS Cost of Goods Sold Cov Covariance
CPA Charter Public Accountant T Time
DEP Depreciation N Number in sample
DI Discretionary Inventory Þ Correlation
DIO Days Inventory Outstanding
DSO Days Sales Outstanding
EMH Efficient Market Hypothesis
EPS Earnings per Share
EU European Union
GAAP Generally Accepted Accounting Principles
HPR Holding Period Return
i.e. Id est (that is)
IASB International Accounting Standards Board
IFRS International Financial Reporting Standards
INV Inventory
mo month
NetNCA Net Non Current Assets
NI Net Income
NOA Net Operating Assets
OCA Other Current Assets
OCL Other Current Liabilities
OLS Ordinary Least Square
p. Page
pp. Pages
Rev.Acc. Accelariting Revenue
RevMis Revenue Mistatement
RWH Random Walk Hypothesis
S&P Standard & Poor's
SEC Securities and Exchange Commision
SGA Selling,General, Administrative Expenses
TA Total Assets
Tot.Rev. Total Revenue
U.K. United Kingdom
U.S. United States of America
Un.Rev. Unearned Revenue
1 
Abstract 
European Regulation n. 1606/2002 introduced the mandatory requirement that 
countries in the European Community report their financial statements under 
International Financial Reporting Standards (IFRS) starting in fiscal year 2005
1
. This 
has been one of the most significant regulatory changes in accounting history with the 
aim to improve corporate transparency and financial reporting quality, which should 
ultimately benefit investors.  However, the debate on the merits of the new accounting 
system is still open and there is skepticism that a simple mandate of new accounting 
standards is sufficient to achieve more informative and transparent corporate reporting 
and more efficient capital markets.  
 
The main objective of the dissertation is to investigate the practice of opportunistic 
behavior by managers in compiling financial reports and its impact on investors 
(agency theory) through the links between the quality of earnings, corporate 
governance and future stocks returns (efficient market hypothesis). The empirical 
setting is that of Europe, given the challenges that this datasets presented until the 
introduction of IFRS and a uniform set of accounting standards. 
 
The presentation is that of three original articles which focus on three aspects of the 
main objective: 
 
1. The impact of a new accounting system (IFRS) on the quality of earnings to 
determine in which European countries it is possible to exploit the accruals 
mispricing to build outperforming stocks portfolios. 
2. The relationship between the accruals mispricing and industry affiliation across 
different European countries. 
3. The importance of corporate governance characteristics (independence and 
competence) to add value to the quality of earnings as a stock selection 
methodology. 
 
 
The results point to the importance for investment professionals to be careful about 
applying widely accepted U.S. based stock selection methodologies because Europe is 
a different context. In fact, the main conclusions of the dissertation are that: 
1. While earnings management decreased, the accruals mispricing is still present 
is some European countries (those with the highest number of institutional 
varibales indicating a higher probability of earnings management). 
2. The accruals mispricing is not present in all industries within the Euroepan 
dataset studied. 
3. Corporate governance quality matters and is linked to higher quality and higher 
future stock returns in the Netherland dataset. 
                                              
1
 Prior to 2005, each European country had its’ own body of local accounting standards. In fact publicly listed 
companies were listed on the stock exchanges of their respective countries and subject to national 
supervision and national accounting standards.
3 
Premise 
 
This dissertation is structured as the cumulative work of three original articles 
presented in a monograph form. In addition to the three articles, there is an 
introductory section (Chapter 1) and a conclusion (Chapter 5). Given that the articles 
are shown as originally submitted to journals and/or conferences and seminars, there 
are inevitable repetitions between the general introduction and parts of the articles 
(Chapters 2, 3 and 4). The first article (Chapter 2) is under review at the Journal of 
International Financial Management and Accounting (JIFMA), while all three articles 
have been presented at various international conferences including: 
 
• Mathematical and Statistical Methods for Actuarial Sciences and Finance, 
Universita’ Ca’ Foscari, Venice, April 2012 
• International Accounting Conference, Universita’ Ca’ Foscari, Venice, 
November 2011 
• AFFI PhD Workshop, Montpellier, France, May 2011  
• 18th Annual Conference of the Multinational Finance Society,Rome, Italy, 
June2011 
• EIASM 8th Corporate Governance Workshop, Brussels, June 2011 
• EIASM 5th Workshop on Accounting and Regulation, Siena, Italy, September 
2010 
• EIASM 7th Corporate Governance Workshop, Brussels, June 2010 
The dissertation has been edited by a professional English mother tongue.
4 
 
0 Introduction 
 
0.1 Problem Analysis 
 
In the investment management industry, it is common for investors, analysts and 
portfolio managers to focus on a firm’s bottom-line reported earnings as an indicator 
of a firm’s future performance. Their main interest is to assess a company’s ability to 
generate future cash flows using reported financial statements.From this perspective, a 
high quality earnings number is a good indicator of current and future operating 
performance and is a useful summary measure for assessing firm value. Such earnings 
are referred to in the accounting literature as “permanent earnings.” 
2
 However, it may 
be important to include other financial statement items in the evaluation process, 
because the rules of financial reporting havemanagerial discretion embedded in them. 
This discretion manifests itself with “numerous opportunities to make critical 
estimates of variables that can affect reported earnings.” These types of estimates 
made by management can bring both unintended and neutral errors as well as intended 
or strategic errors in the numbers that are reported.  Managers do havenumerous and 
varied incentives to “meet the numbers” and the discretion to manipulate earnings. 
This discretionary behavior can result in observable and measurable systematic biases 
in reported earnings, ultimately producing deterioration in earnings quality. Corporate 
accounting scandals of the 21st century are a clear example that such practicesare not 
all that uncommon and are evidence that “persistence and predictability” in earnings 
are not sufficient conditions of high quality. For example, in the case of Enron, 
                                              
2
Black (1980);Beaver (1998), Ohlson and Zhang (1998).
5 
whichhad consistently positive EPS surprises from 1998 to 2000,managers were 
hiding losses in special purpose entities. In hindsight, the earnings that appeared to be 
persistent and predictable actually were poor indicators of current performance, and 
failed to accurately annuitize the intrinsic value of the firm.  
 
Given that the purpose of accounting for a company is to convey complete and 
decision-relevant information about the financial and earnings position of the 
company, it is critical for portfolio managers and analysts to identify companies that 
could be manipulating earnings and that could, in a worst case scenario, result in 
bankruptcy and financial fraud. The importance of studying the “quality” of earnings 
in investment practice dates back to the seminal work of Sloan (1996) in the U.S., who 
documented an interesting anomaly associated with accounting accruals. This study 
found that current earnings performance was more persistent for companies with low 
levels of accruals, where accruals were measured as the difference between a firm 
accounting earnings and its underlying cash flow.Sloan’s results suggest that it would 
be possible to build superior portfolios by selecting stocks with low levels of accruals 
and higher quality of earnings. In the U.S., the accruals anomaly has been extensively 
studied and confirmed. In contrast to the U.S., evidence on the accrual anomaly in 
other developed countries is sparse and conflicting. There is disagreement in published 
studies about which international countries, if any, do exhibit it. A recent 
comprehensive literature review (Richardson et al., 2010) on accounting anomalies 
states that “only a few papers examine whether the accruals anomaly is globally 
generalizable and the findings from these studies are somewhat mixed.” What makes 
the international dataset a challenge is the fact that for years, companies domiciled in
6 
 
different countries, used different set of accounting principles in compiling their 
financial statements. In fact, Kaserer and Klinger (2008) criticize prior studies 
investigating the presence of an accruals mispricing in international countries, because 
these studies pool different countries with varying accounting systems. Given the cross 
sectional differences, mixing data under different accounting standards and rules found 
across countries, is not justified.  
 
 
0.2 Objective and Research Questions 
 
The focus of the dissertation is on the importance of “Earnings and Governance 
Quality” as a determinant of future firm existence and performance, in the context of 
European countries.  
Specifically, this research aims at contributing to the current unresolved puzzle in the 
literature with regards to the accruals mispricing in Europe and it is structured around 
the following three research questions, which will ultimately result in three original 
articles.    
Research Question n.1 
 
Following the suggestion that further research on a country by country basis is needed, 
we intendto investigate whether there is a difference in the presence and magnitude of 
the accruals mispricing in a sample of European countries before and after the 
introduction of Regulation No. 1606/2002, whichrequired all EU listed companies to
7 
prepare their consolidated financial statements in accordance with IFRS as of January 
1, 2005.  
In fact, the mandatory introduction of a uniform body of accounting standards 
constitutes an interesting setting for researchers because it allows investigating 
whether international harmonization has been accomplished. While the needs for 
international harmonization of financial accounting standards go back to 1973 with the 
creation of the International Accounting Standards Committee (IASC), researchers 
(prior to 2005) produced robust evidence on the number of obstacles to the creation of 
a uniform set of accounting standards for financial reporting purposes. Citing factors 
such as cultural, economic factors, differences in legal systems, capital markets, 
governance,Baker and Barbu, 2007, discuss the impediments to harmonization. 
Currently academics are still debating whether the introduction of mandatory IFRS 
reporting brings with it true harmonization. The research presented in this dissertation 
adds additional points of clarification on the question.  
 
Research Question n.2 
 
To investigate whether the degree of accruals mispricing is an industry specific 
phenomenon in a sample of European countries as represented in the S&P Euro 350 
Index.
3
 
                                              
3
Chan et al.,2006study the accruals anomaly in the U.S. and find that the predictive power of accruals should 
vary across industries depending on the levels of working capital.