1. CFS021002HK-ZWE391-ql Comments on Market Valuation and Earnings Manipulation (by Shing-yang Hu, and Yueh-hsiang Lin ) Qiao Liu, University of Hong Kong 2006 NTUICF December 2006

2. Focus of This Study – does the manger of high valuation company demonstrate stronger incentive to manipulate earnings? What types of high valuation firms are especially so?  Test the hypothesis that managers of high valuation firms have stronger incentive to manipulate earnings  High valuation firms with less investor attention (e.g., non-S&P 1500 index firm) manipulate earnings more  High valuation firms manage earnings in SEOs to raise more proceeds  Firms with good corporate governance tend to be less aggressive in managing earnings The paper thus makes contribution to two literatures: The accruals literatureThe accruals literature Corporate governance literatureCorporate governance literature

3. Overall Comments  This paper tests a popular belief, which has not been tested before in the literature --- high valuation firms tend to manipulate earnings more  The paper show some evidence that firm-level market to book ratio (proxy for high valuation) is associated with a higher level of next period earnings management  Such a correlation is asymmetric --- it is more pronounced among firms with least investor attention and weak governance  Quite careful empirical design and very detailed documentation

4. Of Course, There is always room for further improvement, and I will focus on the following…  Empirical design, especially the built in endogeneity issue  Alternative hypotheses  Doubts on the SEO example  Some minor issues

5. The Endogeneity Issue  The paper uses market-to-book ratio in year t to account for discretionary accruals in year t+1. However, market to book ratio is also an endogenous variable  Could it be possible that some hidden factors explain market to book ratio in year t and discretionary accruals in t+1 simultaneously?  Just establishing a correlation between market to book ratio and discretionary accruals does not necessarily suggest the causality

6. Alternative Hypothesis I?  The high valuation stocks are in most cases growth stocks, which tend to concentrate in industries with more growing opportunities (e.g., high-tech industries). If those firms’ earnings prospects are volatile, they will be reflected in the discretionary accruals. Is this a plausible alternative? Need more careful thoughts on this to make your story more convincing!!

7. Alternative Hypothesis II?  Go back to the familiar accrual anomaly --- higher accruals lead to lower future stock returns, that is lower valuation. Could it be possible that the correlation between accruals and valuation is just a mechanical reflection of accrual anomaly and mean-reverting long-run stock returns? Is this a plausible alternative? Need more careful thoughts on this to make your story more convincing!!

8. The SEO Example?  The two way sorting portfolio approach is not convincing enough! The results are largely driven by More SEO quintile, no monotonic relation observed.

9. Several Minor Issues  In equation (3), should constant be included? It is not in the original Jones’ (1991) model.  May consider using financial analysts variables and PIN to measure the degree of information asymmetry  Need to think a bit hard on the motivations of managing earnings by high value firms, just showing SEO example and executive ownership example might not be enough.

10. Thanks