Abstract
We evaluate the representational faithfulness of the accounting treatment of a recent and well-established type of structured transaction—accelerated share repurchases (ASRs). ASRs are popular because accretive earnings per share benefits are recognized immediately, while any gains or losses on the forward contract used to execute an ASR bypass income, and are reported directly in equity. We document lower value relevance for the liabilities of ASR companies compared with a size- and industry-matched sample. ERC tests also indicate a market discount for the earnings of ASR companies compared with the control sample. Finally, we document significant abnormal returns to a trading strategy based on unrealized gains or losses on ASR transactions. Our results indicate that the current accounting for ASRs does not result in representative reporting of these transactions. As a result, financial statement users might benefit from recognition of ASR elements in financial statements.
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Notes
Our data ends in 2007, in part to calculate post-ASR transaction variables. Although the market downturn in 2008–2009 resulted in a decline in dividend payouts and stock repurchases, market analysts expect a resurgence in stock repurchases, as companies have accumulated significant excess cash (Mnyandu 2010; Krantz 2010).
For example, Marquardt et al. (2009) provide evidence that ASR usage is more prevalent in companies that use EPS in compensation contracts. Note that the FASB/IASB proposal is consistent with the contingent claim framework developed in Ohlson and Penman (2005), who argue that, when a firm is obligated to issue shares at prices different than the fair value, this gives rise to a liability (a contingent claim in which existing shareholders give up value to the claimants). Ohlson and Penman also argue that that the unrealized gains and losses can be separated into two parts: (1) an imputed finance charge, which should flow through the income statement, and (2) a nonrecurring, unpredictable change in value due to changes in market factors, which should be reported in other comprehensive income.
This is consistent with FASB and IASB Conceptual Frameworks’ common conclusion that disclosure is not an acceptable substitute for recognition (FASB SFAC No. 5).
Grullon and Michaely (2002) document that the aggregate value of share repurchases exceeds that of dividends. According to a Standard & Poors’ study, stock repurchases among the S&P 500 companies totaled more than $367 billion in 2006 compared with just $131 billion in 2003 (Standard & Poors 2007; Marquardt et al. 2009).
Another motivation is related to providing a signal to outside parties about the value of the company. Alternatively, stock repurchases can also be used to alleviate agency problems arising from the over-consumption of perquisites (perks). Lastly, stock repurchases serve to reduce cash buildup, which may indicate a lack of investment opportunities.
We add another 43 ASR contracts to the initial sample published in the Bear Stearns research report, bringing the total ASR contracts between 2002 and 2005–1994.
Some companies contractually cap their potential losses at settlement through “collar” agreements. Collars were used with increasing frequency over our sample period. However, the collars limit the magnitude of unrealized gains and losses and, as such, will bias against finding a market reaction to the off-balance sheet amounts.
The consequences of off-balance sheet accounting have been explored by Bauman (2003)—equity method investments; Marquardt and Wiedman (2007)—contingently convertible securities; Hann et al. (2007)—pension assets and liabilities; and both Dhaliwal et al. (1999) and Chambers et al. (2007)—other comprehensive income items (i.e., marketable securities, pension, and foreign currency adjustments). Both the magnitude and growth of ASR transactions, as well as the effects of ASR off-balance arrangements on the balance sheet and the income statement, support the economic importance of our study relative to off-balance sheet research.
FAS. No. 128—“Contracts that may be Settled in Stock or Cash” discusses the computation of EPS with respect to the ASR plan. EITF 00-19—“Accounting for derivative financial instruments indexed to, and potentially settled in, a company’s own stock,” (FASB 2000) discusses the intent of management in the computation of diluted EPS. The “management intent” criterion opens the door for EPS management. While most companies ultimately settle in cash (57.72% in our sample), virtually all companies generally assume share settlement when calculating diluted EPS (Bear Stearns 2006). By assuming share settlement, rather than cash settlement, companies achieve higher diluted EPS in the period of contract execution.
Stephens and Weisbach (1998) find that 25–30% of announced traditional share repurchases remain unexecuted 3 years subsequent to the announcement. However, contrary to the strength of the signaling mechanism of the ASR, Marquardt et al. (2009) find no difference in the short window market reactions to ASR and traditional stock repurchase announcements.
An additional cost from bringing a third party into the repurchase transaction is the fee paid to the investment bank. Based on selected ASRs where fees are disclosed, Gumport (2007) reports that fees are as high as 6% of contract value.
See http://www.fasb.org/project/liabeq.shtml. In the conclusion to this paper we discuss the merits of this proposal in light of our empirical findings. A related project addresses EPS calculations related to ASRs. In this project, the FASB and IASB have proposed to eliminate diversity in the accounting for the dilutive EPS effects of ASRs by requiring that companies assume share settlement of the forward contract (see http://www.fasb.org/project/short-term_intl_convergence.shtml).
Some question the relevance of tests based on associations between accounting measures and market variables to standard-setters (see Brown et al. 1999; Holthausen and Watts 2001). We are careful not to draw prescriptive standard-setting conclusions from our results. Rather, our goal is to document the significance of ASR transactions and associations of ASR-related amounts with market variables to provide insights on the economic substance of ASR transactions. This evidence, as well as the potential abnormal returns that could be earned, based on unrecognized ASR amounts, provides insights to standard-setters about the adequacy of the accounting for ASRs. We acknowledge that standard-setters factor evidence such as ours, as well as other non-investor oriented costs and benefits into their standard-setting decisions (Barth et al. 2001).
A computer program was developed with an algorithm to search annual and quarterly reports for specific text substrings. The search terms used were “accelerated stock repurchase,” “accelerated share repurchase,” “accelerated stock buyback,” “accelerated share buyback,” “overnight stock repurchase,” “overnight share repurchase,” “overnight stock buyback,” “overnight share buyback,” “broker-dealer counterparty transaction,” and “privately negotiated repurchase”. The flagged reports were read to collect specific details of the nature, timing, and amount of the accelerated share transaction.
Observations in which greater than 20% of the outstanding shares were repurchased are excluded from the sample because it is possible that these repurchases were executed by tender offer (Hribar et al. 2006).
Of the 250 ASR observations, only 130 were also identified as repurchases using the treasury stock and retirement methods. This suggests that some companies that use ASRs also use traditional repurchase methods. An analysis of possible differences among the firms that use both ASRs and traditional repurchases versus that use ASRs exclusively is reported in Table 2, Panel B.
Eight contracts were initiated and settled in the same quarter, and are not in our sample. We require the contracts to be outstanding for at least one full quarter in order to compute unrealized gains or losses on the contract.
The magnitude of the coefficient on OBSL is large (−5.90) relative to the coefficients on the recognized assets and liabilities. There are several explanations, which we explore later in the paper: (1) the large number of zero observations for OBSL (all nonASR firms) are skewing the coefficient values, (2) OBSL is measured with error due to potential correlated omitted variables, and (3) investors treat the OBSL as a discount to the earnings coefficient, which is also large in magnitude (15.56).
In later specifications, we examine a model that controls for possible endogeneity associated with the repurchase decision to further rule out the possibility of a correlated omitted variable explanation.
The insignificant results for off-balance sheets assets documented throughout may be explained in part by the infrequency of assets arising in an ASR, as well as the smaller magnitude of ASR gains/assets relative to ASR liabilities. For example, there are 149 observations containing unrealized losses ranging from $1.5 billion to $0.1 million. There are 101 unrealized gain observations ranging from $0.3 million to $552.0 million. Thus, both the frequency and magnitude of ASR assets is less than that of ASR liabilities. Theoretically, based on the Ohlson and Penman (2005) framework, “one can interpret the issuance of a claim as an activity that finances the firms’ operations, which in turn implicitly leads to a borrowing cost” (p. 4). Investors likely react more strongly to unrealized losses than unrealized gains (the ASR asset reflects an offset to borrowing costs—an asymmetric reaction). This prediction is supported by loss aversion theory (Kahneman and Tversky 1979) with empirical support in the prior literature indicating that negative earnings and nonrecurring items can adversely affect the value relevance of earnings (Basu 1997). Similarly, Skinner (1994) finds that the magnitude of returns over all earnings-based announcements is larger for bad news firms than for good news firms.
While our value relevance models are similar to those used in prior research that examines associations between accounting measures and market metrics (e.g., Landsman 1986; Barth 1991; and Pfeiffer 1998), share price models can be susceptible to various specification issues. For example, Easton and Sommers (2003) find price-level regressions can be driven by firms with large share prices, which causes nonlinearity in the relation between market capitalization and financial statement variables. To address these concerns, our results are robust to using a variety of scalers (number of shares, assets, and sales revenue). We also perform returns regressions (discussed in the next section) to help address concerns that our findings may be the result of specification issues.
All results presented throughout the paper are invariant to using market-adjusted returns from one-quarter ahead, market model abnormal returns or raw returns as the dependent variable, and unexpected earnings based on a random walk expectations model as the explanatory variable.
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Acknowledgments
The authors appreciate the helpful comments of Jim Ohlson (the editor), two anonymous referees, Hollis Skaife, Mary Ellen Carter, Changling Chen, Xia Chen, Qiang Cheng, Shana Clor-Proell, Mark Kohlbeck, Ting Luo, Carol Marquardt, Nicole Thorne-Jenkins, Ray Pfeiffer, Greg Sommers, and workshop participants at Hanyang University, Tsinghua University, the University of Waterloo, the Wisconsin School of Business, and session participants at the 2008 AAA Meeting in Anaheim, CA. Terry Warfield acknowledges financial support from the Arthur Andersen Center at the University of Wisconsin.
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Dickinson, V., Kimmel, P. & Warfield, T. The accounting and market consequences of accelerated share repurchases. Rev Account Stud 17, 41–71 (2012). https://doi.org/10.1007/s11142-011-9162-7
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DOI: https://doi.org/10.1007/s11142-011-9162-7