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Share repurchases and accounting conservatism

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Abstract

The prior literature indicates that financial policy (e.g., payout policy) as well as accounting policy (e.g., conservatism) can be used to address incentive problems in firms but finds mixed evidence. We conjecture that stock repurchases, an increasingly popular form of payout, and conservatism are potential mechanisms to counter managerial propensity to engage in overinvestment using free cash flows. Consequently, we expect a negative relation between repurchases and conservatism as well as a stronger negative relation between these two mechanisms in firms with high levels of free cash flows. We find results consistent with these expectations. By contrast, we find a weaker negative relation between repurchases and conservatism when CEO tenure is higher, which confirms that more entrenched CEOs have less incentives to solve the overinvestment problem.

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Notes

  1. One possible reason for divergent results is empirical design. First, Ahmed, et al. (2002) and Louis and Urcan (2015) use similar measures for dividends, but different measures for accounting conservatism. Second, Ahmed et al. (2002) use conservatism as the dependent variable, while Louis and Urcan (2015) use payout as the dependent variable.

  2. The archival financial accounting literature identifies factors associated with specific accounting policies such as conservatism. For example, conservatism is negatively related to managerial optimism. More generally, the literature identifies factors such as CEO compensation, managerial style, board structure, taxes, and audit infrastructure. While there is considerable evidence on factors influencing policies or mechanisms such as conservatism, there is little evidence on exact methods and processes by which firms adopt and implement them.

  3. To calculate this measure, we extract the purchase of common and preferred stock (Compustat items prstkcy) and subtract the decrease of redeemable preferred stock (Compustat item pstkr; use if change in pstkr < 0). We also consider the increase in treasury stock (Compustat item tstkc) as a lower bound: we replace the numerator with the increase in treasury stock if that value is higher. Finally, we consider the possibility that the numerator is negative in certain cases, and in those instances, we set the value to zero. Thus, this ratio is bounded between zero and one.

  4. Using a raw measure of dollar value of actual repurchase (in the numerator of the formula in Eq. 3) yields qualitatively similar results.

  5. We also replicate our test using measures of accumulated actual repurchase after announcement using Compustat quarterly data, following Bonaimé (2015). Non-repurchase firm-year observations are thus dropped in the test. The results are qualitatively similar to those presented in panel C from Tables 4, 5, 6 and 7 whether we accumulate repurchase activity over nine quarters or four quarters. We also find similar results when we accumulate annual data over 2 years.

  6. For example, the announcement by Columbia Sportswear Company (Ticker: COLM) contains the statement “The repurchase program does not obligate the Company to acquire any specific number of shares or to acquire shares over any specified period of time.” Second, although the NYSE and NASDAQ require listed companies to issue a press release when a share repurchase program is initiated, the Securities Exchange Act doesn’t require such a disclosure (Banyi et al. 2008). On December 2003, the SEC modified Rule 10b-18 to require all repurchasing firms to report ex-post repurchases in periodic filings. Nevertheless, the announcement is not legally binding.

  7. In untabulated robustness checks, we use alternative measures of conservatism, such as Basu (1997) and Ball and Shivakumar (2005) and find consistent results.

  8. We find similar results when we use the conservatism measure contemporaneously, which is probably due to its stickiness. This further supports the substitution effect between conservatism and share repurchase.

  9. Researchers also argue that conservatism represents an important aspect of accounting quality. Although we generate our prediction of a negative relation between conservatism specifically and repurchases, some of our arguments perhaps extend to the more general construct of accounting quality. To provide a preliminary examination of this possibility, in untabulated tests, we substitute accrual quality (our measure of accounting quality) for conservatism and re-estimate the models. We measure accrual quality using the approach in Dechow and Dichev (2002) and Francis et al. (2004). Results show a positive relation between repurchase and accrual quality. Thus, our results appear specific to conservatism as a measure of reporting quality, and do not generalize to other measures.

  10. As in the Panel B, we also explore the contemporaneous relation between conservatism and actual repurchase, and find qualitatively similar results.

  11. Although we measure conservatism at t − 1 (lag = 1) in our main tests and repurchase at t, we conservatively interpret the relation as an association rather than as causality. In this section, we examine other lag periods to explore the issue further. Specifically, we use contemporaneous data (lag = 0) as well as conservatism leading repurchases by one period (lag = − 1). The results are maintained for the contemporaneous specification but not for the leading specification suggesting that the decision to repurchase is conditional on conservatism and not vice versa.

  12. It is also possible that the relation we document could be driven by the year effect, as discussed in Petersen (2009). To address this concern, we use the Fama and MacBeth (1973) two-step approach. These untabulated tests show a pervasive negative relation between repurchase and conservatism and confirm other reported results.

  13. In untabulated tests, we examine two contemporaneous specifications for the association between conservatism and share repurchases. In the first model, we use Conservatism score as the dependent variable and stock repurchases as the independent variable, with both variables measured contemporaneously. Second, we use a Basu (1997) type model and interact the dummy for repurchases with the other independent variables. In both tests of contemporaneous association, we find a negative relation between accounting conservatism and share repurchases. Detailed results are available upon request.

  14. We also use an alternative free cash flow measure following Opler et al. (1999) and find consistent results.

  15. Because interacting two continuous variables may induce multicollinearity, we follow Aiken and West (1991) and subtract FCFt−1 from its sample mean to get FCFCt−1, and then compute the interaction term FCFCt−1\(\times\)Conservatism scoret−1.

  16. We also consider the possibility that repurchases are opportunistically used by managers to manipulate earnings per share through a reduction in the number of shares. The prior literature finds that firms may use accretive stock repurchases as a real earnings management tool to meet or beat analysts’ EPS forecasts (Hribar et al. 2006; Burnett et al. 2012). To address this issue, we eliminate accretive stock repurchases and find that our results hold.

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Acknowledgements

We gratefully acknowledge the valuable comments and suggestions from Steven Balsam, Stan Hoi, Sangwon Lee, Henock Louis, Dana Zhang, Hao Zhang and Rong Yang. Kean Wu acknowledges financial support from Saunders College of Business and RIT’s Sponsored Research Services office. All remaining errors or omissions are the authors’ responsibility.

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Authors and Affiliations

  1. Department of Accounting and Taxation, Bauer College of Business, University of Houston, Houston, TX, 77004, USA

    Gerald J. Lobo

  2. Department of Finance and Accounting, Saunders College of Business, Rochester Institute of Technology, Rochester, NY, 14623, USA

    Ashok Robin & Kean Wu

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  1. Gerald J. Lobo
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  2. Ashok Robin
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Correspondence to Kean Wu.

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Appendices

Appendix A: Variable definitions

Variable name

Description

Repurchase

A dummy variable that equals 1 if the firm announces a repurchase plan, 0 otherwise

Actual repurchase ratio

A measure of actual repurchase based on Compustat Fundamentals Annual according to Bonaimé (2015). First, we calculate Actual repurchase as purchase of common and preferred stock (Compustat item prstkcy) minus any decrease in redeemable preferred stock (pstkr). Second, we update Actual repurchase by the increase in treasure stock (tstkc) if the first step Actual repurchase is smaller than the increase in treasure stock, which is considered as a lower bound. Third, we set Actual repurchase to zero if it is negative. Fourth, we divide Actual repurchase by the market capitalization at the beginning of the year to get the Actual repurchase ratio

Conservatism score

A firm-year measure of conditional conservatism based on Khan and Watts (2009). In the first stage, we estimate annual cross-sectional Basu (1997) regressions, specifying the asymmetric earnings timeliness coefficient as a linear function of the firm-specific characteristics size(ln(csho*prcc_f)), market-to-book(prcc_f *csho/ceq), and leverage((dltt + dlc)/(csho*prcc_f)). We then calculate Conservatism score by substituting the firm’s size, market-to-book and leverage into the estimated regression for that year

Leverage

Total liabilities (lt) divided by total assets (at)

Firm size

The market capitalization (csho*prcc_f) of the firm in year 2000 dollars

M/B

The market capitalization (csho*prcc_f) divided by book value of equity (seq)

Cash

Cash and short-term investments (che) divided by market value of common stock (csho*prcc_f)

Cash flow

Cash flow (income before extraordinary items plus depreciation and amortization) (ib + dp) divided by market value of common stock (csho*prcc_f)

Excess returns

The return on the company’s stock minus the return on the value-weighted CRSP index

Options

The total dollar value of options exercised (the number of shares times the stock price on the day of exercise) divided by the stock’s market capitalization at the start of the period

Payout

The ratio of cash dividends (dv) paid to net income (ni)

Takeover

A dummy variable that equals 1 if the firm is the target of a takeover attempt or if there is a rumor of a potential threat of a takeover attempt in either the year prior to or the year of the repurchase, 0 otherwise

Blockholder

A dummy variable that equals 1 if the firm has at least one major blockholder, defined as a firm that has filed SEC form 13G within the past 12 months, 0 otherwise

Active blockholder

A dummy variable that equals 1 if at least one of the firm’s major blockholders is an active blockholder, defined as a firm that has filed SEC form 13D within the past 12 months, 0 otherwise

Cash flow volatility

The standard deviation of quarterly cash flow (quarterly income before extraordinary items plus depreciation and amortization) divided by firm size and measured over the 12 prior quarters

GDP growth

The annual growth in real GDP

Returns to S&P500

The annual returns on the S&P 500 index

Industry average

The portion of firms in the same two-digit SIC code that announce a repurchase plan during the fiscal year, not including the firm itself

FCF

Operating income before depreciation(oibdp) minus interest expenses(xint), the sum of preferred and common dividends(dvp), income taxes (txt) excluding deferred taxes(txdi), all scaled by total assets(at). At certain circumstance, we mean-center the value of this variable (FCFC)

CEO tenure

The natural log of the number of years that the CEO has served in that capacity. At certain circumstance, we mean-center the value of this variable (CEO tenureC)

All continuous variables are winsorized at the 1% and 99% levels.

Appendix B: Basu (1997) measure of conservatism and conservatism score (Cscore)

Basu (1997) estimates conservatism using the following model:

$$X_{i,t} = \beta_{1,t} + \beta_{2,t} D_{i,t} + \beta_{3,i,t} R_{i,t} + \beta_{4,i,t} D_{i,t} R_{i,t} + \varepsilon_{i,t}$$
(4)

X is income before extraordinary items divided by lagged market value. R is annual return compounded from monthly returns ending 3 months after the fiscal year end. D is a dummy variable that equals one for firms with negative returns, and zero otherwise. In Eq. (4), \(\beta_{4}\) is the measure of conservatism. It captures the incremental timeliness of bad news relative to good news reflected in returns.

Based on Eq. (4), Khan and Watts (2009) express \(\beta_{3}\) and \(\beta_{4}\) as linear functions of three time-varying firm-specific characteristics: size, market-to-book ratio, and leverage. These three characteristics are shown to vary conceptually and empirically with conservatism. Specifically, Khan and Watts use the following identities:

$$Gscore = \beta_{3,i,t} = \mu_{1} + \mu_{2} SIZE_{i,t} + \mu_{3} MB_{i,t } + \mu_{4} LEV_{i,t}$$
(5a)
$$Cscore = \beta_{4,i,t} = \lambda_{1} + \lambda_{2} SIZE_{i,t} + \lambda_{3} MB_{i,t } + \lambda_{4} LEV_{i,t}$$
(5b)

Cscore is the incremental timeliness of bad news over good news. SIZE is the natural log of market value of equity, MB is the market-to-book ratio, and LEV is the sum of long-term and short-term debt divided by market value of equity. λi and μi are constant across firms, but vary over time.

Equations (5a) and (5b) are substituted into Eq. (4) to yield the following empirical specification:

$$\begin{aligned} X_{i,t} & = \beta + \beta_{2,t} D_{i,t} + R_{i,t} \left( {\mu_{1} + \mu_{2} SIZE_{i,t} + \mu_{3} MB_{i,t } + \mu_{4} LEV_{i,t} } \right) \\ & \quad + D_{i,t} R_{i,t} \left( {\lambda_{1} + \lambda_{2} SIZE_{i,t} + \lambda_{3} MB_{i,t } + \lambda_{4} LEV_{i,t} } \right) + \varepsilon_{i,t} \\ \end{aligned}$$
(6)

Following Khan and Watts, we estimate Eq. (6) annually to obtain the year-specific estimated parameters, λi and μi. We then substitute λi into Eq. (5b), along with firm-specific measures of firm size (SIZE), market-to-book (MB) and leverage (LEV) to obtain the firm-year specific Cscore. In our estimation of (6), we exclude observations with (1) missing data for any of the variables in the equation, (2) negative total assets or book value of equity, (3) price per share less than one, and (4) in the top and bottom 1% of the distributions of earnings, returns, size, market-to-book ratio and leverage in each year.

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Lobo, G.J., Robin, A. & Wu, K. Share repurchases and accounting conservatism. Rev Quant Finan Acc 54, 699–733 (2020). https://doi.org/10.1007/s11156-019-00804-9

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