Does stock price reflect earnings persistence evidence from vietnam

Policies and Sustainable Economic Development | Does Stock Price Reflect Earnings Persistence? Evidence from Vietnam VO XUAN VINH University of Economics HCMC - vinhvx@ueh.edu.vn CHU THI KIM HUONG Maybank Kimeng Securities Limited huong.chu@maybank-kimeng.com.vn Liability Company HCMC Abstract This paper investigates the persistence of earnings and the contribution of accruals and cash flows component in earnings We also examine whether earnings, accruals, and cash flows are correctly priced Our data sample includes 245 listed firms on the Ho Chi Minh City stock exchange covering the period 2007 - 2013 The empirical results show that the earnings persistence rate of Vietnamese firms is quite high Moreover, we find that the accruals component of earnings causes earnings to be less persistent than the cash flows component of earnings Further, this study reports that persistence of earnings, cash flows and accruals component are not fully reflected in stock price Keywords: earnings persistence; abnormal return; cash flow; accruals; Vietnam stock market - Introduction Earnings quality is an important topic in corporate finance which draws attention from different stakeholders, including firm management and equity investors Particularly, the reliability of accounting information is clearly relevant in equity pricing This is reflected by a huge volume of papers in the literature devoted to investigate earnings quality Moreover, a large volume of papers examining earnings management (Dou et al 2016 forthcoming; Kadan & Yang 2016) The topic is important because earnings manipulation is detrimental in corporate world However, most of the papers seem to cover the data from mature markets while papers considering emerging markets tend to be limited in the literature This paper sheds further light on this important issue in the context of Vietnam, a member of CIVETS emerging markets group, which is characterized by high economic growth rate and innovative population While earnings persistence, its components (cash flow and accruals) and its role in securities pricing has been widely covered in the developed markets, study of this topic in the context of developing markets like Vietnam is relatively underexplored The central objectives of this paper are: (i) investigating the persistence of earnings and information contained in the accrual and cash flow components of earnings; and (ii) examining the magnitude to which this information is reflected in Vietnam stock market We focus on the quality of earnings using the dataset of Vietnam listed firms since the accounting fraud and earnings manipulation have recently been a serious problem More importantly, this accounting manipulation practice has been discovered in many large Vietnamese corporation Consequently, the quality of reported earnings has attracted attention from different market participants This is an important motivation for the current paper because quality of earning is more important in emerging markets due to the overall lacking of institutional quality Many previous authors also recognize the profound importance of earnings quality in emerging markets (Shen & Chih, 2007) Another important motivation of our paper is the mixed findings in the current literature Particularly, a large number of prior studies show that earnings persistence is more contributable by cash flow component than accruals component of earnings, but they also report that market participants usually overestimate more on accruals than earnings in actual investment More importantly, Sloan (1996) claims that investors concentrate on current earnings to predict future earnings in an influential work However, investors tend to fail to estimate the information contained in the two components of earnings which are accruals and cash flows Many subsequent authors extend the work of Sloan (1996) to provide further evidence on the persistence of earnings (Amir et al., 2015; Beneish & Vargus, 2002; Fairfield et al., 2003; Hanlon, 2005; Hui et al., 2016; Richardson, 2005; Subramanyam & Wild, 1996; Xie, 2001) Our paper is also motivated by the light volume of this topic in the context of emerging markets We recognize that there is a few papers investigating earnings quality in the context of developing countries, for example, China (Navissi et al., 2006) and Korea (Hong-Bok & Gee-Jung, 2010) These papers also examine the pricing of earnings and earnings components offering consistent findings with the ones using the developed country data However, studies using the less developed country data seem to provide compelling results (Çelik et al., 2013; Clinch et al., 2012; Ozkan & Kayali, 2015) The results of this paper show that firms in Vietnamese stock market has a high level of earnings persistence Moreover, we observe that the accrual component of earnings causes earnings to be less persistent than the cash flow component of earnings These findings are consistent with previous results in the context of developed countries such as the US (Sloan, 1996) and the UK (Soares & Stark, 2009) The current paper also suggests that Vietnamese investors generally underestimate the persistence of current earnings into future earnings while overestimate the contribution of accrual component in relative with cash flow component Vietnam stock market reaction on earning persistence is inconsistent with the findings of papers using the context of developed markets, however, it is similar to the results of previous papers employing data of emerging markets, including China (Navissi et al., 2006), Korea (Hong-Bok & Gee-Jung, 2010), and Turkey (Çelik et al., 2013) The remainder of the paper is structured as follows Section reviews the literature Section introduces data and methodology Section reports the results and discussion of results Section concludes the paper Literature review Dechow (1994) demonstrates that cash flows and accruals are measures of earnings persistence and is based on the ground that the cash flows and accrual components of earnings should have similar forecasting information However, Sloan (1996) argues that accruals may be less informative than cash flows because they are less reliable To support this argument, Sloan (1996) provides evidence that accruals are less useful than cash flows in forecasting future earnings This argument indicates that earnings persistence which is contributed by the accruals component of earnings is lower persistent than earnings performance contributed by the cash flows component of earnings In the same vein, Pincus et al (2007) and Ball et al (2016) conduct the test and yield the similar findings Other studies in the context of emerging markets provide agreeable results, for instance, Navissi et al (2006) find that cash flow components of earnings mainly drive a high level of earning persistence in China, and Hong-Bok and Gee-Jung (2010) extract the same evidence for Korean stock market These findings lead to form our first testable hypothesis: H1: The persistence of earnings is lower by the contribution of the accruals component of earnings and higher by the contribution of cash flows component of earnings These pioneer works of Dechow (1994) and Sloan (1996) map the way for a voluminous papers investigating the pricing of the earnings, cash flows and accruals components of earnings (Beneish & Vargus, 2002; Dechow et al., 2006; Fairfield et al., 2003; Fairfield et al., 2003; Hanlon, 2005; Persakis & Iatridis, 2015; Richardson, 2005; Subramanyam & Wild, 1996; Xie, 2001) However, the results are mixed While many papers demonstrate that market participants overprice the earnings’ persistence and they also overvalue the accruals components of earnings, Dechow et al (2006), in contrast, shows that market participants correctly anticipate the persistence of earnings and cash flows components of earnings The tests in the developing economies present compelling results Çelik et al (2013) and Clinch et al (2012) offer evidence from Turkey and Australia showing that market participants seem overestimate the properties of earnings persistence while fully reflect implication of accruals but underprice the value of cash flows component However, Ozkan and Kayali (2015) reports that investors react similarly on cash flows component, but different from accruals They overprice accruals in analyzing for investment From aforementioned evidences both in developed and developing markets, we predict that Vietnam investors fail to take into account the different levels of persistence of the two earnings’ components and form our second testable hypothesis as follows: H2: Stock prices fail to anticipate the higher earnings persistence contributed by the cash flows component of earnings and the lower earnings persistence contributed by the accruals component of earnings Data, variable measurement, and methodology 3.1 Data Accounting data and stock market trading data are obtained from Bloomberg database Our sample covers 245 listed firms on the Ho Chi Minh City stock exchange which have available data for the period from 2007 to 2013 We exclude banking, financial, and insurance institutions from our analysis because the distinction between operating and investing activities is not clear for these firms We also eliminate firm-year observations with insufficient data 3.2 Variable definition The financial variables used in this paper are earnings, cash flows, accruals and abnormal stock return We use the firm’s net income to proxy for earnings (NI) Sloan (1996) defines accruals as the difference between net income and cash flows from operating activities However, this definition of accruals omits cash flows from investment According to Richardson et al (2001), there is no clear evidence to expect that accruals relating to investment cash flow will be more or less reliable than accruals relating to operation cash flows To eliminate that shortcoming, we obtain accruals (ACC) definition as the difference between earnings (NI) and cash flows (CF), in which cash flows (CF) variable is measured as the sum of cash from operation (CFO) and cash from investment (CFI) Similar to Sloan (1996), in order to analyze earnings persistence and its components across a large set of firms, we standardize all of variables by scaling earnings, accruals, and cash flows by average total assets, measured as the average of the beginning and ending year total assets These variables are defined as follows: Average total assets ( ATA) = (Total assetsbegin + Total assetsend)/2 Net income (NI) Earnings (NI) Average total assets ( ATA) = Cash flows (CFO) + Cash from Cash from(CFI) Operation Investment Average total assets ( ATA) Net income (NI) − Cash flow (CF) (CF) = Accruals (ACC) Average total assets ( ATA) = Following Alzahrani and Skerratt (2010), we use the market adjusted model to estimate abnormal returns as the difference between corresponding national index ���:return of the stock ��� and return of the AR it = R it − R mt The daily stock return for each stock and for the market index are calculated as follows: R it Pit − Pit−1 Pit−1 and Rmt MP t− MP t−1 MPt−1 = = where: �� is the abnormal return for firm i in year t; � it is the �� firm stock return for i in year t; �stock i is the stock price of firm i at year t; �i-1 is the stock price of firm i at year t-1; �� � is the return of the VN-index in year t; MPt is the VN-index value at year t; and MPt-1 is the VN-index value at year t-1 3.3 Methodology Following Freeman et al (1982) and Sloan (1996), we estimate the following Equation to test whether information of the persistence of current earnings is reflected in future earnings: ���� = �0 + �1 ����−1 + �� (1) where: ���� : net income of firm i in year t; and ����−� : net income of firm i in year t-1 However, Equation (1) implies that the coefficients on the cash flows and accruals component in earnings are equal while prior literatures show that accruals are supposed as less qualified than cash flows of earnings Therefore, we use the prior studies’ results as assumption to test for Vietnam stock market to investigate whether earnings persistence is more attributable to accruals or cash flows by following model: ���� = �0 + �1 �����−1 + �2 � ��−1 + �� (2) where �����−� is the accruals component of earnings of firm i in year t-1 and ����−� is the cash flows component of earnings of firm i in year t-1 570 | Policies and Sustainable Economic Development To investigate the persistence of accruals and cash flows, we estimate two coefficients γ1 and γ2 in Equation (2) If γ2 is bigger than γ1, earnings persistence is more attributed to cash flows than to accruals, it means that earnings persistence is rely more on cash flows than accruals component of earnings We follow the empirical model of Mishkin (1983)and Sloan (1996) to test how Vietnamese investors react on the information of earnings persistence by estimating following system Equations: ���� = �0 + �1 ����−1 + �� (1) �� �� = �(���� − �0 − � ∗ ����−1) + �� (3) where ARit is the abnormal stock return of firm i in year t The rest the variables investors fullyofunderstand the are as previously defined If Vietnamese information of earnings persistence, then �1 =� ∗ , market efficiency is predictably confirmed in Vietnam stock market We also apply test of Mishkin (1983) and Sloan (1996) to identify whether stock prices differentiate implication of accruals and cash flows in earnings persistence by using below system Equations: ���� = �0 + �1 �����−1 + �2 � ∗ ∗ ��−1 + �� (2) �� �� = �2 (���� − �0 − � �����−1 − � 2� ��−1 ) + �� (4) All of the variables are previously defined In estimating these Equations, we could safely conclude that Vietnam stock market correctly reflect the persistence of cash flows and accruals if the persistence of accruals are equivalent (�1 = ∗ ∗ � ) and the cash flows’ persistence are equal ( �2 =� 2) in the above Equations Empirical Results 4.1 Descriptive statistics Table shows descriptive statistics for firm-year sample used in this study Panel A contains statistics for the components of earnings and abnormal stock return The mean and median value of ACC variable is positive while mean of CF variable is negative, which indicates that listed firms on Vietnam stock market making large investments over the sample period Median value ACC in our test is 0.0836, while median value of ACC documented by Sloan (1996) is negative due to the different accruals definitions Our ACC definition includes the cash flow from financial activities while Sloan excludes it Further, the mean value of CF (-0.0168) is smaller than the mean value of ACC (0.0836), suggesting that over the sample period, earnings are attributable to accruals more than to cash flows Table 14 Descriptive statistics of variables and variables correlations Panel A: Descriptive statistic Variable Mean Median ACCit-1 0.0836 0.0326 CFit-1 -0.0168 NIit ARit 0.068 0.04 0.0463 Maximum Minimum Std Dev 1.56 97 1.79 0.95 -1.6643 1.55 -0.3172 0.1992 0.2058 21 4.5072 -0.9528 0.4527 0.0886 Panel B: Variables correlations Variable ACCit-1 CFit- NIit ARit ACCit-1 CFit-1 -0.9002 NrIit 0.3068 -0.0573 0.12 41 0.07 32 0.0291 ARit Panel B of Table reports the pairwise Pearson correlations among the variables We observe a strong negative correlation between accruals and cash flows (-0.9002) This negative correlation indicates that the effect of accruals is to eliminate transitory components from cash flows into earnings Accruals are negatively correlated with abnormal stock return (0.0573), while cash flow is positively correlated with abnormal stock return AR (0.0732) Persistence of earnings and implication of cash flow and accruals components in earnings Firstly, we estimate Equation (1) to find the level of persistence of earnings: NIit = α0 + α1 NIit−1 + εt (1) The result in panel A of Table shows a significant relationship between current earnings and next year earnings with α1 = 0.627, confirming prior findings in Sloan (1996) that current earnings could be an important indicator to predict future earnings Table Persistence of earnings Panel A: Regression using actual values Variable α0 α1 Coefficient 0.026 11.36 0.627 30.87 8* Coeffici ent 2.079 0.648 tStatis tic 32.88 1* Panel B: Regression using decile ranking Variable α0 α1 Note: * indicates statistical significance at the 1% level t-Statistic * 572 | Policies and Sustainable Economic Development Following Sloan (1996) in examining the robustness of the result, we use the decile rankings of the tested variables instead of the actual value The ranking formation is built up by assigning each variable from (lowest values) to 10 (highest value) The rank regression estimates are reported in panel B of Table with a slight higher coefficient of α1 (0.648) This parameter estimate confirms the result in panel A is robust Next, we analyze how the persistence of the accruals and cash flows component of earnings being reflected in future earnings by estimating the following Equation: ���� = �0 + �1 �����−1 + �2 � ��−1 + �� (2) Tablewhile indicates that the of coefficient the accrual component ) is 0.570 the coefficient the cashofflows component (�2 ) is(� 0.631 This suggests that the accruals component of earnings is less persistent than the cash flow component of earnings Our findings are in agreement with previously studies (Çelik et al., 2013; Dechow et al., 2006; Hong-Bok & GeeJung 2010; Navissi et al., 2006; Ozkan & Kayali, 2015; Pincus et al., 2007; Richardson, 2005; Sloan, 1996) Table The persistence of cash flow and accruals components in future earnings Panel A: Regression using actual values Variable Coefficient t-Statistic �0 0.032 13.92 �1 0.57 * * 28.329 �2 0.631 30.145* Coefficient t-Statistic �0 -2.684 �1 0.727 6.525 19.343* �2 0.738 20.476* Panel B: Regression using decile ranking Variable Note: * indicates statistical significance at the 1% level Market pricing of earning persistence and its components Another objective of this research is to test whether stock prices reflect correctly the information of earnings persistence and different implication of cash flows and accruals components of earnings With respect to investigating how market evaluates earnings persistence, we estimate the system Equations below: ���� = �0 + �1 ����−1 + �� (1) �� �� = �(���� − �0 − � ∗ ����−1) + �� (3) Results with actual value in panel A of Table show that the coefficient of earnings in the Equation * (1) α1 (0.635) is higher than the coefficient of earnings in the (0.468) pricing Equation (3) α1 It suggests that Vietnam investors not fully capture the quality of earnings, specifically they underestimate the information of earning persistence in their equity pricing The results in panel B of Table yield similar conclusion The persistence of earnings is not * significant when using the decile rankings with is -1.174 It appears that the coefficient α1 stock prices not manifest the average persistence of earnings Table Market pricing of earning persistence Panel A: Regression using actual values Variable Coefficient β α1 1.845 0.635 α1 * Null Hypothesis: α1 = α * using actual value 0.468 Chi-square Value t-Statistic 11.39 2* 31.44 4* 8.191 * 8.215 Panel B: Regression using decile ranking Variable Coefficient  α1 α*1 Null Hypothesis: α1 = α * 0.004 t-Statistic 0.458 9.081 0.648 -1.174 * 32.88 1* - using decile ranking Chi-square Probability Value 337.105 Probability 0.000 Note: * indicates statistical significance at the 1% level We use the Chi-squared value as a robustness test This test result strongly rejects the null hypothesis (α1 = α *) that stock prices correctly anticipate the average persistence of earnings (chi- squared: 8.215; pvalue 0.0042 < 0.01) This indicates that stock prices not reflect correctly the persistence of earnings More specially, investors tend to underprice earnings persistence Table Market pricing of the cash flows and accruals persistence Panel A: Regression using actual values Variable β2 γ1 Coefficient 1.738 0.57 t-Statistic 10.76 28.329 * γ1 γ2 0.412 0.631 γ2 0.395 * Null Hypothesis: γ1 = γ1* ; γ2 = γ2* using actual value 6.891 30.145 5.787 Test Statistic Value Chi-square 12.436 Probability 0.002 Panel B: Regression using decile ranking Variable Coefficient t-Statistic β2 0.266 7.755 γ1 γ* 0.795 -0.857 21.166 -3.828 γ2 γ* 0.779 -1.299 22.295 -4.7 Test Statistic Value Probability Chi-square 59.475 0.000 Null Hypothesis: γ1 = γ1* ; γ2 = γ2* using decile ranking * Note: indicates statistical significance at the 1% level In the next section, we estimate the following system Equations to investigate the stock price reaction to information of the persistence of accruals and cash flows components: ���� = �0 + �1 �����−1 + �2 � ∗ ∗ ��−1 + �� (2) �� �� = �2 (���� − �0 − � �����−1 − � 2� ��−1 ) + �� (4) Table reports the estimate results of the system of Equations (2) and (4) We observe that the coefficient of (0.395) It (0.412) is larger than the coefficient of accruals, γ * cash flows γ * appears that Vietnamese investors overestimate the persistence of accrual components despite the fact that * * information of accruals is less valuable than cash flow Moreover, the findings of γ1 < γ1 and γ2 < γ2 imply that Vietnamese investors undervalue of the persistence of accruals and cash flows components in earnings We again test for the second hypothesis using the Chi-squared value as a robustness test Clearly, * this test strongly rejects the null ; γ2 = γ ) with a chi-squared of hypothesis (γ1 = γ * 12.436 and pvalue of 0.002 Hence, the finding suggests that stock prices not reflect fully information in the accrual and cash flow components of earnings Those findings are similar to results of papers using data of developing countries, for example, Navissi et al (2006) using data of Chinese market and Hong-Bok and Gee-Jung (2010) using data of Korean stock market On the contrary, our findings are inconsistent with the results of papers employing data from developed markets In developed markets, investors tend to overprice the persistence of accruals (Sloan, 1996) and correctly price stocks with the persistence of both accruals and cash flows of earnings (Dechow et al., 2006) Conclusion The reliability of accounting information is crucial in equity evaluation This paper investigates the information earnings persistence, properties of its two components (cash flows and accruals) and market pricing of this information in Vietnam, using a data sample of 245 listed firms on the Ho Chi Minh City Stock Exchange for the period 2007-2013 Our analysis indicates that past earnings are useful for predicting firms’ future performance Specially, we show that: (i) earnings are persistent and the rate is rather high with the persistence rate is about 0.627; and (ii) the persistence of earnings is shown to be more dependent on the contribution of cash flows than accrual components of earnings Further, this study also examines whether investors 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(2006) Do stock prices in China reflect information in earnings persistence ACESA2006 Conference , Melbourne, AU, July Ozkan, N., & Kayali, M M (2015) The accrual anomaly: Evidence from Borsa... different levels of persistence of the two earnings? ?? components and form our second testable hypothesis as follows: H2: Stock prices fail to anticipate the higher earnings persistence contributed