Conditional Earnings Conservatism and Corporate Refocusing Activities

Abstract

We extend standard models of conditional earnings conservatism and adaptation value to the context of the corporate refocusing activities of UK listed companies. This analysis is interesting because refocusing activities are:(1) commonly anticipated by significant negative returns in the financial year(s) before the refocusing event;(2) typically associated with large material charges; and (3) likely to be part of a strategic plan with the internal decision preceding the formal public announcement. We complement Burgstahler and Dichev [1997] by showing how their nonlinear relation between share prices and earnings changes around refocusing events as adaptation options are exercised. Because refocusing events also involve large realized losses and major changes to firms' strategic plans, we expect to see systematic changes in the timing relations between stock returns and reported earnings. To capture this, we show how the coefficients of Basu's [1997] model of conditional conservatism change around refocusing events.

Do market predictions affect its reaction to UK listed industrial firms' corporate refocusing announcements?

“…These differences in the behaviour of these two groups of investors implies that they may be able to predict the probability of a firm announcing refocusing and so prepare their reactions to a firm's future announcements (Ragothaman and Bublitz, 1996;Bartov et al, 1999;Barber and Odean, 2008) 3 . This implication is consistent with evidence of a continuous decline in a firm's market performance in the two years prior to any restructuring announcements (Berger and Ofek, 1999;Mak et al, 2011).…”

“…below 5%. The average annual percentage of firms announcing first time refocusing is 5.65%, implying that the frequency of corporate refocusing activities in the 2000s was higher than in the 1990s, as established by Mulherin and Boone (2000) and Mak et al (2011).…”

“…The matching procedure has been developed according to the work of Guo and Fraser (2010) and Parson's (2000Parson's ( , 2001 5 to 1 digit Greedy Match Macro. In order to confirm the quality of the matching, the covariate balance between the independent variables (of Model 1) of 505 pairs of PSM refocusing firms and PSM non-refocusing firms is examined by means of a t-test of differences in mean, and non-parametric tests of differences in median (Armstrong et al, 2010;Mak et al, 2011).…”

“…This is achieved through an examination of the association between firms' monthly stock returns and refocusing announcements, and investors' predicted probability prior to a refocusing announcement. Previous studies have revealed that firms' market and accounting performance decline continuously during the two years prior to restructuring announcements (Berger and Ofek, 1999;Mak et al, 2011). This can mean that investors monitor and adjust predicted performance in line with the new M A N U S C R I P T A C C E P T E D ACCEPTED MANUSCRIPT 3 targets.…”

“…These are significant changes in firms' business strategies and directly affect the sustainability of and trends in their earnings, cash flows and future dividends. (2) The material restructuring charges influence the timing relation between earnings, share prices and stock returns (Burgstahler and Dichev, 1997;Mak, Strong and Walker, 2011). (3) Refocusing and restructuring charges increase investors' uncertainty in relation to predictions for (and the valuation of) firms, in particular when managers announce refocusing subsequent to the initial announcement (Penman 2012;Wahlen, Stephen, Baginski and Bradshaw, 2011).…”