Accounting for Generated vs. Contributed Change in the Enterprise Value
Peter Easton
Center for Accounting Research and Education
University of Notre Dame
Peter Vassallo
Australian School of Management
University of New South Wales
Eric Weisbrod
School of Business Administration
University of Miami
March 2015
We thank Bill Beaver, Demetris Christodoulou, Mincherng Deng, Joseph Gerakos, Aloke Ghosh, Adel Ibrahim,
Steve Lilien, Steve Monahan, Sundaresh Ramnath, Theodore Sougiannis, Oktay Urcan, Terry Walter, Bill Wright
and seminar participants at Baruch College, the University of Illinois at Urbana-Champaign, the University of
Miami and the University of Sydney for helpful comments on an earlier draft.
Abstract
We demonstrate, both analytically and empirically, that the manner and degree to which the
accounting system records change in enterprise value depends upon both the sign (positive vs.
negative) and source (generated vs. contributed) of the value change. Absent accounting
conservatism, the accounting measure, enterprise profit after tax, equals the cum-distribution
change in enterprise market value generated during the period (i.e., generated value change).
Changes in enterprise value can also occur through contributions from/distributions to the
owners of the firm (i.e., contributed value change). We show that accounting conservatism
differentially records these two sources of value change, leading to differences between
accounting and market-based measures of enterprise performance. Our empirical approach
identifies both conditional and unconditional conservatism in the same regression framework.
This allows us to identify empirical manifestations of accounting conservatism that are quite
different from those in the extant literature.
Keywords: Accounting Conservatism, Firm Growth, Free Cash Flows, Earnings Return Relation
2
1. Introduction
The focus of our paper is on the recording of changes in the market value of a corporate
enterprise in the financial statements of the corporation. We use the word “enterprise” to identify
the entity owned by the equity and debt holders, which engages in the firm’s primary revenuegenerating activities.1 From the perspective of the owners of the enterprise, a key measure of
investment performance, or investment growth, is the change in market value generated by the
enterprise before taking into account contributions from/distributions to owners during the
period. We refer to this measure as EVg, Enterprise Value Generated. By comparison, the
accountant’s corresponding cum-distribution measure of the performance of the enterprise is
enterprise profit after tax (EPAT). Prior literature suggests that, due to accounting conservatism,
negative EVg (i.e., a decrease in enterprise value) is more likely to be recorded in EPAT than
positive EVg (i.e., an increase in enterprise value).2 A key premise of our paper is that accounting
conservatism may also affect the way EPAT treats contributions from/distributions to the owners
of the firm (i.e., enterprise cash flows, ECF).3 Because of this, the relation between EPAT and
1
We follow the terminology of Gode and Ohlson [2013] to distinguish between enterprise activities and financing
activities. Enterprise activities are sometimes referred to as operating activities in practice. See Appendix A.1:
Terminology for a quick reference of common terms employed in the paper. Enterprise/operating activities include
activities such as research, development, purchasing inputs, production, marketing, and distribution of products and
services (e.g., coffee in the case of Starbucks, passenger miles in the case of United Airlines, and brand-name
household consumer products in the case of Procter and Gamble).
2
This argument is usually attributed to Basu [1997], who focused on the relation between earnings and cumdividend change in equity. We focus on the relation between enterprise profit and cum-dividend change in the value
of the enterprise because we argue and show that most conservatism occurs at the enterprise/firm level rather than at
the equity level.
3
The variable, which we label enterprise cash flow, ECF, is often referred to as free cash flow. We, like Gode and
Ohlson [2013], use the term enterprise cash flow because we feel it is more descriptive and more encompassing;
e.g., it includes contributions from the owners of an acquired company where the acquisition currency is shares in
the newly-formed enterprise (e.g., the 2006 acquisition of Gillette by Procter and Gamble). Several textbooks on
financial statement analysis and valuation calculate free cash flow using precisely the same method as we follow in
this paper for calculation of ECF; see, for example, Easton et al. [2015], Penman [2012], Wahlen et al. [2015], and
Gode and Ohlson [2013]. Our calculation of this variable amounts to the same calculation as seen in other texts
such as Damodoran [2012] and White et al. [2003], where earnings after taxes are adjusted for accruals and for
capital expenditure. To see the equivalence, note that changes in accruals are in both EPAT and change in book
value of net enterprise assets (ΔNEA) and capital expenditure is part of ΔNEA; the calculation, ECF = EPAT - ΔNEA
the change in market value of the enterprise (ΔEV) depends not only on whether enterprise
performance is positive or negative, but also on changes in enterprise value due to transactions
with owners during the period.
We demonstrate, both analytically and empirically, that the manner and degree to which the
accounting system records ΔEV in EPAT and ΔNEA (change in the book value of net enterprise
assets) depends upon both the sign (positive vs. negative) and source (EVg vs. ECF) of value
change. In principle, if all value generated by the enterprise during the period was realizable and
verifiable, and enterprise transactions with owners of the firm were treated similarly by investors
and accountants, EPAT would be equal to EVg, and ECF would provide no incremental
explanatory power for EPAT.4 In practice, however, markets often incorporate unverifiable
changes in unrealized enterprise value, and accountants often expense value-enhancing
investments from owners, which are instead capitalized by investors.5
Our empirical analyses are based on a regression of the accountants’ measure of change in
enterprise value (EPAT) on the market measure of value generation/loss (EVg) and a measure of
net contributions from/distributions to the owners of the enterprise (ECF), with each of these
variables deflated by beginning-of-year enterprise value (EV). We show that estimates of the
coefficients relating EPAT to EVg and EPAT to ECF vary in predictable ways according to the
signs of ΔEV (i.e., increase vs. decrease in enterprise value), EVg (i.e., internally generated
removes the accruals from EPAT and the remainder is “free cash flow.” In our empirical analyses, EPAT and ΔNEA
are calculated following the appendix to Nissim and Penman [2001], who refer to these variables as operating
income and net operating assets. We use the terms enterprise profit after tax and net enterprise assets to underscore
the focus on the entity (the enterprise), which is owned by the equity and debt holders.
4
This effectively implies that the accounting would be mark-to-market for all enterprise assets (including such
things as human capital, asset synergies, etc.).
5
EPAT may also differ from EVg in the treatment of distributions made to owners. For example, if enterprise assets
are liquidated to provide for distributions to owners, ECF will provide incremental explanatory power for EPAT
when the book value of liquidated assets differs from fair market value (via the gain or loss on sale recorded in
EPAT).
2
growth vs. contraction), and ECF (i.e., cash provided by vs. cash distributed to the owners of the
enterprise).
We also demonstrate that ECF provides significant incremental explanatory power for EPAT
beyond EVg, and that the mapping from EVg to EPAT depends on the sign of ECF. Our results
show that, in most cases, the association between ECF and EPAT is as large as, and sometimes
larger than, the association between EVg and EPAT. We find that, on average, a one standard
deviation change in ECF (EVg) is associated with approximately a 0.27 (0.24) standard deviation
change in EPAT. In other words, we show that accounting measures of enterprise performance
are often more strongly associated with transactions between the enterprise and its owners during
the period than with value generated by the enterprise during the period.
To understand this result, we note that financial statements capture the entire amount of the
net contributions from/distributions to the owners of the firm (ECF), in either the income
statement (i.e., EPAT) or as change in the book value of net enterprise assets (i.e., ΔNEA), in the
fiscal period in which the contribution/distribution is made. Value generation/loss (EVg) is,
however, captured in EPAT in the fiscal period in which the value is generated/lost only to the
extent that the expected change in value is realized during the period; the remaining value
generation/loss, which is captured in change in the market value of the enterprise, reflects
changes in expectations about future profitability.
In any instance where the financial statement treatment (e.g., capitalization vs. expensing) of
ECF differs from the market valuation of ECF, EPAT will differ from EVg, and the extent of the
difference will depend on the nature of ECF. For example, suppose that R&D is highly
successful and results in increased sales in the current year and several future years; enterprise
3
value will increase by an amount equal to the present value of the expected net benefits from the
R&D in the period in which the R&D expenditure occurs. In contrast, under U.S. GAAP, the
full cost of the R&D will be expensed in EPAT in the period in which the R&D expenditure
occurs, while only the portion of the increased sales from R&D that accrue in the current year
will be captured in EPAT of the current period. The deferral of the future benefits from R&D will
decrease the coefficient on EVg in our model, while the accelerated expensing (relative to
market) of the ECF invested in R&D will increase the coefficient on ECF in our model. Indeed,
in our empirical analyses, we interact EVg and ECF with multiple measures of asset tangibility,
including R&D and advertising intensity, and consistently find that the coefficients on EVg
(ECF) decrease (increase) with measures of the enterprises’ investment in intangibles.
Our empirical analyses lead to several key conclusions: (1) conditional and unconditional
accounting conservatism (as defined in the extant accounting literature) interact to determine the
mapping from EVg to EPAT;6 (2) consistent with the notion of conditional conservatism, only
the portion of EVg that relates to creation of value within the fiscal period is reflected in EPAT of
the fiscal period -- a greater portion being captured in current EPAT when EVg is negative (i.e.,
value is lost); (3) consistent with the notion of unconditional conservatism, ECF is completely
captured in the accounting record (in either ΔNEA and/or EPAT) in the period in which the
contribution is made, but the accounting treatment (i.e., the portion of ECF recorded in ΔNEA vs.
EPAT) depends on the use of contributed funds;7 and, (4) the mapping from EVg and ECF to
ΔNEA and EPAT varies with a number of enterprise characteristics including; a) intangibles
6
We define and elaborate on the terms conditional and unconditional conservatism in section 2.
If the ECF expenditure is in a non-zero NPV activity, this NPV will be captured in EVg but not in EPAT of the
period (unless the non-zero NPV effect affects EPAT of the current period), contributing to a coefficient relating
EPAT to EVg that is less than one. This is the form of conservatism modelled by Feltham and Ohlson [1995] and
described empirically by Easton and Pae [2004].
7
4
intensity, b) capital intensity, c) the amount of debt, and d) the ratio of the book value of the
enterprise to the market value of the enterprise.
Our paper is related to the extant literature falling under the oft-used label, “conservative
accounting”, which has followed two paths: (1) studies of conditional conservatism focusing on
the different mapping of earnings to returns conditional on the sign of returns; and, (2) studies of
unconditional conservatism focusing on the pre-determined understatement of earnings. The
conditioning variable in the extant conditional conservatism literature is cum-dividend change in
the value of equity whereas our conditioning variable is cum-free cash flow change in the market
value of the enterprise; our conditioning variable brings the focus to the firm/enterprise where
the transactions that are recorded in the accounting system occur. Our conditioning variable also
recognizes change in the value of debt as a potentially important element of generated value.
Our analysis of the accounting for net contributions by the owners of the enterprise captures
ideas that are implicit in studies of unconditional conservatism. We demonstrate that
unconditional conservatism affects the mapping between earnings and market returns both in the
cross-section and over time due to variation in the amount of capital contributed by/distributed to
owners each period as well as cross-sectional variation in the uses of invested capital. Further,
we extend prior literature by capturing both forms of conservatism in the same regression
framework.
Our inclusion of an analysis of the effects of change in value due to both EVg and ECF,
contributes to the extant literature, which has afforded little attention to the analysis of
5
accounting for changes in value via ECF.8 This is particularly important in the empirical
literature on conditional accounting conservatism (also referred to as asymmetric timely loss
recognition), which, as far as we are aware, has not considered the accounting for this form of
change in market value at all.9
The remainder of the paper proceeds as follows. We begin, in section 2 by describing and
providing reasons for our dissection of change in enterprise value into generated value change
vs. contributed value change. We show that the accounting for generated value change in
income is the same as the accounting for this source of value change on the balance sheet and
only a portion of generated value change is recorded in the financial statements of the current
period. On the other hand, the entire amount of contributed value change is either expensed in
income or capitalized on the balance sheet. We provide two illustrations: contributed value
invested in R&D and distributed value from the sale of property, plant, and equipment.
Section 3 describes our empirical method and predictions. We describe our sample selection
procedure in section 4 and we provide and discuss selected descriptive statistics.
Section 5 analyzes and compares partitions of the data based on whether enterprise value is
increasing or decreasing and on the source of this value increase/decrease; we provide evidence
8
Penman and Yehuda [2004] is one of the few examples. Penman and Yehuda focus on the value relevance of free
cash flow (i.e., analysis of the relation between change in the value of the enterprise and free cash flow), which
differs from our focus on the accounting for change in enterprise value via free cash flow (i.e., we analyze the
relation between free cash flow (labelled ECF in our analyses) and the recording of this free cash flow in the
financial statements). Collins et al. [2014] observe that the manifestation of asymmetric timeliness in cash flow
from operations adds noise or bias to tests of conditional conservatism. There are two vast differences between
Collins et al. and our study. First their focus is on cash flow from operations, while our focus is on ECF. Second,
their focus is on eliminating cash flow effects from measures of conditional conservatism, while we demonstrate that
including ECF in regressions of EPAT on EVg allows researchers to capture conservatism in the accounting
treatment of contributions from/distributions to owners.
9
Much theoretical work has been done on generated vs contributed change in enterprise value and conservatism
(see, for example, Zhang [2000], Easton [2009], and Ohlson [2009]) but we are unaware of empirical work on this
issue.
6
from analyses of a 2 x 2 x 2 partition of the data (i.e., increase vs. decrease in enterprise value,
internally generated growth vs. contraction, and cash provided by vs. cash distributed to the
owners of the enterprise).10 We show that the recording of generated and contributed value varies
considerably across these partitions and that the direction of enterprise cash flow (growth
through cash inflow and contraction via cash outflow) affects the amount of generated value
change that is recorded in current enterprise profit after tax, EPAT. Finally we show that a large
portion (sometimes most) of the association between EPAT and change in the market value of
the enterprise is due to contributed value change during the period (enterprise cash flow),
hitherto largely ignored in the extant literature, rather than enterprise value generated during the
period.
In Section 6, we examine whether the empirical manifestation of change in enterprise value
in the financial statements differs as expected across firm-year characteristics. To summarize,
we predict and show that, when there is cash inflow during the period, the estimates of the
coefficients relating EPAT to ECF, increase (decrease) with investment in R&D and advertising
(capital expenditures). On the other hand, when there is value generated, the estimates of the
coefficients relating EPAT to EVg decrease (increase) with investment in R&D and advertising
(capital expenditures). These results are consistent with conservative accounting principles such
as the immediate expensing of investments in R&D and advertising (accompanied by the
deferred recognition of the benefits of R&D and advertising) compared with the capitalization,
depreciation, and subsequent gain or loss recognition on investments in fixed assets. These
aspects of accounting conservatism are captured only indirectly in the Basu framework.
10
The two empty sets are those with: (1) positive ΔEV and negative EVg and ECF outflow: and (2) negative ΔEV
and positive EVg and ECF inflow.
7
We also examine the effect of debt on the degree of accounting conservatism observed in
financial statements, which has been a focus of prior literature (see, for example, Ball, Robin,
and Sadka [2008] and Kahn and Watts [2009]). Consistent with this literature we find that the
coefficient relating EPAT to EVg increases with leverage. Finally, we examine the effect of
balance sheet conservatism (proxied by the enterprise-level book-to-market ratio) on our
measures of conservatism in EPAT. We find that more conservative balance sheets are associated
with more conservative income statements (and vice versa).
Section 7 presents a summary and conclusions.
2. Change in Enterprise Value and Conservative Accounting
2.1.
Sources of Change in Enterprise Value and Links to the Extant Literature
Our empirical analyses incorporate the key elements of a vast empirical literature on
accounting conservatism. Our emphasis on: (1) the enterprise, which is the entity for which
accounting transactions are recorded; (2) change in the market value of the enterprise; and, (3)
sources of change in market value of the enterprise, permits analyses of the key elements of the
extant literature within one framework.
The extant empirical literature takes two primary approaches/perspectives -- the study of
conditional conservatism and the study of unconditional conservatism. Ryan [2006, p. 511]
describes these approaches as follows:
Conditional conservatism involves the more timely recognition of bad news than good
news in earnings (often referred to as asymmetric timeliness), as occurs with impairment
accounting…Conditional conservatism is distinct from unconditional conservatism,
which involves the predetermined understatement of the book value of net assets, as
occurs with the immediate expensing of the costs of most intangibles.
8
Prior literature has largely focused on conditional conservatism and on the news-dependent
nature of accounting. For example, Ryan [2006, p. 513] goes on to state that “Basu does not
perceive unconditional conservatism to have any usefulness in contracting because of its newsindependent nature.” Similarly, Ball, Kothari and Nikolaev [2013] state that the key difference
between conditional and unconditional conservatism is that conditional conservatism carries new
information.
Our focus on change in the value of the enterprise instead hones in on factors that will affect
current and future enterprise profitability and the recording of the related transactions in
enterprise earnings of either the current period or future periods. Some of the changes in the
market value of the enterprise are reflected in the accountant’s measure of change in value, and
others are not. Our perspective is that earnings record transactions in the current period while
change in the market value of the enterprise captures the effect of changes in expectations related
to transactions of the current period as well as changes in expected future transactions. This
perspective is, in principle, very similar to that of Basu, but differs subtly inasmuch as our focus
is on earnings recording the transactions themselves whereas Basu’s perspective is that earnings
records (or fails to record) the information about generated value creation/loss that is (at the
same time) reflected in the prices of equity shares. Our perspective also captures a source of
conservatism analyzed by Feltham and Ohlson (1995) – the existence of positive NPV projects.11
11
Easton and Pae [2004] is an empirical analysis of accounting conservatism as modelled by Feltham and Ohlson
[1995]. Following the form of earlier studies, where returns are the dependent variable as in Easton and Harris
[1991], rather than the independent variable as in Basu [1997], Easton and Pae [2004] argue and show that, when
enterprise cash flows and lagged net enterprise assets are added to a regression of returns on earnings and earnings
changes: (1) a positive coefficient on enterprise cash flows captures conservatism associated with
investments in positive net present value projects, the effects of which will not flow into the accounting
statements until the expected future benefits are realized; and (2) a positive coefficient on change in lagged
net enterprise assets implies accounting conservatism associated with the application of accounting rules to net
enterprise assets in place. Our results are consistent with those in Easton and Pae [2004] although our method is
quite different; and much more akin to the current literature on conditional and unconditional conservatism.
9
They point out that a firm may be perceived to have the opportunity, in expectation, to undertake
strictly positive NPV projects. Such projects do not affect earnings in the current period but the
same is not true for change in market value of the enterprise.
The impetus for change in the market value of the enterprise is either, events that affect the
current and future profitability of enterprise assets in place, or contributions from/distributions to
the owners of the firm. We view change in market value (which is akin to the conditioning
variable in the conditional conservatism literature) as a manifestation of the internally generated
change in value, which is or is not recorded in current earnings, rather than as the impetus in and
of itself for accounting conservatism.12 As an important aside, we recognize that change in the
market value of debt is also a manifestation of enterprise value change.13 Put another way,
generated value will be reflected in change in the value of the enterprise, and some of this value
change will be recorded in the current earnings of the enterprise; that is, the conditioning variable
is enterprise value change.
Externally sourced (contributed/distributed) change in enterprise value has not been
considered in the literature on conservative accounting and fits best into Ryan’s description,
“pre-determined understatement of earnings,” whereby, for example, contributions used to fund
12
Some examples of generated value change (growth) include increases in expected asset turnover or profit margin,
new product developments, increased brand recognition, and increased growth options due to weakening of
competition or increases in the size of the economy as a whole. Stated differently, we define generated value change
as any increase in the market value of the enterprise beyond the value change (growth) due to cash inflows from
owners during the period. Similarly, a generated decrease in enterprise value could be driven by the same economic
factors cited as growth examples. Notably, our definition of generated growth includes growth from what
Roychowdhury and Watts [2007] refer to as “rents” and Ball Kothari and Nikolaev [2013] label as the g component
of stock returns (which is associated with “revisions in the value of growth options or un-booked intangibles”).
Generated value change may also be associated with the investment of ECF (i.e., contributed growth) in non-zero
NPV projects, modelled in Feltham and Ohlson [1995].
13
Empirically, and as expected, much of generated growth is captured in change in the market value of equity. This
is due to the fact that the equity holders are the residual claimants to the value of the enterprise; they reap most of
the benefits of growth and pay much of the cost of contraction because the return to debt holders is largely through
contractual payments. As a practical empirical matter, our estimate of generated value change (growth) is highly
correlated with equity returns.
10
capital expenditure will be capitalized while those used to fund R&D will be expensed. Thus, by
focusing on the enterprise rather than equity and considering the separate and joint manifestation
of generated and contributed change in value we are analyzing the effects of both conditional
conservatism (mostly via the recording of generated value change) and unconditional
conservatism (mostly via the recording of contributions/distributions).
2.2.
The Empirical Manifestation of Change in Enterprise Value in the Financial
Statements; Accounting Conservatism
Our empirical analyses are based on a regression of EPAT on the corresponding market
measure of enterprise value generation/loss (EVg) and a measure of net contributions
from/distributions to the owners of the enterprise (ECF), with each of these variables deflated by
beginning of year enterprise value (EV). Conservatism will be manifested in the coefficient
relating EPAT to EVg being less than one or the coefficient relating EPAT to ECF being greater
than zero because, absent conservatism, EPAT = EVg.
Change in enterprise value, ΔEV is estimated as the sum of the market value of equity plus
the market value of debt (estimated as the book value of debt). Net contributions, ECF, are
calculated from the income statement and balance sheets as enterprise profit after tax, EPAT,
minus the change in net enterprise assets, ΔNEA. Generated value creation/loss, EVg, is
calculated as the sum of ΔEV and ECF; i.e., EVg is the change in the market value of the
enterprise before net distributions to/contributions from the owners of the enterprise
(alternatively this variable may be described as the cum-free cash flow increase in the market
value of the enterprise, which is analogous to the cum-dividend change in the market value of
equity).
11
The identity, ECF = EPAT - ΔNEA captures the fact that the sum of the effects of a dollar of
contributions/distributions on the income statement and the balance sheet will be one dollar.
Cash inflow from the owners of the firm will be used to pay expenses of the period or invested in
an enterprise asset, which will be expensed (i.e., depreciated) in future periods as the investment
generates future sales. Re-writing the identity as EPAT = ECF + ΔNEA, highlights the fact that,
in the absence of conservatism in accounting (i.e., ΔNEA = ΔEV), EPAT = ECF + ΔEV.
Accounting conservatism will be manifested in ΔNEA less than ΔEV and a correspondingly
higher EPAT; e.g., when ECF is spent on R&D, the corresponding ΔNEA is, ceteris paribus, zero
and EPAT = ECF, yet ΔEV equals ECF.
The identity, ECF = EPAT - ΔNEA also makes it clear that, absent ECF, EPAT will equal
ΔNEA; that is, value generated/lost via the enterprise assets in place will, unlike
growth/contraction via contributions from the owners of the enterprise, have the same effect on
the income statement and the balance sheet. The difference between the accounting for
generated value change and value change via ECF may be illustrated by continuing the R&D
example. Value creation due to the success of R&D may affect current sales and hence current
EPAT as well as future sales and profitability; the only effect on current ΔNEA will be through
current EPAT; the portion of generated value that is captured in both the income statement and
the balance sheet will be the same and will range from none if all of the benefits of the R&D
accrue in future periods to one if all of the benefits accrue in the current period.
As another example, consider generated value change which enhances/reduces the usefulness
of enterprise assets; again, the only effect on current ΔNEA will be through current EPAT (i.e.,
the portion of generated value change that is captured in both the income statement and the
12
balance sheet will be the same). But there is an asymmetry in the recognition of enterprise value
increase vs. enterprise value decrease in both the income statement and in the balance sheet.
Only the portion of value increases that affects current profitability is captured in current EPAT
and current ΔNEA whereas expenses (write-downs and restructuring charges) associated with
reduction in expected future profitability (i.e., value decreases) will be taken in current EPAT
and current ΔNEA. This is the form of conservatism investigated by Basu and characterized as
“recognize losses in value immediately but recognize gains in value with a lag.”
To summarize, our perspective on conservative accounting introduces accounting for ECF as
well as generated value creation/destruction, EVg; this perspective adds to the literature because
these ECF effects have, by and large, not been hitherto considered in the empirical accounting
literature, and they matter. Our perspective also focuses on the enterprise as a whole, which is
the entity where transactions that are recorded by accounting arise.
3. Empirical Method and Predictions
We begin with a simple relation between the accounting measure of the change in
enterprise value and the change in the market value of the enterprise:
it =
it
eit
Then, we note that
its owners,
it
(
it
(A)
it
has two components: (1) net distributions from the enterprise to
to the owners of the enterprise is signed positive while
it
from the
owners of the firm is signed negative) and, (2) generated change in the value of existing assets of
the enterprise
it .
That is:
13
it =
it
Substituting for
(B)
it
it
it =
in (A):
it
it
eit
(C)
This relation motivates our core regression:
it
= α10t + α11t
α12t
it
ε1it
(1)
That is,
it
it
= α10t + α11t
it
= α10t + α11t
it
it
= α10t + α21t
it
α12t
α12t
it
ε1it
it
1
ε1it
That is:
where the variable
it
α22t
is calculated as
ε1it
it
+
(1a)
it .
it
is contributed value change and
is value change generated by the existing enterprise assets. In other words,
it
increase/decreases with positive/negative
it .
it
it
,
it
it
and increases/decreases with negative/positive
For expositional convenience in the remainder of the paper, we will refer to the variables
it
and
it
as EPAT, EVg and ECF.
14
Note that α11t
α21t ; i.e., the mapping from EVg to EPAT is the same as the mapping
from EVg to ΔNEA. Also note that α22t ‐α12t
1; i.e., ECF goes to/comes from either EPAT of
the period or a decrease/increase in net enterprise assets. Much of our analyses consider
partitions of the data according to the sign of ECF.
Absent conservatism, the accounting measure of value generated, EPAT, will be equal to
the market measure of value added, EVg, and it follows that the coefficient relating EPAT to EVg
will be one and the coefficient on ECF will be zero; but, with conservatism the estimate of the
coefficient on EVg may be less than one and the estimate of the coefficient on ECF may be
greater than zero. Conservatism in the accounting treatment of EVg will likely differ from
conservatism in the accounting treatment of ECF. We will discuss each form of conservatism
separately.
Internally generated increase in value (i.e., positive EVg) due to such things as
discovery of new technology, acquisition of new contracts, which may be serviced with the
existing enterprise assets, effective cost-cutting, re-investment of internally generated cash in
positive NPV projects, etc., may affect both current EPAT and future EPAT. The change in
enterprise value will reflect the present value of the effect of growth on current and future EPAT.
The relation between current EPAT and this internally generated value change (i.e., α21t ) will
depend on the extent to which the growth effect is expected to be more transitory (with a relation
that is close to one-to-one) vs. more permanent with a relation that is much less than one-to-one.
The effect of generated value change on NEA will be equal to the effect on EPAT.
Internally generated decrease in value (i.e., negative EVg) due to such things as loss of
comparative technological advantage, loss of market share, cost increases, etc., may affect both
15
current EPAT and future EPAT. Since these effects are more likely to be transitory rather than
permanent on average (otherwise the firm will go out of business), the relation between EPAT
and internally generated contraction (i.e., α21t ) is likely to be closer to one-to-one than the
relation between EPAT and internally generated value creation (i.e., positive EVg).
Further, generally accepted accounting principles place greater verification thresholds on
increases in value recorded in EPAT than on decreases in value recorded in EPAT, which can
also contribute to a greater portion of EVg being recognized in current-period EPAT when EVg is
negative.
In short, consistent with prior literature, we predict that the accounting system is more likely
to record internal contraction than internal growth (i.e., we will observe a higher coefficient α21t
for internal contraction). In other words, the accounting system records more of decreases in EVg
in the current EPAT than increases in EVg, consistent with the notion of conditional
conservatism.
If there is conservatism in the accounting treatment of ECF and there is no conservatism
in the accounting treatment of internally generated value increase/decrease (EVg) (i.e., there is no
reason why the difference between EPAT and EVg is systematically related to EVg), the estimate
of coefficient relating EPAT to EVg will be one and the estimate of the coefficient relating EPAT
to ECF will capture the conservatism in the recording of ECF in EPAT. We return to the R&D
example to illustrate this point.
In the absence of conservatism in the accounting treatment of ECF, EPAT = ΔNEA +
ECF = ΔEV + ECF. So, if we were to regressed EPAT on ΔEV and ECF in the absence of
16
conservatism, the coefficients would both be one. In regression (1a) we regress EPAT on ΔEV +
ECF (that is, EVg) and ECF; in the absence of conservatism, EPAT is identically equal to EVg
and it follows that the coefficient on EVg will be one and the other variable, ECF, can have no
incremental explanatory power (i.e., the coefficient relating EPAT to ECF will be zero).
Conservatism in the recording of ECF introduces variation in EPAT but does not affect
EVg. The effects of $100 of ECF invested in a zero NPV enterprise will be: (1) ΔEV + ECF =
$100 + (-$100) = EVg = 0; and, (2) R&D will all be expensed so that EPAT = - $100. ECF will
completely explain EPAT (because EVg is zero), with a coefficient of 1; i.e., EPAT = 1*0 + 1*($100).14 Suppose, however, that the R&D investment has positive NPV of $10, all of which is
recorded in current period sales, then the effects will be: (1) ΔEV + ECF = $10; and, (2) EPAT =
- $90. Now, EPAT = 1*$10 + 1*(-$100) = -$90. The R&D example is a most vivid example but
the logic follows for less conservative accounting actions (such as accounting depreciation being
greater than economic depreciation). Expanding this example further, suppose that there is
conservatism in the accounting treatment of ECF and in the accounting treatment of internally
generated value change; in this example this may mean that some of the effects of the positive
NPV is expected in future periods rather than in the current period and the coefficient on EVg
will be less than one.
As a further illustration, suppose that there is $100 of ECF outflow funded entirely by the
sale of a depreciated enterprise asset. If the book value and the salvage (sale) value are the same
(i.e., the accounting has not been conservative), EVg = EPAT=ΔEV + ECF =ΔNEA + ECF = $100 + $100 = 0 and EPAT = 1*EVg+0*ECF = 1*0 + 0*$100 =0. But, if the book value is
14
If partial capitalization of R&D was permitted under the accounting rules, the coefficient on ECF will be less than
one. For example, if only half of the R&D in this example was expensed, ΔNEA would be $50, EPAT would be $50, which would equal 1*0 + 0.5*(-$100) = -$50.
17
$50 (i.e., book value is depreciated beyond economic salvage value), ΔNEA = $50 and EPAT =
$50 because there is a gain on sale (i.e., EPAT = 1*0 + 0.5*$100).
4.
Sample Selection and Selected Descriptive Statistics
We obtain annual financial statement data from the Compustat (Xpressfeed) database for
fiscal years 1963 – 2012. We match this with stock return data from the CRSP database. The
sample period begins in 1963 in order to ensure data availability in Compustat and for
consistency with prior studies examining accounting conservatism (e.g., Basu 1997; Ball,
Kothari and Nikolaev 2013). We exclude foreign incorporated firms (we require that Compustat
FIC=USA), financial institutions (SIC codes 6000 – 6900), utilities (SIC codes 4900 – 4999),
observations with negative market value or total assets (potential data errors), and observations
with beginning-of-fiscal-year stock prices less than one dollar. We require that all observations
included in the sample have sufficient data available for the calculation of all variables in Table
1. To mitigate the influence of extreme observations on our results, we truncate observations that
fall in the top or bottom 2.5 percent of any of the variables included in the primary regression
equation (equation 1a) as well as price-deflated earnings and annual returns.
Table 1 provides descriptive statistics for our sample of 110,144 observations. Initial
evidence of conservatism in accounting is seen in the fact that the mean (median) change in
enterprise value as a percentage of opening enterprise value (ΔEV) is greater (0.109 (0.040)) than
the mean (median) change in the book value of the enterprise as a percentage of opening
enterprise value (ΔNEA) (0.056 (0.036)). The mean EPAT is less than the mean ΔNEA (0.040
compared with 0.056) and the mean (median) ECF is -0.016 (0.004). The mean (median) R&D
plus advertising (RDADV) is 0.047 (0.018) of enterprise value; 66.23 percent of observations
18
have non-zero (positive) R&D and advertising.15 Mean (median) capital expenditures are 0.080
(0.050) of enterprise value. The mean (median) ratio of the market value of net financial
liabilities to opening enterprise value is 0.126 (0.110) and 32.85 percent of sample observations
exhibit negative values of net financial liabilities, indicating that these observations have net
financial assets.16
Table 2 reports Spearman correlations among key variables. We discuss some highlights.
The correlation between our dependent variable EPAT and the dependent variable in Basu (X/P,
i.e., price scaled earnings) is 0.931 and the correlation between EVg and RET is 0.966. Thus, it
is not at all surprising that the estimates of our coefficient relating EPAT to EVg are generally
very similar to the estimates of the coefficient relating earnings to equity returns. As expected
the correlations between EPAT and EVg and EPAT and ECF are both positive (0.408 and 0.274)
and highly significant. The correlation between EVg and ECF is significantly positive (0.158);
that is, in general, higher generated value change is associated with more cash outflow. We will
refer back to this table when correlations among other variables become pertinent to subsequent
analyses and discussions.
5. Initial Empirical Analyses
The basic premise of our paper is that the accounting for change in the market value of the
enterprise depends upon the source of the value change. To shed light on this premise we first
examine samples of observations in which the value of the enterprise is either increasing or
15
This result is not tabulated.
That is, the equity holders own the enterprise and a “pile of cash” (as in Microsoft, for example). It follows that
calculating EV as MVE + NFL (where negative NFL implies net financial assets) remains valid.
16
19
decreasing. Then we further partition according to the source of increase/decrease in enterprise
value, resulting in a total of six sub-samples:
(1) Enterprise Growth, Value Creation, Net Cash Inflow (+ΔEV, +EVg, ECF in): there is growth
on every dimension (i.e., all is going well and there is a further injection of cash);
(2) Enterprise Growth, Value Creation, Net Cash Outflow (+ΔEV, +EVg, ECF out): the
enterprise is growing but there is net cash outflow (i.e., all is going well and there is a
removal of cash);
(3) Enterprise Growth, Value Loss, Net Cash Inflow (+ΔEV, -EVg, ECF in): the enterprise is
growing because of net cash inflow despite negative internal growth (i.e., the enterprise
growth is due to the injection of cash by its owners):
(4) Enterprise Contraction, Value Creation, Net Cash Outflow (-ΔEV, +EVg, ECF out): the
enterprise is contracting because net cash outflow is greater than value generated (i.e.,
generated growth is not large enough to replace the value that the owners are taking out of
the enterprise);
(5) Enterprise Contraction, Value Loss, Net Cash Inflow (-ΔEV, -EVg, ECF in): the enterprise is
contracting despite net cash inflow (i.e., the enterprise is fairing badly and there is an
injection of cash) and,
(6) Enterprise Contraction, Value Loss, Net Cash Outflow (-ΔEV, -EVg, ECF out): there is
contraction on every dimension (i.e., the enterprise is fairing badly and there is removal of
cash).
20
5.1.
Growth vs. Contraction
A summary of the results from estimation of regression (1a) for the entire sample of
observations and for the sub-samples with enterprise value increasing and with enterprise value
decreasing is provided in Table 3, Panel A. We also present results from the estimation of
earnings-return regressions to provide evidence of manifestations of conservatism that are
observed when taking our enterprise value change perspective but are not observed when
implementing the news/information perspective.
Since the results for the full sample are more or less an average of the results from the
enterprise value increasing and the enterprise value decreasing sub-samples, we focus our
discussion on the results for these sub-samples. There are two striking differences in the results
across these sub-samples. First, the estimate of the coefficient relating EPAT to EVg is not
significantly different from zero for enterprises that are increasing in value (-0.001 with a tstatistic of -0.07) while this estimate is significantly positive for the enterprises that are
decreasing in value (0.141 with a t-statistic of 14.41).17 That is, none of the generated increase in
value is captured in contemporaneous EPAT while 14.1 percent of the enterprise value loss is
captured in contemporaneous EPAT. Second, the estimates of the coefficients relating EPAT to
ECF are quite similar for each of the groups of enterprises (0.192, with a t-statistic of 11.18, for
enterprises with increasing value and 0.179, with a t-statistic of 8.94, for enterprises with
decreasing value). That is, conservatism in the reporting of ECF in EPAT is similar across
enterprises that are increasing in value and for enterprise that are decreasing in value, on average.
17
t-statistics reported throughout our analyses are calculated using two-way clustered standard errors, clustered by
firm and year.
21
In Panel B of Table 3, we present the results of the Basu-style regression of earnings on
returns with a dummy variable capturing the sign of the return. The results are similar to those in
the extant literature; the estimate of the coefficient on returns when returns are positive is not
significantly different from zero (0.018 with a t-statistic of 1.25) and the estimate of this
coefficient when returns are negative is significantly positive (0.182 with a t-statistic of 9.13).
For comparison, we also run a Basu-style regression at the enterprise level. We regress EPAT on
EVg interacted with a dummy variable capturing the sign of EVg. The results are quite similar to
those in the earnings on returns regression. The estimate of the coefficient on EVg is not
significantly different from zero (-0.009 with a t-statistic of -0.98) and the estimate of this
coefficient when returns are negative is significantly positive (0.189 with a t-statistic of 14.89).
The higher t-statistic on negative EVg and the slightly higher adjusted R2 (0.148 cf. 0.137)
relative to these statistics in the regression of earnings on returns are consistent with our
motivation to examine the enterprise as a whole, which is the entity where transactions that are
recorded by accounting arise.
Throughout our analyses, we also report the number of negative return observations in each
estimation sample. While the full sample is roughly equally split between positive and negative
return observations, observations within sub-samples (1) – (6) are either almost all positive
(when EVg is positive) or almost all negative (when EVg is negative) consistent with the high
correlation between EVg and RET reported in Table 2.18 Due to the homogenous nature of
returns within each sub-sample, we report, in the analyses that follow, simple regressions of
earnings on returns for each sub-sample (as opposed to piecewise asymmetric timeliness
regressions), and then compare earnings/return coefficients across sub-samples.
18
Results are qualitatively very similar if we run regressions with only the positive return observations when EVg is
positive and with only negative return observations when EVg is negative.
22
5.2.
Sources of Change in Enterprise Value
Descriptive statistics and regression results for each of the six enterprise value change
sub-samples are summarized in Table 4. Panel A presents descriptive statistics for the subsamples. Panel B presents simple Spearman correlations. Panel C presents regression results
from estimating regression (1a). Panel D reports the results from a regression of earnings on
returns along with the number of negative return observations in each sub-sample.
(i)
Enterprise Value Change and Value Generation
We begin with a comparison of the two sub-samples of observations where the enterprise
value is increasing and there is value generated from the existing enterprise assets (i.e., subsamples (1) and (2). The results for these sub-samples are summarized in the first two columns
of Table 4. In sub-sample (1), with 26,020 observations, the owners have contributed to the
enterprise value change via ECF inflow while in subsample (2), which has 28,709 observations,
value has been distributed to the owners of the enterprise via ECF outflow.
Sub-sample (1) is comprised of enterprises that are increasing in value due to both creation of
value via the enterprise assets in place and cash inflow from the owners of the enterprise.
Consistent with this, the median ΔEV (0.397) reported in Panel A is the highest among the six
sub-samples. Sub-sample (2) enterprises have a similar median EVg (0.289 cf. 0.262), but are
distributing some of the enterprise value back to owners, resulting a slightly lower median ΔEV
of 0.209, which is still the second-highest enterprise value change among the six subsamples.
Panel A also shows that, while both sub-samples with increasing enterprise value report positive
median current-period enterprise profit, they are still investing in both intangibles (the median
RDADV for sub-sample (1) is similar to the median for sub-sample (2), 0.018 cf. 0.020) and
23
fixed assets (the median PPE for sub-sample (1) is similar to the median for sub-sample (2),
0.307 cf. 0.302).19 Most of the cash inflow in sub-sample (1) comes from debt holders (median
ECF of -0.084 and ΔNFL of 0.081) and much of the cash outflow in sub-sample (2) goes to debt
holders (median cash flow of 0.059 and ΔNFL of -0.036). The enterprises that are distributing
cash to the owners are more than twice the size of those receiving cash from the owners (median
EV of $0.246 billion cf. $0.113 billion).
Turning to the simple correlations presented in Panel B, it is notable that the correlation
between EPAT and EVg is not significantly different from zero (-0.005) for sub-sample (1), but
positive and significant (0.221) for sub-sample (2). The correlation between EPAT and ECF for
sub-sample (1) is the lowest (0.049) among the six sub-samples, while the correlation between
EPAT and ECF for sub-sample (2) is the highest among the six sub-samples (0.295).
A summary of the results from the estimation of regression (1a) is presented in Panel C. We
continue the comparison of the two sub-samples of observations where enterprise value is
increasing and there is value generated from the existing enterprise assets. The estimate of the
coefficient on EVg in sub-sample (1) shows a statistically significant 3 cent net expense in the
current period per dollar of value generated. This may, for example, be an indication of current
period accrual expenses, which have been made to enhance future profitability, but were not
funded by current period cash flow. More importantly, the coefficient on EVg for sub-sample (1)
is the smallest (i.e., least positive) of the six sub-samples consistent with the notion that, in this
sample where growth is most evident, accounting captures net expenses (the estimate of the
coefficient relating EPAT to EVg is significantly negative, -0,030 with a t-statistic of -4.19),
19
All analyses and comparisons based on PPE have been repeated replacing PPE with capital expenditure. Results
are very similar, which is not surprising because PPE and capital expenditure are highly correlated (0.680 for the full
sample).
24
which are associated with the generation of profits in future periods rather than in the current
period. Further, note that, while the estimate of the coefficient on EVg in significantly negative
for sub-sample (1) where there is cash inflow, it is significantly positive for sub-sample (2)
(0.015) when there is cash outflow.
The estimate of the coefficient on ECF (i.e., 0.108) in sub-sample (1) implies that the effect
of conservative accounting for ECF is 0.108 per dollar of ECF inflow; in other words, the effect
of ECF inflow on EPAT is overstated by 10.8 cents per dollar of ECF. The estimate of the
coefficient on ECF in sub-sample (2), where ECF is positive, (i.e., there is net cash outflow) is
much higher than in subsample (1) (0.290 vs. 0.108); the higher coefficient in subsample (2) is
consistent with accounting conservatism having a greater effect on the reporting of cash outflows
of enterprises that are increasing in value than on the reporting of cash inflows for enterprises
that are increasing in value. The interpretation of these coefficients is that the difference
between accounting EPAT and economic EPAT is 0.108 per dollar of ECF when there is ECF
inflow and 0.290 when there is ECF outflow; in other words, the over-statement of the EPAT
(i.e., net expense) effect of the ECF inflow is less than the overstatement of the EPAT (i.e., net
profit) effect when there is ECF outflow.
The characteristics of these sub-samples (see Panel A) provide some indication of the reasons
for this difference. A possible explanation is the fact that, although the enterprise value is
increasing in both sub-samples, the observations in sub-sample (1) have a median increase in
NEA of 14.4 percent of enterprise value while those in sub-sample (2) have virtually no change
in NEA (0.016); i.e., much of the cash inflow is going to build enterprise assets but, not
surprisingly (in light of the fact that the enterprises in sub-sample (2) are also growing), cash
25
outflow is not coming from sale of enterprise assets – rather it is coming from EPAT of the
period.
For comparison, Panel D of Table 4 also reports the Basu-style estimates of earnings/return
coefficient for each of the six sub-samples. The coefficient of 0.003 on RET in sub-sample (1) is
not significantly different from zero. Similar to the coefficient on EVg, the coefficient on RET
for sub-sample (1) is the smallest earnings/return coefficient among the six sub-samples, and also
the only one that is not significantly positive. On the other hand, for sub-sample (2), where there
is cash outflow, the estimate of the coefficient on RET is significantly positive (0.39 with a tstatistic of 2.54).
(ii)
Enterprise Contraction and Value Loss
Next we compare the two sub-samples (5 and 6) of observations where the enterprise
value is decreasing and the existing enterprise assets are losing value. In sub-sample (5), with
22,098 observations, the owners have contributed to enterprise value change via ECF inflow;
while in subsample (6), with 22,081 observations, ECF outflow has been distributed to the
owners of the enterprise. The results for sub-samples (5) and (6) are summarized in the last two
columns of Table 4.
The enterprises in sub-sample (5) are contracting due to loss in value of the enterprise
assets, but they continue to receive support from the owners of the enterprise via ECF inflows.
These are relatively small enterprises (median EV of $0.105 billion compared with $0.160 for
sub-sample (6)). These enterprises are, on average, the most unprofitable enterprises across all
six sub-samples (median EPAT of 0.010); they have higher intangible intensity and much lower
26
property plant and equipment than enterprises in sub-sample (6) (median RDADV of 0.022 cf.
0.014 and mean PPE of 0.161 cf. 0.229). These are growth-oriented (vs. value-oriented)
enterprises with the lowest mean BTM (0.388) of any of the six sub-samples. Consistent with the
contraction experienced by these enterprises, they exhibit the highest correlation between EPAT
and EVg of the six sub-samples (0.394).
Moving to Panel C, the estimate of the coefficient on EVg in regression (1a) of 0.156 for subsample (5) indicates that there is a 15.6 cent loss in the current period per dollar of internal
contraction, while the estimate of this coefficient for sub-sample (6) is smaller (0.118); in words,
more of the value lost relates to current earnings for the sub-sample of enterprises for which
owners are contributing cash (presumably this cash contribution leads to expenses of the period
(for example R&D, advertising and capital expenditure used to stem future losses)) relative to
those where the owners are removing cash. The striking feature in the comparison across the
results from sub-samples (5) and (6) is the difference in the coefficients on ECF across these two
samples of contracting enterprises. Net cash inflow appears to go to support EPAT of the current
period (coefficient of 0.359), whereas little of net cash outflow comes from current EPAT.
For comparison, Panel D of Table 4 also reports the earnings/return coefficient for each subsample. The coefficients of 0.193 and 0.208 for sub-samples (5) and (6), respectively, are very
similar to each other. Consistent with extant literature, these coefficients are significantly
positive and much higher than the coefficients for sub-samples (1) and (2). Notably, the similar
earnings/returns coefficients for these two sub-samples mask the differences in ECF
conservatism that become apparent when the sources of enterprise value loss are considered.
27
(iii)
Enterprise growth, value loss, net cash inflow
The results for sub-sample (3) are summarized in column (3) of Table 4. While enterprise
growth (contraction) is driven by generated value increase/decrease for most enterprises, the
enterprises in sub-sample (3) are experiencing value increase due to large injections of cash by
the owners of the enterprise despite experiencing value loss/contraction during the fiscal year.
This is an unusual situation, evidenced by the fact that sub-sample (3) is the smallest of the six
sub-samples and only contains 5.6 percent of the observations in the full sample (see Table 1,
Panel B). The mean levels of EV in Panel A indicate that sub-sample (3) contains, on average,
the smallest enterprises in the sample, consistent with these enterprises’ small market
capitalization serving as a contributing factor in their ability to grow the value of the enterprise
by attracting additional capital despite experiencing value loss.
These enterprises are relatively unprofitable (median EPAT of 0.042), they invest little in
intangibles (lowest median RDADV of 0.013), and heavily in fixed assets (median PPE of
0.350). Because of their high asset tangibility, these enterprises are able to raise a high
percentage of their market value from ECF inflows (most negative median ECF across all subsamples, -0.181), resulting in large increases in leverage (median ΔNFL of 0.170).
The results from estimation of regression (1a) are summarized in Panel C. The estimate of
the coefficient on EVg (0.251) indicates that there is a 25.1 cent EPAT loss in the current period
per dollar of generated enterprise value loss. It is also interesting to note that the annual equity
return (RET) is negative (i.e., in Basu parlance, there is bad news) for most of the observations in
sub-sample (3) (6,255 of 6,606). Consistent with prior literature (e.g., Basu 1997), the estimates
of the coefficients on EVg and the earnings/return coefficient are much higher (0.251 and 0.196,
28
respectively, with t-statistics of 7.06 and 4.77) for this sub-sample than for sub-samples (1) and
(2) where EVg was positive.
The estimate of the coefficient on ECF (0.064) implies that there is little conservatism in the
accounting for ECF for these observations. This is consistent with the high levels of PPE in
these enterprises and indicates that the majority of the financing raised by these enterprises goes
towards investments that are capitalized into NEA (the implied coefficient relating ΔNEA to ECF
is 0.936) rather than covering expenses of the current period. These enterprises are capitalizing
ECF at a slightly higher rate than those in sub-sample (1) and again we see that the capitalization
rate in this sub-sample is much higher than the liquidation rate in sub-sample (2), where the
implied coefficient relating ΔNEA to ECF is 71.0 cents per dollar.
(iv)
Enterprise contraction, value generation, net cash outflow
The results for the analysis of sub-sample (4) are summarized in column (4) of Table 4.
Similar to sub-sample (3) this subsample is comprised of enterprises where the overall growth
pattern runs counter to its internal growth pattern. In this case, the enterprise is contracting
despite internal growth, a somewhat rare occurrence indicated by the fact that only 6.70 percent
of our observations are in sub-sample (4). Sub-sample (4) enterprises have high beginning-ofperiod leverage (median NFL of 0.370, which is the highest among the six sub-samples).
Despite experiencing positive median EVg of 0.052, these enterprises are contracting due to large
cash outflows to the owners of the enterprise, generally resulting in a deleveraging of the
enterprise by returning capital to debt holders (median ΔNFL of -0.086).
The results from estimation of regression (1a) are reported in Panel C. The estimate of the
coefficient on EVg (0.229) indicates that there is a 22.9 cent profit in the current period per dollar
29
of generated value change. It is interesting to note that the coefficients on EVg and the
earnings/return coefficient are significantly positive and relatively high (0.229 and 0.218,
respectively, with t-statistics of 8.55 and 6.24); this, perhaps, seems odd because EVg and the
majority of returns are positive (“good” news) and this would suggest lower EVg and
earnings/return coefficients. In un-tabulated analysis, we penetrated this result further by running
the earnings/return regression as specified by Basu (i.e., with an intercept and slope dummy,
which is one if returns are negative, zero otherwise). The estimate of the coefficient on positive
returns is, contrary to the prediction in Basu, significantly positive (0.162 with a t-statistic of
3.08). That is, we have isolated a sample of observations where equity returns are positive and
there is a substantial estimated coefficient relating earnings to return. Note that the EVg and
earnings/return coefficients are much lower in the other sub-samples in which there is value
generation (i.e., sub-samples (1) and (2)). The key characteristic of this sample is that the
enterprises are contracting due to cash outflow despite positive internal growth, highlighting the
importance of considering overall enterprise growth as well as the direction of ECF in the
analysis of accounting conservatism.
The estimate of the coefficient on ECF (i.e., 0.069) implies that for each dollar of cash
outflow there is little conservatism in the accounting for EPAT for these observations. Perhaps
the most relevant comparison for this coefficient is that of sub-sample (2). Both sub-samples are
comprised of enterprises with internal value creation who are returning cash to owners;
enterprises in sub-sample (4), however, are somewhat less profitable and make larger payouts
that shrink the size of the enterprise. Accordingly, enterprises in sub-sample (2) are able to
source a larger percentage of cash outflows from current EPAT relative to sub-sample (4)
enterprises.
30
5.3.
Putting it all together
We have shown that the recording of enterprise value increases/decreases in EPAT differs
according to whether the value increase/decrease is generated via existing enterprise assets or
contributed by/distributed to the owners of the enterprise. We have also shown differences
across sub-samples based on the sign of the change in the market value of the enterprise, the sign
of value generation/loss, and the sign of enterprise cash flow. Since generated enterprise value
change is highly correlated with equity returns, which is the variable that is the focus of much of
the extant work on conservatism in accounting, many of our empirical results from the analysis
of the relation between EPAT and EVg are similar to those from the analysis of the relation
between earnings and returns. Our primary contribution to the empirical understanding of the
effects of growth on conservative accounting is through the introduction of cash flow to/from the
owners of the enterprise. There are several key results.
First, as highlighted in the comparison of sub-samples (5) and (6) where the enterprise is
contracting, there is loss in value of the existing enterprise assets, and there is either cash outflow
or cash inflow, the extent to which cash flow affects the recording of EPAT varies a great deal
(0.359 when there is cash inflow and not significantly different from zero when there is cash
inflow).
Second, the direction of cash flow affects the sign and magnitude of the coefficient relating
EPAT to EVg; in other words identifying the direction of contributed/distributed value helps our
understanding of conservatism in accounting for internally generated value change. This effect
is best seen in the comparison of the estimates of the coefficients relating EPAT to EVg across
sub-samples (1) and (2), where there is enterprise growth and generation of value from existing
31
enterprise assets, and across sub-samples (5) and (6), where there is enterprise contraction and
loss of value of the existing enterprise assets. Partitioning growing enterprises (sub-samples (1)
and (2)) on the sign of enterprise cash flow facilitates identification of a significantly negative
relation relating EPAT to EVg when there is cash inflow (coefficient estimate of -0.030 with a tstatistic of -4.19) and a significantly positive relation when there is cash outflow (coefficient
estimate of 0.015 with a t-statistic of 2.45). Partitioning contracting enterprises (sub-samples (5)
and (6)) on the sign of cash flow facilitates identification of a significantly higher coefficient
relating EPAT to EVg when there is cash inflow (0.156) than when there is cash outflow (0.118);
the t-statistic for the differences between these two coefficient estimates is 2.95.
Third, our results highlight the role of overall enterprise growth/contraction in accounting
conservatism as opposed to positive or negative equity return “news.” This point is best
illustrated by sub-sample (4), which isolates a sample of observations where equity returns are
generally positive, but the estimated coefficient relating earnings to return is actually the largest
of the six sub-samples. The key characteristic of this sample is that there is overall enterprise
contraction due to cash outflow despite positive EVg and generally positive equity returns.
5.4.
The relative magnitude of the effects of EVg and ECF on EPAT.
The magnitude of the effect of ECF on recorded EPAT is, in many cases, equal to or
greater than the magnitude of the effect of generated value change on EPAT. We summarize
these effects in Figure 1. We plot the marginal effects of one-standard deviation changes in EVg
and ECF for each regression sample, relative to the standard deviation of EPAT in each sample.20
In all but sub-sample (6), where the enterprise is contracting on all dimensions and the
20
Note that this is equivalent to normalizing the regression (1a) variables to have a mean of zero and standard
deviation of 1 within each regression sample and then plotting the absolute value of the normalized regression
coefficients for EVg and ECF.
32
coefficient relating EPAT to ECF is not significantly different from zero, a one standard
deviation change in ECF contributes substantially to EPAT. In fact, for the full sample, the
estimated effect of a one-standard deviation change in ECF is slightly larger than the estimated
effect of a one standard-deviation change in EVg, such that a one standard deviation change in
ECF is associated with a change of 27.10 percent of a standard deviation of EPAT, while an
equivalent change in EVg is only associated with a change of 23.62 percent. These estimated
marginal effects are not statistically different from each other, indicating that ECF explains a
roughly equal amount of EPAT variation as EVg for the full sample. As further illustrated in
Figure 1, the marginal effect of an ECF change is significantly lower than that of an EVg change
in sub-samples (3) and (4), roughly equivalent to that of an EVg change in sub-samples (1) and
(5), and significantly greater than (almost four times as much as) an EVg change in sub-sample
(2). In short, variation in ECF, which has been, by and large, omitted from previous studies of
accounting conservatism, accounts for much of the observed variation in EPAT across
enterprises.
6. Accounting for Change in Enterprise Value and Enterprise Characteristics
Thus far, we have demonstrated the effects of conservative accounting in recording the
effects of value change generated from the existing net enterprise assets vs.
contributed/distributed value change. We have shown that each dollar of ECF is recorded in
either EPAT or in ΔNEA; that is, if the amount of value change due to ECF captured in EPAT is
low, the amount recorded in change in the book value of enterprise assets is high and vice-versa.
Importantly, the entire amount of the ECF is recorded in either EPAT or ΔNEA. For generated
growth, however, the coefficient relating EPAT to EVg is the same as the coefficient relating
33
ΔNEA to EVg; that is the manifestation of conservatism on the income statement is the same as
the manifestation of conservatism in consecutive balance sheets.
In this section, we further demonstrate these aspects of our framework by examining how the
EVg and ECF coefficients in regression (1a) vary with enterprise-year characteristics. This
additional analysis serves to validate the inferences we have made thus far regarding the effects
of accounting conservatism on the estimated coefficients in regression (1a), and highlights three
possible contributions of our work: (1) enhancing our understanding of the nature of
conservative accounting as we illustrated via discussion of the R&D and change in enterprise
asset value examples, above; (2) focusing our understanding of the effects of the presence of and
the amount of debt on conservative accounting; and, (3) enhancing our understanding of the link
between balance sheet conservatism and income statement conservatism. These analyses are
based on regressions where we add interaction terms to regression (1a).
We undertake four sets of analyses based on four (separately considered) interaction terms.
We independently partition the data into deciles of: (1) investment in intangibles (i.e., the ratio of
R&D plus advertising expense to beginning of year market value of the enterprise); (2)
investment in fixed assets (i.e., the ratio of property, plant and equipment to beginning of year
market value of the enterprise);21 (3) the amount of debt (i.e., the ratio of beginning of year net
financial liabilities to market value of the enterprise); and, (4) the enterprise-level book-tomarket ratio (i.e., the ratio of the book value of the enterprise at the beginning of the year to the
market value of the enterprise).
21
Because the correlation between (annual capital expenditure (i.e., CAPEX/EV) and the balance in property, plant
and equipment (i.e., PP&E/EV) is large (Pearson correlation of 0.608)), we conduct our analyses with partitions
based only on PP&E; we obtain very similar results if instead we partition on CAPEX.
34
Specifically, for each characteristic, by fiscal year, we rank all observations in the full sample
into deciles. We then scale the decile rankings to have a mean of zero and a range of one. This
decile rank transformation mitigates the effect of extreme observations and facilitates
interpretation of the regression coefficients. We then run regression (1a) including interaction
terms between the characteristic variable and EVg as well as the characteristic variable and ECF,
as follows:
it =
1+
2
it
3
it
4
_
5
it
∗
_
it
6
it
∗
_
it
εit
where DEC_X indicates a decile transformation of variable X. All other variables are as defined
in regression (1a). The results of these regressions are summarized in Table 5 for each of the
sub-samples (1) to (6) described in section 5.
The results for the partition on RDADV are summarized in Panel A of Table 5.22 As
expected, for enterprise that are increasing in value and generating value internally (sub-samples
(1) and (2)), the coefficient relating EPAT to EVg decreases with DEC_RDADV (coefficient
estimates of -0.059 and -0.042 with t-statistics of -6.07 and -5.60); although the R&D leads to
expected future profits, the effect on current EPAT is negative due to the expensing of R&D. For
contracting firms (sub-samples (5) and (6)), the coefficient relating EPAT to EVg increases with
DEC_RDADV (coefficient estimates of 0.075 and 0.046 with t-statistics of 3.74 and 2.60); for
these observations the expensed R&D is associated with negative EVg – it seems that the R&D is
being made in an attempt to counteract the expected decline in future profits reflected in the
negative EVg. As expected, the interaction between DEC_RDADV and ECF is highest for the
22
For consistency with the rest of the analyses in this section, we rank RDADV into deciles in the same way we rank
other characteristics despite the fact that almost exactly one third of the observations in the full sample have zero
RDADV. For robustness, we performed an alternate analysis where we partitioned RDADV into no, low, and high
RDADV groups with roughly equal observations in each tercile. All inferences remain unchanged.
35
three sub-samples of observations where there is ECF inflow; the greater the R&D the greater
the amount of ECF expensed in current EPAT. The negative estimate of the coefficient on the
interaction between DEC_RDADV and ECF (-0.120) in sub-sample (4) where the enterprise
value is declining because ECF outflow is greater than enterprise value generated is interesting;
we postulate that this reflects the success of R&D, generating both future growth (positive EVg)
as well as surplus ECF in the current period from prior positive EVg projects.23
Since higher intangibles intensity may imply lower tangibles intensity and since we observe a
negative correlation between RDADV and PPE (0.203 for the full sample), we expect the
estimates of the interactions based on DEC_PPE to be, more or less, the mirror image of those
based on RDADV. This is seen for some of the sub-samples. For example, for sub-samples (1)
and (2), the estimates of the coefficients on the interaction of DEC_PPE and EVg are
significantly positive (0.034 and 0.035 with t-statistics of 2.02 and 2.73) and, for each of the subsamples where there is ECF inflow, the estimates of the coefficients on the interaction of
DEC_PPE and ECF are significantly negative (-0.348, -0.258 and -0.617). Notable exceptions
are the significantly positive estimates of coefficient on the interaction of DEC_PPE and EVg for
the sub-samples of contracting firms (sub-samples (5) and (6)); this result may reflect the
existence of more write-offs in EPAT for these observations simply because there are more assets
to be written off.
Much work has been done on the effect of debt on the coefficient relating earnings to returns,
focusing particularly on this coefficient when returns are negative (i.e., news is bad); see, for
example, Ball, Robin, and Sadka [2008] and Kahn and Watts [2009]. This work generally
observes a larger coefficient relating earnings to negative returns when the debt level is higher.
23
Future work will penetrate this postulate further.
36
We observe a similar pattern for the coefficient relating EPAT to EVg. This is evidenced by the
positive coefficient on EVg*DEC_NFL in sub-sample (5) and (6), see Panel C, where EVg is
negative (coefficient estimates of 0.050 and 0.100). Interestingly, the estimates of this
coefficient are also significantly positive (0.064 and 0.037) for sub-samples (1) and (2) where
EVg is positive. This result is new to the literature as far as we are aware; the extent to which
change in generated enterprise value is captured in current EPAT increases with debt level when
the enterprise is doing well and when the enterprise is doing poorly.
The estimates of the coefficient on ECF*DEC_NFL are negative and significant for all six
sub-samples. This suggests that when enterprises have higher levels of debt, ECF inflows are
more likely to be capitalized into NEA than expensed to EPAT, and that cash outflows are more
likely to come from liquidating NEA than from current EPAT.
Our emphasis to this stage has been on the effects of conservative accounting on the income
statement and on changes in consecutive balance sheets. The effects of conservatism will,
however, accumulate on the balance sheet leading to lower book-to-market ratios. The estimate
of the coefficients on EVg*DEC_BTM reported in Panel D are positive for all sub-samples and
much higher for the sub-samples where enterprise value is declining and EVg is negative; for
these observations, the higher book-to-market will mean that the likelihood of a write-off
affecting current EPAT will be higher because there will be less of a buffer between the book
value of assets and the market value of assets. The estimate of the coefficient on
ECF*DEC_BTM is negative and significant in all sub-samples. Recall that the lower the
estimate of the coefficient relating EPAT to ECF, the higher the coefficient relating ΔNEA to
37
ECF; it follows that, again, we observe that the less conservative the balance sheet, the less
conservative the income statement.
7. Summary and conclusions
We introduce an alternate perspective on accounting conservatism, focusing on the recording
of change in enterprise value in the financial statements. We demonstrate, both analytically and
empirically, that the manner and degree to which the accounting system records change in
enterprise value depends upon both the sign (positive vs. negative) and source (internal vs.
external) of the value change. Our framework allows researchers to measure an aspect of
accounting conservatism that has not been examined in prior studies: conservatism in the
accounting treatment of enterprise cash flows (i.e., contributed value change). We show that this
source of value change explains a considerable portion of EPAT; in fact, it explains almost four
times that explained by variation in internal growth for a sub-sample of observations where there
is enterprise growth due to internally generated growth yet there is net cash outflow to the
owners of the firm. We validate our framework’s ability to capture novel aspects of accounting
conservatism by demonstrating that the degree to which the accounting system captures both
generated and contributed enterprise value change varies with enterprise characteristics such as
intangible intensity, capital expenditures, debt level, and enterprise-level book-to-market ratio.
38
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40
Appendix A: Variable Measurement
A.1: Terminology
Throughout our paper, we adopt the terminology of Gode and Ohlson [2013] for distinguishing
between the productive enterprise of the firm and the financing of that enterprise. As noted by
Gode and Ohlson [2013], enterprise activities are often referred to as operating activities. We do
not use the word “operating” because there is ambiguity about its precise meaning. In particular,
GAAP operating cash flows differ from enterprise cash flows. We adapt the following from
Gode and Ohlson [2013] as a terminology reference:
Ours
Enterprise Value [EV]
Enterprise profit after tax [EPAT]
Enterprise assets [EA]
Enterprise liabilities [EL]
Net enterprise assets [NEA = EA – EL]
Enterprise cash flows
[ECF = EPAT – Change in NEA]
Financial assets [FA]
Financial liabilities [FL]
Net financial liabilities [NFL = FL- FA]
Alternatives used in practice
Firm Value [FV]
Market Value of the Firm [MVF]
Net operating profit after tax [NOPAT]
Earnings before interest but after taxes [EBIAT]
Unleveraged NI, prefinancing NI
Operating assets [OA]
Operating liabilities [OL]
Net operating assets [NOA = OA – OL]
Free cash flows to the firm [FrCF or FCF]
Unlevered cash flows
“Cash” or cash and marketable securities
Debt, Finanical Obligations [FO]
Net debt = Debt – “Cash”
Net Finanical Obligations [NFL]
A.2: Variable Definitions
# = Compustat Data Item.
Δ = Change between current and prior fiscal year.
Enterprise Value (EV) = Market Value of Equity (MVE) plus Net Financial Liabilities (NFL).
Market Value of Equity (MVE) = Fiscal year end price (#PRCC_F) times common shares
outstanding (#CSHO), from Compustat. Scaled by beginning-of-period enterprise value
(EVt-1).
Net Financial Liabilities (NFL) = Financial Liabilities (FL) minus Financial Assets (FA). Scaled
by beginning-of-period enterprise value (EVt-1).
Financial Liabilities (FL) = Debt in current liabilities (#DLC) plus long term debt (#DLTT) plus
preferred stock (#PSTK) minus preferred treasury stock (#TSTKP) plus preferred
dividends in arrears (#DVPA).
Financial Assets (FA) = Cash and short term investments (#CHE) plus investments and
advances-other (#IVAO).
41
Net Enterprise Assets (NEA) = Net Financial Liabilities (NFL) plus Common Stockholders’
Equity (CSE) plus Minority Interest (#MIB). Scaled by beginning-of-period enterprise
value (EVt-1).
Common Stockholders’ Equity (CSE) = Common equity (#CEQ) plus preferred treasury stock
(#TSTKP) minus preferred dividends in arrears (#DVPA).
Enterprise Profit After Tax (EPAT) = Comprehensive Net Income (CNI) plus Net Financial
Expense (NFE) plus minority interest in income (#MII). Scaled by beginning-of-period
enterprise value (EVt-1).
Comprehensive Net Income (CNI) = Net Income (#NI) minus preferred dividends (#DVP) plus
Clean Surplus Adjustment to Net Income (CSA).
Clean Surplus Adjustment to Net Income (CSA) = marketable securities adjustment (#MSA)
minus lag marketable securities adjustment (#MSAt-1) plus cumulative translation
adjustment (#RECTA) minus lag cumulative translation adjustment (#RECTAt-1).
Net Financial Expense (NFE) = After-tax interest expense ((#XINT)*(1 – marginal tax rate))
plus preferred dividends (#DVP) minus after tax interest income ((#IDIT)*(1-marginal
tax rate)) plus unusual financial expense ((#MSAt-1)-(#MSA)).
Comprehensive Net Financial Income (CNFI) = Comprehensive Net Income (CNI) minus
Enterprise Profit After Tax (EPAT).
Marginal Tax Rate = The top statutory federal corporate tax rate plus 2% average state corporate
tax rate. The top statutory federal corporate tax rate was 52% in 1963, 50% in 1964, 48%
in 1965 – 1967, 52.8% in 1968 – 1969, 49.2% in 1970, 48% in 1971 – 1978, 46% in 1979
– 1986, 40% in 1987, 34% in 1988 – 1992 and 35% in all sample years thereafter.
Enterprise Value Generated (EVg) = Change in Enterprise Value (ΔEV) plus Enterprise Free
Cash Flow (ECF). Scaled by beginning-of-period enterprise value (EVt-1).
Enterprise Free Cash Flow (ECF) = Enterprise Profit After Tax (EPAT) minus change in Net
Enterprise Assets (ΔNEA). Scaled by beginning-of-period enterprise value (EVt-1).
Earnings scaled by Price (X/P) = Earnings before extraordinary items (#IB) scaled by beginning
of period Market Value of Equity (MVEt-1).
Stock Return (RET) = Cumulative buy-and-hold fiscal year stock return, from CRSP.
Research, Development, and Advertising (RDADV) = R&D Expense (#XRD) plus Advertising
Expense (#XAD). Scaled by beginning-of-period enterprise value (EVt-1).
Property Plant and Equipment (PPE) = Property plant and equipment, net of accumulated
depreciation (#PPENT). Scaled by beginning-of-period enterprise value (EVt-1).
Enterprise Book-to-Market (BTM) = Beginning-of-period Net Enterprise Assets (NEAt-1)
divided by beginning-of-period Enterprise Value (EVt-1).
42
Table 1
Descriptive Statistics
Panel A: Full sample descriptive statistics
N
Mean
σ
EV ($ Bil.)
110,144 1.917 12.368
110,144 0.109
0.482
ΔEV
110,144 0.056
0.156
ΔNEA
110,144 0.040
0.105
EPAT
110,144 0.092
0.468
EVg
110,144 -0.016 0.149
ECF
110,144 0.037
0.127
X/P
110,144 0.084
0.477
RET
110,144 0.047
0.084
RDADV
110,144 0.080
0.095
CAPX
110,144 0.373
0.358
PPE
110,144 0.126
0.334
NFL
110,144 0.020
0.138
ΔNFL
110,144 0.660
0.468
BTM
p1
0.003
-0.739
-0.333
-0.343
-0.795
-0.518
-0.422
-0.745
0.000
0.000
0.005
-0.804
-0.312
-0.024
p25
0.036
-0.172
-0.016
0.014
-0.168
-0.077
0.005
-0.233
0.000
0.022
0.106
-0.056
-0.049
0.306
Median
0.140
0.040
0.036
0.057
0.047
0.004
0.054
0.032
0.018
0.050
0.268
0.110
0.006
0.603
Panel B: Frequencies among enterprise growth sub-samples
(1)
(2)
(3)
(4)
(5)
+ ΔEV
+ ΔEV
+ ΔEV
- ΔEV
- ΔEV
+ EVg
+ EVg
- EVg
+ EVg
- EVg
ECF in
ECF out
ECF in
ECF out
ECF in
N
26,020
28,709
5,932
7,391
21,080
Pct (%)
23.62
26.06
5.39
6.71
19.14
p75
0.651
0.295
0.115
0.092
0.278
0.064
0.095
0.321
0.060
0.102
0.532
0.333
0.075
0.936
(6)
- ΔEV
- EVg
ECF out
21,012
19.08
p99
32.071
1.781
0.576
0.251
1.657
0.316
0.321
1.589
0.373
0.458
1.555
0.814
0.483
2.043
Total
110,144
100
This table presents descriptive statistics for the full sample of observations used in our analysis. Panel A presents
sample statistics. σ and p denote the sample standard deviation and percentiles, respectively. Panel B presents
frequencies of observations within each enterprise growth sub-sample used in our empirical analyses. As described
in Section 5 of the text, we partition the full sample into six enterprise growth sub-samples based on the sign of
ΔEV, EVg, and ECF. A positive (negative) sign denotes that observations in the sub-sample are restricted to those
where the corresponding variable is greater than or equal to zero (less than zero). All variables are defined in
Appendix A.2.
.
43
Table 2
Spearman Correlations Among Key Measures
[1]
[1] EV
[2] ΔEV
[3] ΔNEA
[4] EPAT
[5] CNFI
[6] EVg
[7] ECF
[8] X/P
[9] RET
[10] RDADV
[11] PPE
[12] NFL
[13] ΔNFL
[14] BTM
[2]
[3]
[4]
[5]
0.201
0.018 0.367
0.044 0.323 0.366
0.033 -0.054 -0.044 -0.165
0.215 0.919 0.112 0.408 -0.062
0.072 -0.174 -0.699 0.274 -0.062
0.059 0.302 0.318 0.931 -0.156
0.214 0.882 0.105 0.414 -0.039
-0.045 0.014 -0.070 -0.061 0.160
-0.030 0.156 0.155 0.345 -0.491
0.034 0.005 -0.077 0.137 -0.827
-0.032 0.119 0.682 -0.106 -0.103
-0.216 0.080 -0.031 0.318 -0.605
[6]
[7]
[8]
[9]
[10]
[11]
[12]
[13]
0.158
0.395 0.282
0.966 0.166 0.419
0.014 -0.019 -0.067 0.022
0.171 0.088 0.345 0.170 -0.188
0.067 0.198 0.193 0.057 -0.218 0.468
-0.173 -0.828 -0.123 -0.182 -0.037 0.099 -0.059
0.151 0.242 0.336 0.149 -0.092 0.694 0.612 -0.030
This table presents Spearman rank correlations among key variables in the sample. All variables are defined in Appendix A.2. Correlations presented in bold
typeface are statistically significant at the 1% level.
44
Table 3
OLS regressions of Earnings Measures on Market Measures
Panel A: Regressions of EPAT on Generated vs. Contributed Enterprise Value Changes
Adj. R2
N
Intercept
EVg
ECF
***
***
***
Full Sample
0.038
0.053
0.191
0.138
110,144
(7.20)
(4.28)
(11.34)
Enterprise Growth Sample
0.069***
-0.001
0.192***
0.097
60,661
(12.09)
(-0.07)
(11.18)
0.141***
0.179***
0.227
49,483
Enterprise Contraction Sample
0.045***
(8.44)
(14.41)
(8.94)
Panel B: Basu Model Replication
Intercept
RET
D(RET<0)
0.018
-0.010**
X/P 0.065***
(8.96)
(1.25)
(-2.34)
EPAT
Intercept
0.071***
(12.46)
EVg
-0.009
(-0.98)
D(EVg<0)
-0.018***
(-4.24)
RET*D(RET<0)
0.182***
(9.13)
EVg*D(EVg<0)
0.189***
(14.89)
Adj. R2
0.137
Adj. R2
0.148
N
110,144
N
110,144
N RET <0
51,533
N EVg <0
48,024
This table presents estimates from OLS regressions of accounting measures of changes in enterprise and equity
value on market-based measures of changes in enterprise and equity value. Panel A presents estimates of regressions
of EPAT on generated vs. contributed changes in enterprise value (EVg and ECF, respectively). The growth sample
is composed of firm-year observations in which enterprise value increased during the fiscal year (ΔEV >=0), while
the contraction sample is composed of firm-year observations in which enterprise value decreased during the fiscal
year (ΔEV < 0). Panel B presents estimates of OLS regressions of earnings on returns, following Basu [1997].
D(RET<0) is an indicator variable equal to one when RET < 0 and zero otherwise. For comparison, Panel B also
presents regressions of EPAT on EVg, interacted with an indicator variable [D(EVg<0)] equal to one when EVg < 0
and zero otherwise. In each analysis, we report the number of sample observations for which the indicator variable is
equal to one. All other variables are defined in Appendix A.2. t-statistics reported in parenthesis are calculated using
two-way clustered standard errors, clustered by firm and year. *, ** and *** indicate (two-tailed) significance at the
10%, 5% and 1% levels respectively.
45
Table 4
Summary of Results by Sub-Sample
(1)
(2)
(3)
(4)
+ ΔEV
+ ΔEV
+ ΔEV
- ΔEV
+ EVg
+ EVg
- EVg
+ EVg
ECF in
ECF out
ECF in
ECF out
(5)
- ΔEV
- EVg
ECF in
(6)
- ΔEV
- EVg
ECF out
Panel A: Sample Medians for Key Measures
EV ($ Bil.)
ΔEV
ΔNEA
EPAT
EVg
ECF
RDADV
PPE
NFL
ΔNFL
BTM
0.113
0.397
0.144
0.065
0.262
-0.084
0.018
0.307
0.101
0.081
0.595
0.246
0.209
0.016
0.080
0.289
0.059
0.020
0.302
0.132
-0.036
0.667
0.079
0.081
0.197
0.042
-0.071
-0.181
0.013
0.350
0.152
0.170
0.654
0.122
-0.055
-0.052
0.074
0.052
0.127
0.014
0.407
0.370
-0.086
0.965
0.105
-0.234
0.062
0.010
-0.331
-0.061
0.022
0.161
0.010
0.059
0.388
0.160
-0.235
-0.007
0.046
-0.156
0.049
0.014
0.229
0.137
-0.028
0.618
Panel B: Spearman Correlations between Key Measures
EPAT x EVg
EPAT x ECF
EVg x RDADV
EVg x PPE
EVg x NFL
EVg x ΔNFL
EVg x BTM
ECF x RDADV
ECF x PPE
ECF x NFL
ECF x ΔNFL
ECF x BTM
PPE x RDADV
PPE x NFL
PPE x ΔNFL
PPE x BTM
NFL x ΔNFL
NFL x BTM
ΔNFL x BTM
-0.005
0.049
0.095
-0.163
-0.292
-0.190
-0.223
-0.012
-0.100
0.030
-0.470
-0.058
-0.223
0.467
0.395
0.690
0.217
0.588
0.423
0.221
0.295
0.116
-0.094
-0.260
-0.402
-0.068
0.077
0.171
0.079
-0.705
0.306
-0.122
0.460
0.080
0.707
0.080
0.589
-0.037
0.172
0.106
-0.043
0.040
0.211
-0.291
0.134
-0.025
-0.049
0.143
-0.483
0.041
-0.243
0.422
0.331
0.620
0.141
0.564
0.344
0.268
0.216
0.047
0.147
0.114
-0.529
0.318
0.036
0.189
0.226
-0.845
0.452
-0.085
0.338
-0.068
0.577
-0.148
0.565
-0.322
0.394
0.218
-0.143
0.345
0.414
-0.046
0.372
-0.110
0.012
0.181
-0.497
0.066
-0.257
0.473
0.307
0.708
0.068
0.568
0.303
0.256
0.134
-0.067
0.318
0.353
-0.009
0.315
-0.016
0.188
0.226
-0.752
0.383
-0.164
0.432
0.019
0.658
-0.077
0.608
-0.157
Observations
26,020
28,709
5,932
7,391
21,080
21,012
46
Table 4 (continued)
Summary of Results by Sub-Sample
(1)
(2)
(3)
(4)
+ ΔEV
+ ΔEV
+ ΔEV
- ΔEV
+ EVg
+ EVg
- EVg
+ EVg
ECF in
ECF out
ECF in
ECF out
Panel C: Estimates of Regression (1a)
Intercept
0.073***
0.057***
EVg
ECF
Adjusted R2
(12.14)
-0.030***
(-4.19)
0.108***
(4.76)
(14.86)
0.015**
(2.45)
0.290***
(6.80)
0.043***
(5.54)
0.251***
(7.06)
0.064***
(2.94)
0.040
0.098
0.062
Panel D: Estimates of Earnings-on-Returns Regressions
Intercept
0.045***
0.071***
0.021***
(5)
- ΔEV
- EVg
ECF in
(6)
- ΔEV
- EVg
ECF out
0.046***
(11.30)
0.229***
(8.55)
0.069***
(3.40)
0.067***
(10.20)
0.156***
(12.67)
0.359***
(9.15)
0.058***
(19.53)
0.118***
(9.45)
-0.027
(-0.65)
0.074
0.225
0.054
0.047***
(7.13)
0.193***
(13.03)
0.074***
(13.62)
0.208***
(11.44)
RET
(5.25)
0.003
(0.21)
(12.22)
0.039**
(2.50)
(2.64)
0.196***
(4.77)
0.056***
(5.86)
0.218***
(6.24)
Adjusted R2
0.000
0.025
0.033
0.081
0.104
0.108
Observations
26,020
1,876
28,709
319
5,932
5,707
7,391
1,821
21,080
21,018
21,012
20,792
N RET <0
This table provides descriptive statistics and OLS regression estimates for each enterprise growth sub-sample. Each
column presents results for one of the enterprise growth sub-samples (1) – (6) defined in Table 1. Panel A presents
the sub-sample medians for key variables. Panel B presents univariate correlations between key variables within
each sub-sample. Correlations presented in bold typeface are statistically significant at the 1% level. Panel C reports
the estimated coefficients and adjusted R2 from estimating regression (1a) on each sub-sample. The dependent
measure in these regressions is EPAT. Panel D reports the estimated coefficients and adjusted R2 from regressing
earnings (X/P) on returns for each subsample. We also report the number of observations in each sub-sample with
negative RET. All variables are defined in Appendix A.2. t-statistics reported in parenthesis are calculated using
two-way clustered standard errors, clustered by firm and year. *, ** and *** indicate (two-tailed) significance at the
10%, 5% and 1% levels respectively.
47
Table 5
Effects of firm-year characteristics on the regressions of EPAT on generated vs.
contributed enterprise value changes, by sub-sample
(1)
(2)
(3)
(4)
(5)
(6)
+ ΔEV
+ ΔEV
+ ΔEV
- ΔEV
- ΔEV
- ΔEV
+ EVg
+ EVg
- EVg
+ EVg
- EVg
- EVg
ECF in
ECF out
ECF in
ECF out
ECF in
ECF out
Panel A: Effect of R&D Plus Advertising
Intercept
0.069***
0.055***
(11.94)
0.008
(1.12)
-0.016***
(-2.88)
-0.059***
(-6.07)
0.115***
(4.82)
0.312***
(6.01)
(14.88)
0.014***
(3.22)
0.021***
(3.75)
-0.042***
(-5.60)
0.286***
(6.86)
0.025
(0.78)
0.043***
(5.83)
-0.019
(-1.44)
0.226***
(6.45)
0.132
(1.44)
0.084***
(3.66)
0.254***
(3.38)
0.101
0.103
0.135
0.075
0.270
0.056
(12.05)
0.024***
(3.98)
-0.017*
(-1.96)
0.034**
(2.02)
0.181***
(8.19)
-0.348***
(-10.98)
0.056***
(14.61)
0.010
(1.58)
0.019***
(2.62)
0.035***
(2.73)
0.292***
(7.90)
-0.218***
(-3.92)
0.044***
(6.17)
0.038***
(4.36)
0.200***
(5.64)
-0.014
(-0.18)
0.131***
(4.79)
-0.258***
(-4.08)
0.047***
(11.62)
-0.012**
(-2.21)
0.230***
(9.11)
-0.058
(-0.86)
0.067***
(3.11)
0.085
(1.58)
0.066***
(10.19)
0.012**
(1.99)
0.164***
(10.96)
0.104***
(5.08)
0.316***
(8.86)
-0.617***
(-16.76)
0.059***
(20.26)
-0.006
(-1.18)
0.135***
(9.58)
0.070***
(4.10)
-0.021
(-0.49)
0.044
(0.71)
Adjusted R2
0.120
0.105
0.130
0.074
0.251
0.059
Observations
26,020
1,876
28,709
319
5,932
5,707
7,391
1,821
21,080
21,018
21,012
20,792
DEC_RDADV
EVg
EVg*DEC_RDADV
ECF
ECF * DEC_RDADV
Adjusted R2
Panel B: Effect of Asset Tangibility
Intercept
0.073***
DEC_PPE
EVg
EVg*DEC_PPE
ECF
ECF*DEC_PPE
N RET <0
48
0.047***
(11.19)
0.015***
(2.75)
0.232***
(8.61)
0.105**
(2.16)
0.065***
(3.11)
-0.120***
(-3.23)
0.061***
(9.54)
0.014
(1.49)
0.140***
(13.21)
0.075***
(3.74)
0.311***
(9.16)
0.459***
(11.21)
0.057***
(19.26)
0.001
(0.11)
0.117***
(9.65)
0.046***
(2.60)
-0.024
(-0.56)
0.084**
(2.13)
Table 5 (Continued)
Effects of Firm-Year Characteristics
(1)
(2)
(3)
(4)
+ ΔEV
+ ΔEV
+ ΔEV
- ΔEV
+ EVg
+ EVg
- EVg
+ EVg
ECF in
ECF out
ECF in
ECF out
Panel C: Effect of Debt Level
Intercept
0.066***
DEC_NFL
EVg
EVg*DEC_NFL
ECF
ECF*DEC_NFL
Adjusted R2
(5)
- ΔEV
- EVg
ECF in
(6)
- ΔEV
- EVg
ECF out
(10.69)
-0.023***
(-3.09)
-0.005
(-0.77)
0.064***
(6.86)
0.107***
(5.14)
-0.370***
(-7.89)
0.059***
(15.67)
-0.018***
(-4.17)
0.013***
(2.61)
0.037***
(6.79)
0.287***
(8.17)
-0.402***
(-12.99)
0.037***
(4.68)
0.024
(1.63)
0.184***
(6.34)
-0.029
(-0.29)
0.069***
(3.31)
-0.193***
(-3.15)
0.051***
(12.51)
-0.029***
(-4.29)
0.169***
(5.88)
0.100
(0.98)
0.159***
(5.54)
-0.310***
(-5.30)
0.063***
(10.04)
-0.047***
(-5.04)
0.174***
(14.42)
0.050*
(1.81)
0.244***
(6.52)
-0.585***
(-11.06)
0.065***
(21.41)
-0.033***
(-5.21)
0.170***
(14.96)
0.100***
(5.75)
0.044
(1.08)
-0.346***
(-4.95)
0.091
0.140
0.098
0.157
0.239
0.133
0.048***
(12.70)
-0.035***
(-4.35)
0.198***
(6.68)
0.138**
(2.17)
0.144***
(5.95)
-0.197**
(-2.43)
0.070***
(9.96)
-0.010
(-1.09)
0.223***
(10.19)
0.251***
(5.72)
0.226***
(6.40)
-0.729***
(-12.03)
0.057***
(19.71)
-0.003
(-0.35)
0.165***
(12.30)
0.243***
(6.32)
0.153***
(5.26)
-0.527***
(-7.00)
Panel D: Effect of Balance Sheet Conservatism
Intercept
0.070***
0.054***
(11.31)
0.015**
(2.29)
-0.014
(-1.28)
0.020
(0.88)
0.137***
(6.63)
-0.398***
(-9.71)
(14.43)
0.004
(0.59)
0.017**
(2.18)
0.034**
(2.15)
0.345***
(12.71)
-0.358***
(-5.06)
0.040***
(5.38)
0.020
(1.49)
0.195***
(5.55)
0.013
(0.13)
0.091***
(4.05)
-0.250***
(-3.20)
Adjusted R2
0.112
0.111
0.102
0.107
0.261
0.161
Observations
26,020
1,876
28,709
319
5,932
5,707
7,391
1,821
21,080
21,018
21,012
20,792
DEC_BTM
EVg
EVg*DEC_BTM
ECF
ECF*DEC_BTM
N RET <0
This table presents estimates from OLS regressions of EPAT on EVg and ECF (regression 1a) for each sub-sample,
including interaction terms between relevant firm-year characteristics and both EVg and ECF. DEC_ denotes that
the corresponding variable has been ranked into deciles. We sort all observations in the full sample into deciles by
fiscal year. Decile ranks are then scaled to have a mean of zero and range of one. All variables are defined in
Appendix A.2. t-statistics reported in parenthesis are calculated using two-way clustered standard errors, clustered
by firm and year. *, ** and *** indicate (two-tailed) significance at the 10%, 5% and 1% levels respectively.
49
Estimated marginal effect as a %
of one EPAT std. dev.
Figure 1
Normalized marginal effects of changes in enterprise value on estimated EPAT
EVg
60%
ECF
50%
40%
30%
20%
10%
0%
Full
Sample
+EV
+EVg
ECF in
+EV
+EVg
ECF out
***
+EV
-EVg
ECF in
**
-EV
+EVg
ECF out
***
-EV
-EVg
ECF in
-EV
-EVg
ECF out
***
This figure presents the marginal effects of one standard deviation changes in enterprise value on EPAT. Each
column plots the magnitude of the effect of a one standard deviation change in EVg or ECF on EPAT based on the
estimated coefficients from regression (1a) for each regression sample listed along the horizontal axis. The
regression sub-samples are defined in Table 1. The height of each column is scaled by the standard deviation of
EPAT for the corresponding sample, facilitating comparison across sub-samples. This is equivalent to normalizing
all regression variables within each regression sample and plotting the (absolute) normalized coefficients. For
example, the leftmost column in the figure was calculated by multiplying the full sample EVg coefficient (0.053,
Table 3, Panel A), by the standard deviation of EVg for the full sample (0.468, Table 1). This marginal effect of
approximately 0.025 was then scaled by the standard deviation of EPAT in the full sample (0.105, Table 1). The
height of the column indicates that a one standard deviation change in EVg in the full sample is associated with a
0.2362 standard deviation change in EPAT (23.62%). *, ** and *** indicate that the heights of the two columns for
the corresponding sample are significantly different at the (two-tailed) 10%, 5% and 1% levels respectively, based
on Wald tests of the corresponding normalized regression coefficients.
50