Accounting Variables and Stock Returns: The Impact of Leverage

Abstract

The fundamental relationship between accounting variables and firm valuation is a recurring theme in capital market research. This paper investigates this relationship within a balance sheet context and highlights the importance of controlling for relevant economic factors. We do this by conditioning explanatory power on the firm's relative financial leverage position, after controlling for cashflows and firm size, and using an arctan regression model to take account of temporary components in cash and earnings flows. Using data for 743 firm‐years for Australian Stock Exchange listed stocks, we find that for firms which are ‘above optimal leverage’: (i) earnings contain a greater level of transitory items, particularly when firm size is small; and (ii) cashflows provide higher incremental information. Our results are consistent with investors perceiving earnings as progressively less informative as the probability of failure increases, and the likelihood of earnings manipulation for the purpose of reducing proximity to debt covenants increases.

Capital structure and earnings manipulation

“…This is consistent with Richardson et al (2002) and Hodgson and Stevenson-Clarke (2000) where firms which have excessive debt are more likely to be involved in EM.…”

“…Second, we compare different contractual arrangements between an investor and an entrepreneur as well as their impact on the entrepreneur's effort. This is important given that several recent papers analyze the links between financing structures and EM (see, for instance, Hodgson & Stevenson-Clarke, 2000;Jensen, 2004;Richardson, Tuna, and Wu, 2002). Finally, we compare the model's predictions with EM and without EM.…”

The informational impacts of Australian listed companies reporting the direct or indirect method statement of cash flows: cash flow disclosure

“…Hodgson and Stevenson-Clarke (2000a) suggest that earnings become less informative as the probability of failure increases. Furthermore, incentives for earnings manipulation increase for highly leveraged companies because of concerns regarding the proximity of debt covenants (Defond and Jiambalvo, 1994;Dichev and Skinner, 2002).…”

“…We therefore include a measure of leverage in this study. Hodgson and Stevenson-Clarke (2000a) evaluate the importance of aggregate operating cash flow in relation to a company's financial leverage. Their findings indicate that operating cash flows become incrementally more important for companies above their optimal leverage.…”

“…Prior studies have evaluated the relative information content of cash flows and earnings in the context of a company's leverage (Hodgson and Stevenson-Clarke, 2000a;Habib, 2008). Hodgson and Stevenson-Clarke (2000a) find that companies above their optimal leverage experience increased transitory earnings and thus cash flow information becomes incrementally important.…”