Accounting Information, Capital Investment Decisions, and Equity Valuation: Theory and Empirical Implications

The role of accounting fundamentals and other information in analyst forecast errors

“…In accordance with evidence in the prior literature that linear functions do not fully capture the effects of earnings, book value and dividends on equity value and future earnings (Burgstahler & Dichev, 1997;Collins et al, 1999;Zhang, 2000), we also conduct robustness tests and estimate analysts' expectation of other information c OI * t,tþ1 and realized other information c OI t,tþ1 using nonlinear specifications by adding quadratic terms of earnings components, book value and dividends on each panel regression (see Appendix A).…”

“…In summary, our results suggest that analysts are generally optimistic based on the impact of negative other information on earnings but pessimistic based on the impact of positive other information on earnings. Regardless of the literature findings that linear functions do not fully capture the effects of earnings, book value, and dividends on equity value and future earnings (Burgstahler & Dichev, 1997;Collins et al, 1999;Zhang, 2000), the equivalence of results based on designers that relate accounting fundamentals to analysts' expectation of future earnings considering either linear and nonlinear specifications suggests that analysts may not formulate their expectations based on nonlinearity. If this basis were the case, analysts' inefficiency would not increase with the magnitude of earnings.…”

“…To establish a theoretical link between analyst forecast errors and the corresponding influence of accounting information and other information on forecasts, we base our analysis on Ohlson (1995) and Zhang (2000). Ohlson (1995) models a linear information dynamic that links earnings (x t ), book value (b t ), dividends (d t ), and other information (OI t ) with expectation of future earnings:…”

“…We base our analyst error disaggregation approach on Ohlson's (1995) linear information dynamic, which links accounting fundamentals and other information with expectations of future earnings. We also consider the nonlinear relation between accounting fundamentals and valuation functions (Burgstahler & Dichev, 1997;Collins, Pincus & Xie, 1999;Zhang, 2000) to estimate our models.…”

The Market's Valuation of Fraudulently Reported Earnings

“…At t +1 the company chooses either: (1) to discontinue its operations and apply its resources to another business with an adaptation value of B t (as in Burgstahler and Dichev, 1997), or (2) to continue its current operations with a value equal to kX t+1 , where k is the earnings capitalization factor. As shown in Burgstahler and Dichev (1997) and Zhang (2000), the optimal decision is for the company to exercise the adaptation option if its profitability (q t+1 ) falls below a critical point, which equals q * ≡ 1/k in this setting, and to stay in business otherwise.…”