The Credibility of Stock Repurchase Signals Chao Chen Min-Ming Wen

Information Hypothesis Asymmetric information” or “signaling story”: A signal that the firm’s stock price is significantly undervalued Vermalen (1981, JFE) Dann and DeAngelo (1983, JFE) document that stock Ikenberry, Lakonishok and Vermalen (1995, JFE)

Alternative Observations Bartov (1991, JAE) Jagannathan and Stephenes (2003, FM) Grullon and Michaely (2003, JF) Huang, Liano, and Pan (2003) Zhou and Lin (2004) Kahle (2002, JFE)

Credibility of Repurchase Signals Stock repurchase signals are cheap to make, because firms do not need to follow up on their announcements. (The Wall Street Journal and Fortune) Billett and Xue (2003), false signal with the subsequent seasoned equity offerings Kim, Schremper, and Varaiya (2004), the least stringent regulation on execution and disclosure of repurchase

Research Questions Do firms really do what they announced? Can it be a false repurchase signal sent by managers who intend to benefit from it due to their employee stock options ready for exercise or other self motivated activities? Is there any link between stock repurchase and earnings management? Do firms with earnings management have a higher probability of leaving repurchase program incomplete?

Measures of Credibility and Earnings Management This study uses whether a firm completed its repurchase program as a measure of the credibility of repurchase announcement. Following Teoh, Welch and Wong (1998a, b), we use discretionary accruals as a measure of earnings management

Completed v.s Incompleted Completed repurchase program-- if the shares that the board wants to repurchase under the authorization have been repurchased. Incompleted repurchase: (i) Temporarily suspended by the board (ii) the repurchase authorization is withdrawn by the board

Incomplete Repurchase A typical repurchase program lasts for three years (Stephens and Weisbach 1998) Incompleted status means that up to January 2003, firms that had announced repurchase programs between 1995 and 2000 did not complete the repurchase.

Hypothesis 1: Earnings management neutral hypothesis Based on the information hypothesis, if a firm announces its intention to repurchase stock, the firm should be neutral on earnings management. Thus, the discretionary current accruals before and after the announcement of stock repurchase will be indifferent.

Implications A rejection of the null hypothesis: (i) is in favor of the existence of earnings management prior to the announcement of stock repurchases (ii) indicates that stock repurchase firms shift future earnings prior to the announcement. (iii) ROA will be negatively correlated with pre-stock repurchase discretionary current accruals

Hypothesis 2: Managerial entrenchment hypothesis If top managers decide to leave the stock repurchase program incomplete, the negative effect of earnings management prior to repurchase announcements on future earnings changes will be more severe.

Implication Following hypothesis 2 and the rejection of hypothesis 1 => if a firm has a greater incentive of manipulating earnings, the credibility of stock repurchase can be lower so that the probability of leaving the repurchase program incomplete is higher.

Data and Sample The Securities Data Corporation’s (SDC) Worldwide Merge and Acquisition database Firms made the repurchase initial authorization between 1995 and COMPUSTAT data up to 2002 Non-financial firms

Data and Sample Panel A of Table 1 presents the number of firms initialized repurchase programs in each sample year and the frequency and percentage of completed v.s. incompleted repurchase.

Table 1

Methodology (1) Earnings management model Following Teoh, Welch, and Wong (1998a, JF, 1998b, JFE) methodologies. (2) Logistic Model

Methodology Cross-sectional regression of the change in return on asset (∆ROA) in year 1 and year 2 on variables in year –1: ∆ROA i, t+j =α 1 +δ 1 DCA i, t-1 +δ 2 NDCA i, t-1 +δ 3 (OCF/TA) i, t-1 + δ 4 (MV/TA) i, t-1 + e i, t+j ∆ROA i, t+j (j=1 or 2) = α 1 + δ 1 TotalCA i, t-1 + δ 3 (OCF/TA) i, t-1 + δ 4 (MV/TA) i, t-1 + e i, t+j

Empirical results I. Testing earnings management hypothesis Table 2

Implications of Table 2 DCA > 0 if t =-1, 0; DCA < 0 if t =1,2 Consistent with Bartov (1991), Jagannathan and Stephenes (2003), and Grullon and Michaely (2004) Results of Table 2 suggest the possibility that earnings management exists among the firms intended to buyback their shares.

Results Table 3 Non-discretionary current accruals, operating cash flows, and size have a significantly negative effect on the changes of returns on asset one year after repurchase. Discretionary current accruals inversely and significantly affects the post-repurchase performance of firms.

Results: Complete v.s. Incomplete Results of imposing equation (5) on the completed and incompleted groups

Empirical Results Comparisons of post-stock repurchase announcement ROA of completed and incompleted groups Table 4A: the descriptive statistics of firm size and repurchase contents (number of shares and the percentage of targeted shares) of completed and incompleted firms

Results: Table 4B (1) Incomplete firms: significant negative effects of earnings management prior to repurchase announcements on both ∆ROA i,t+1 and ∆ROA i,t+2 (2) Completed firms: discretionary current accruals prior to repurchase announcements have insignificant negative effects on both ∆ROA i,t+1 and ∆ROA i,t+2.

Methodology-- Logistic model To link the probability of leaving a repurchase program incomplete and the incentives of earnings management

Logit Model Logit (p) = log (p/1+p) = α + ß’ x p -- the probability of leaving a repurchase program incomplete and defined as Pr (Y = 1 | x ), Y =1 if the repurchase program is incompleted, Y = 0, otherwise x is a vector of explanatory variables (i) pre-stock repurchase discretionary current accruals, (ii) the number of shares firms intended to buyback, (iii) firm size, (iv) debt ratio, (v) whether the firm disclose the funding source of repurchase. p = e ßX /(1+e ßx ).

Empirical Results: Logistic regression model (1) firms with higher pre-stock repurchase discretionary accruals tends to have significantly higher probability leaving the repurchase program incomplete. (2) Higher discretionary accruals prior to the stock repurchase suggest a greater incentive of managing earnings. (3) A linkage between the probability of conducting earnings management and the probability of leaving repurchase program incomplete.

Conclusions The earnings management inversely and significantly affects the post-repurchase performance of firms with incomplete repurchase programs. Stock repurchase may be a false signal and the firm’s value may actually be overvalued

Conclusions firms with higher pre-stock repurchase discretionary accruals tend to have significantly higher probability leaving the repurchase program incomplete.

Methodology Current accrual (CA) model : CA i,t =  [AR i,t + INV i,t + OCA i,t ] -  [AP i,t + TP i,t + OCL i,t ] (1) Discretionary and nondiscretionary accruals for a given year, = a 0 ∙ + a 1 ∙ + ε i,t (2)

Methodology CA i,t = the current accruals of firm i at year t, AR i,t = accounts receivables, INV i,t = inventory, OCA i,t = other current assets, AP i,t = account payable, TP i,t = tax payable, and OCL i,t = other current liabilities.  Sales i,t = the change in sales from the previous year (t-1) for firm i. TA = Total Assets

Methodology Nondiscretionary current accruals (NDCA) : NDCA i,t = ∙ + ∙ (3)  AR i,t = the change in account receivable in year t for firm i. and are the coefficients estimates from equation (2)

Methodology The scaled discretionary current accruals (DCA) : DCA i,t = - NDCA i,t (4) DCA i,t is used for the proxy of earning management

Equations for Accruals Total Accruals = Changes in Net Operating Assets (NOA) =(NOAt – NOAt-1)/NOAt-1 NOA = Operating Assets (OA) – Operating Liabilities (OL) OA = Current Operating Assets + Non-current OA (NCOA) OL = Current Operating Liabilities (COL) + Non-COL (NCOL) COA = Current Assets (CA) – Cash and Short Term Investments (STI) NCOA = Total Assets (TA) – CA – Investments and Advances COL = CL – Debt in Current Liabilities NCOL = TL – Current Liabilities – Long-term debt SG = sales growth = (Sales t – Sales t-1 ) - 1