Abstract
We examine how cross-country differences in product, capital, and labor market competition, as well as earnings management affect mean reversion in accounting return on assets. Using a sample of 48,465 unique firms from 49 countries, we find that accounting returns mean revert faster in countries where there is more product and capital market competition, as predicted by economic theory. Country differences in labor market competition and earnings management are also related to mean reversion in accounting returns—but the relation varies with firm performance. Country labor competition increases mean reversion when unexpected returns are positive but slows it when unexpected returns are negative. Accounting returns in countries with higher earnings management mean revert more slowly for profitable firms and more rapidly for loss firms. Thus earnings management incentives to slow or speed up mean reversion in accounting returns are accentuated in countries where there is a high propensity for earnings management. Overall, these findings suggest that country factors explain mean reversion in accounting returns and are therefore relevant for firm valuation.
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Notes
Of course forces of competition can force persistent loss-making firms to quickly exit the market. However, note that the competition variable of interest here is the competition in the labor market (and not competition in markets that force firms to easily exit, e.g., the takeover market).
Siegel and Larson (2009) show that the extent to which the pay-for-performance relationship holds in different countries is related to the bargaining power of domestic labor unions.
When we use net income excluding extraordinary items, we find very similar results, and when we use net income including extraordinary items, we find similar results but the statistical significance is reduced.
Our specification differs from the standard partial adjustment model used in the capital structure literature (Flannery and Rangan 2006). Unlike standard adjustment models, which use current variables to measure the level of the future targets (e.g., expected target ROA), we use current observables to measure the level of the current expected value (e.g., expected current ROA). An important assumption for our model is that expected ROA does not include abnormal profits. If this assumption does not hold, leading to measurement errors that are correlated with our country-level competition variables, the model estimates are likely to be biased. In our main analyses, we include specific country-level controls that can drive such measurement errors (e.g., properties of reported earnings). In addition, we test the sensitivity of our results using a one-stage estimation methodology (see Table 5).
The average explanatory power of this model is 20 %, similar to the explanatory power that Fama and French (2000) report in their sample of US firms. We also estimated expected ROA by omitting country and industry indicator variables. The predicted ROA was highly correlated (0.89) with the estimate we use. Note, however, that our 12-year sample period is relatively short and may yield noisy lambda estimates.
The Murphy-Topel adjustment accounts for the fact that estimated regressors (e.g., E(ROA i,t)]) may be measured with sampling error. Such sampling error may bias the estimated covariance matrix in the second stage, even in large samples.
Earnings timeliness is the estimated sum of coefficients on stock returns and stock returns times an indicator variable for negative returns, from an asymmetric timeliness model of earnings and returns as in Bushman and Piotroski (2006). We also test the sensitivity of the analysis using measures of timely loss recognition (coefficient on the indicator variable for negative returns) and find similar results.
How the level of corruption will influence the rate of mean reversion in corporate profitability critically depends on who bribes. If more profitable firms pay bribes to acquire permits and contracts, then the rate of mean reversion of corporate profitability will be slower. If less profitable firms pay bribes, then they will be able to improve their performance faster, leading to a faster mean reversion of corporate profitability. Cheung et al. (2012) find that underperforming firms in corrupt countries are more likely to pay bribes, which would accelerate competition and mean reversion in accounting returns. In contrast, Bliss and Di Tella (1997) find that strong performing firms pay bribes to protect their market position, which would reduce mean reversion in accounting returns through less competition.
For more information, see http://www.imd.org/research/publications/wcy/index.cfm.
In untabulated results, we find that the results are largely consistent when we include all 54 parameters in our measure of market competition.
Prior studies find that the small profit measure is a component of the overall measure (Durtschi and Easton 2009). In untabulated analysis, we rerun our analysis excluding the small profit measure from our EM measure. Our inferences remain unchanged.
Most of the observations we eliminate are for firms classified as financial institutions or firms with missing observations for some of the variables of interest.
Fama and French (2000) exclude the observations of firms with total assets below $10 million or a book value of equity below $5 million. Given that we have an international sample, we halved the book value of assets threshold. In untabulated analysis, we find that our results are robust to imposing an even lower threshold of $1 million.
We winsorize all dependent and independent variables in the regression at 1 and 99 %.
We do not report the country-level competition measures because of the restrictions in the purchase agreement with IMD. Alternatively, we provide the list countries in the high, medium, and low tercile group for each competition measure (see Table 1). We thank the editor for making this suggestion. .
In untabulated analysis, we find that the country average rate of mean reversion for the pooled sample is 0.26. Fama and French (2000) estimate the mean reversion for a sample of US firms for an earlier period at 0.38.
The mean reversion parameters in all these models are negative. A negative interaction term therefore implies that the rate of mean reversion is greater for more competitive countries.
None of the variance inflation factors were higher than four, suggesting that multicollinearity is not a significant problem. We further investigate the stability of the estimated coefficients by estimating our model using a large set of randomly drawn subsamples. We draw 500 samples, each with 50 % of the observations randomly drawn from our original sample. We re-estimate Eq. (4) and generate a distribution of 500 coefficients for each market competition variable. The sample means (standard deviation) of coefficients on product, capital, and labor market competition are −0.07 (0.022), −0.03 (0.013), and 0.03 (0.014), respectively. The statistical inferences from this analysis resemble those reported in Table 3, with t-statistics of 3.18, 2.31, and 2.14 for each of the competitiveness coefficients.
The value to book multiples are \( \sum\nolimits_{t = 1}^{10} {\frac{{0.17*(1 - .2)^{{{\text{t}} - 1}} *(1 + g)^{{{\text{t}} - 1}} }}{{(1 + r)^{\text{t}} }}} \) for the firm from the bottom five country and \( \sum\nolimits_{t = 1}^{10} {\frac{{0.17*(1 - .34)^{{{\text{t}} - 1}} *(1 + g)^{{{\text{t}} - 1}} }}{{(1 + r)^{\text{t}} }}} \) for the firm from the top five country, where g is the growth rate 3 % and r is the weighted average cost of capital 6 %.
Research has indicated that, with more competition in the product markets, firms have less incentive to provide quality disclosure because they have incentives to hide profitable business opportunities from their competitors (Li 2010). This suggests that earnings management incentives to slow mean reversion for high-performing firms and to accelerate mean reversion for poor-performing firms are likely to be attenuated in countries with more competitive product markets. In untabulated results, we test this hypothesis, by estimating the effect of product market competition separately for firm-years with positive and negative unexpected ROAs. The model mirrors Eq. (5) but includes additional terms that interact the effect of country earnings management and product competition on mean reversion. We find that, for the positive unexpected ROA sub-sample, the significant earnings management estimate of 0.0174 is consistent with managers of countries with a high earnings management propensity using their reporting discretion to delay mean reversion, as documented above. But this effect is attenuated for managers of firms in more competitive product markets, reflected in the significant interactive estimate of −0.0019. This finding is consistent with product market competition counteracting incentives of managers in countries with high earnings management to boost reported profitability and slow mean reversion.
If either foreign assets or sales are missing, then we define a firm as multinational if either foreign assets or sales are greater than 20 % of total assets or sales, respectively.
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Acknowledgments
We appreciate comments from two anonymous referees, Russell Lundholm, Krishna Palepu, Lakshmanan Shivakumar (editor), and seminar participants at UC Berkeley and Tilburg University. We gratefully acknowledge financial support from the Division of Research of the Harvard Business School. All errors are our own.
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Appendix
Appendix
See Table 6.
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Healy, P., Serafeim, G., Srinivasan, S. et al. Market competition, earnings management, and persistence in accounting profitability around the world. Rev Account Stud 19, 1281–1308 (2014). https://doi.org/10.1007/s11142-014-9277-8
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DOI: https://doi.org/10.1007/s11142-014-9277-8