923
P_DM -0.8870.001
P_RM -0.9620.0001
Hausman test 1
st
-stage adj. R
2
56.64 54.04
2
st
-stage adj. R
2
70.46 59.23
p-value for Hausman stat. 0.0001
0.0001 Definition of Variables:
DM: discretionary accruals RM: abnormal CFO
P_DM or P_RM: the predicted value form the first-stage regression
Given the finding of the simultaneously of RM and DM, we use the recursive regressive Model 2 to test H2-H4. The results are reported in Table 4-5.
In the Table 4-5, Big4 and Abnda
t-1
are factors for DM management activity, DK_SCORE and ISLE_S are factors for RM management activity.
H2 predicts that in both models, while Big4 is negatively related with DM, positively related with RM. Consistent with H2, Table 4-5 shows that RM is significant
positively related with Big4 at 10 level. However, DM is insignificant related with Big4, suggesting that firms are reluctant to manager earnings using DM when firms
have audited by Big4 audit firm. Also, tests of H3 are indicated by the coefficient estimates for Abnda
t-1
in both models. If firms used DM activity much more in previous year, they may be constrained using DM in next year. Thus, we expected
that managers are more likely to manage earnings using RM activity. Abnda
t-1
in RM model is significant positively at 1 level as coefficient t-value is 0.09212.81.
While in DM model is significant negatively at 1 as coefficientt-value is -0.166- 21.63. The results are to support H3.
One of the factors for RM, DK_SCORE, is dummy variable that equals one if the firms K_ SCORE is smaller than median of full samples K_ SCORE and zero
otherwise. DK_ SCORE in RM model is significant negatively at 1 level as coefficientt-value is
-0.00311.69
. While in DM model is significant negatively at 1 as coefficientt-value is
0.00310.26
. The results are to support H4. Also, NP and LEV as incentive variables are expected positive coefficient. In the
924
RM model, NP and LEV are significant positively at 1, 5 level respectively. In the DM model, while NP is significant positively at 1, LEV is insignificant. These results
indicate that both RM and DM are negatively correlated with their own factors although ISLE_S in the RM model and Big4 in the DM model are insignificant. Also,
RMor DM is positively correlated with the factors of DMor RM although ISLE_S in the DM model is insignificant. Specifically, firms which are able to avoid reported
losses by earnings management are likely to using both RM and DM to manage earnings.
Table 4-5 Test of the factors between RM and DM management
Modeln=1,842 Dependence variable
RM DM
Intercept -0.125-5.24
0.0431.70 Big4
0.0051.82 0.0020.83
Abnda
t-1
0.09212.81 -0.166-21.63
DK_
SCORE
-0.001-2.03 -0.003-1.64
ISLE_S -0.0007-0.39
-0.001-1.47 NP1
0.04711.51 0.0399.10
LEV 0.0012.31
-0.0010.88 SIZE
0.0032.73 -0.004-3.35
DLOSS -0.029-6.88
-0.044-9.68 Including dummy variables yearly
Adj R
2
23.41 28.41
Footnote 1 , , are significant at the 10, 5, 1 level , respectively Definition of Variables:
DM: Discretionary accruals estimated by adjusted Jones model1991, 1995 RM: measurement of real activity management, which is abnormal CFO, abnormal production cost and
abnormal discretionary expenditure Big4: Dummy variable equals 1 if the firms auditor is a Big four, otherwise 0
LEV: Debt ratio, that is current debt current asset NP1: Dummy variable equals 1 if reported earnings before managing earnings is positive, otherwise 0 .
AbnDA
t-1:
Abnormal accruals, DK_SCORE: Dummy variable that equal 1 if the firms K_SCORE is less than median of full samples
K_SCORE, and otherwise 0 SALE_S: The percentage of the companys sales to the total sales of its industry.
SIZE: Lntotal asset in the previous period DLOSS: Dummy variable equals 1 if reported earnings is negative, otherwise 0
YR: Dummy variables yearly.
925 4.3.1 Additional Analysis
To test whether managers make RM and DM decisions simultaneously or sequentially quarterly, we also conduct the Hausman test for each quarters as well
as annual. Table 4-6 reports the results of the Hausman tests for each quarter. In the panel
1 and panel 3, Hausman tests reject the exogeneity of RM in the DM regressionswith p-value ranging from 0.001 to 0.0001, which means DMor RM is
correlated with RMor DMs error term. These results indicate that RM and DM are determined simultaneously. On the other hand, in the panel 2, Hausman test fail
reject the exogeneity of DM in the RM equations.with p-values 0.588 In contrast, all of the Hausman tests reject the exogeneity of DM in the RM model, which means DM
is correlated with RMs error term. These results indicate that RM and DM are determined sequentially, with RM preceding DM.
Table 4-6 Hausman Test for Simultaneity versus Sequentiality of Real and Accrual Manipulations about each quarter
Panel 1: first quarter
Modeln=1,842 RM
DM
Endogenous Coefficientp-value
Coefficientp-value variables:
DM 1.5510.001
RM 1.5990.0002
P_DM -1.1860.001
P_RM -1.7660.0001
Hausman test 1
st
-stage adj. R
2
48.75 41.70
2
st
-stage adj. R
2
21.54 31.35
p-value for Hausman stat. 0.001
0.0001
Panel 2: second quarter
Modeln=1,842 RM
DM
Endogenous Coefficientp-value
Coefficientp-value variables:
DM -0.334-2.36
RM 6.7350.0001
P_DM 0.0120.082
926
P_RM -0.9360.588
Hausman test 1
st
-stage adj. R
2
0.87 12.81
2
st
-stage adj. R
2
0.30 2.64
p-value for Hausman stat. 0.082
0.588
Panel 3: third quarter
Modeln=1,842 RM
DM
Endogenous Coefficientp-value
Coefficientp-value variables:
DM 16.4070.001
RM 0.0130.593
P_DM -11.3100.001
P_RM -0.0680.001
Hausman test 1
st
-stage adj. R
2
43.82 6.53
2
st
-stage adj. R
2
3.69 7.69
p-value for Hausman stat. 0.001
0.001 Definition of Variables:
DM: discretionary accruals RM: abnormal CFO
P_DM or P_RM: the predicted value form the first-stage regression
5 Conclusions
Substantial studies on earnings management have been performed for a long time. Prior literatures provided evidence that managers frequently used discretionary
accruals in managing earnings.Dechow and Sweeney 1995, Jones 1991, Kothari, Leone and Wasley 2005. However, recent studies provide some evidence that firms
may utilize real activities in managing earning even if this will incur additional costs for firms. Therefore, we investigate earnings management through both real activities
and discretionary accruals for a broad sample of firms over 2003-2007. The purpose of this study is to find whether real activity managementRM and
discretionary accruals managementDM are performed simultaneously or sequentially to manage earnings. Also, we investigate how differently other factors
927
influencing DM will affect managers RM decisions. This result of this study is important for two reasons. First, as mentioned by Fields,
Lys and Vincent2001, examining only one earnings management tool at a time cannot explain the overall effect of earnings management activities. In particular, if
managers use RM or DM as a substitute, the examination of either types earnings management in isolation cannot reach definitive conclusions. Further, managers are
more likely to use RM or DM as substituteor combination. Second, factors that influence DM are more likely to affect managers RM decision, which may be related
to managers accounting choices. First of all, this paper tests whether DM or RM are determined sequentiality or
simultaneity. Also, we define factors which may influence RM or DM to test for whether DM affect managers decisions on RM, and we test the relation between
these factors and RMor DM. Lastly, this study tests whether RM or DM are determined differently depending on associated quarters.
The results of this study provide evidence that managers use RM and DM to mange earnings simultaneously. Further results show that RMor DM is correlated with the
factors for DMor RM in an opposite direction although
ISLE_S in DM mo
del is insignificant. Also, firms which want to avoid reported losses through earnings
management have incentive to manage earnings using both RM and DM. This study differs from previous literatures in the following respects. First, this study
tests whether RM or DM are determined sequentially or simultaneously, and whether managers decision for RM or DM is different quarterly. Second, we examine some
factors associated with DM and RM and their effect on the relation between DM and RM.
The results of this study will provide an insight into the real activities management as a means to manage earnings to related regulators and the users of firms financial
information.
928
Reference
Baber, W., P. Fairfield and J. Haggard, 1991. The effect of concern about reported income on discretionary spending decisions: The case of research and development,
The accounting review 664:47-63. Becker, P., M. DeFond, J. Jiambalvo, and K. Subramanyam, 1998. The effect of
audit quality on earnings management, Contemporary Accounting Research 15:1-24. Bushee, B. 1998. The influence of institutional investors on myopic RD investment
behavior, The Accounting Review 733: 305-333. Cohen, D., A. Dey and T. Lys, 2007. Real and Accrual-Based Earnings Management
in the Pre-and Post-Sarbanes-Oxley Periods, The Accounting Review 833:757-787. Dechow, P. and D. Skinner, 2000. Earnings management: Reconciling the views of
accounting academics, practitioners, and regulators, Accounting Horizon 142: 235- 250.
Dechow, P. R. Sloan and A. Sweeney, 1995. Detecting earnings management, The Accounting Review 70: 3-42.
DeFond, M. and J. Jiamgbalvo, 1994. Debt covenant effects and the manipulation of accruals, Journal of Accounting and Economics 17:35-59
Fundenberg, D., and J. Tirole, 1995. A theory of income and dividend smoothing based on incumbency rents, Journal of Political Economy 1031:75-93.
Francis, J., E. Maydew and H. Sparks, 1999. The role of Big Six .auditors in the credible reporting of accruals, Auditing: A Journal of Practice and Theory 18:17-35.
Guenther, D. 1994. Measuring Earnings Management in Response to Corporate Tax Rate Changes: Evidence from the 1986 Tax Reform Act, The Accounting Review
69:230-243. Healy, P. and J. Wahlen, 1999. A review of the earnings management literature and
its implications for standard setting, Accounting Horizons 134: 365-383. Jones, J. 1991. Earnings management during import relief investigations, Journal of
929
Accounting Research 29:193-228. Kasznik, R., 1999. On the association between voluntary disclosure and earnings
management, Journal of Accounting Research 37:57-81. Kothari, S., A. Leone and C. Wasley, 2005. Performance matched discretionary
accrual measures, Journal of Accounting and Economics 39; 163-197. Lev, B. and T. Sougiannis, 1996. The capitalization, amortization and value-
relevance of RD, Journal of Accounting and Economics 21:107-138. Roychowdhury, S. 2005. Management of earnings through the manipulation of real
activities that affect cash flow from operations, Working paper, MIT. Sweeney, A. 1994. Debt-Covenant Violations and Managers Accounting Responses,
Journal of Accounting and Economics 17:281-308. Subramanyam, K. 1996. The Pricing of Discretionary Accruals, Journal of Accounting
and Economics 22: 249-281. Schipper, K. 1991. Commentary on earnings management. Accounting Horizon,
December 1989:91-102 Thomas, J. and H. Zhang, 2002. Inventory changes and future returns, Review of
Accounting studies 7: 163-187. Zang, A. 2007. Evidence on the Tradeoff between Real Manipulation and Accrual
Manipulation, working paper
930
EARNINGS MANAGEMENT BY MEANS OF CHANGES IN ACCOUNTING ENTITIES
The Case of Tobu Railway Company
Yoshihiro Tokuga
11
and Toshitake Miyauchi
12
Abstract
Companies sometime hide liabilities or losses through changes in accounting entity. Although few textbooks deal with this topic, studying how to use changing
entity is very important. In this case, we consider the Tobu Railway Company, which has benefited from industrial policy on several occasions through affecting changes
in accounting entity. To ignore this aspect of the company in any analysis, investors andor analysts attempting to analyze this company would misunderstand it. Through
investigating a comp any‘s current accounting entity situation, we are sometimes able
to quantify the benefits andor changes attributed to the accounting entity. The case described below is intended for undergraduate accounting students,
graduate students, MBA students, CPAs, security analysts, and other business people who want to increase their awareness of, and to improve their business
analysis techniques.
Introduction
Although extensive case materials have been produced for Business Analysis education, most of these materials have a North American or European bias, and few
have been produced describing the activities of Asian companies. However, for comparative purposes, it is important for students at business schools in Asia to
study the accounting behaviors of Asian multinational companies using Asian case materials. We have therefore decided to develop case materials describing the
accounting activities of Asian companies. Companies sometime hide liabilities or losses through changes in accounting entity.
Although few textbooks deal with this topic, studying how to use changing entity is very important. In this case, we consider the Tobu Railway Company, which has
benefited from industrial policy on several occasions through affecting changes in accounting entity. To ignore this aspect of the company in any analysis, investors
andor analysts attempting to analyze this company would misunderstand it. Through investigating a company‘s current accounting entity situation, we are sometimes able
to quantify the benefits andor changes attributed to the accounting entity.
11
Professor of Accounting, Graduate School of Management, Kyoto University
12
Researcher specially appointed by Mizuho Securities Endowment, Graduate School of Management, Kyoto University
931
The case described below is intended for undergraduate accounting students, graduate students, MBA students, CPAs, security analysts, and other business
people who want to increase their awareness of and to improve their business analysis techniques.
Tobu Department Stores, which is a subsidiary of The Tobu Railway Company, incurred considerable unrealized capital losses on real estate because it bought a
great deal of land during the bubble economy before land prices dropped. In addition, the Tobu Railway Group was at risk of posting considerable losses due to revaluation
of fixed assets, which was required because Asset Impairment Accounting would become compulsory from the end of fiscal year 2005 beginning March 2006. At the
same time, the Land Revaluation Law temporary legislation was enacted in 1998, which permitted an increase in land valuation for a limited time period. Skillful
utilization of this legislation would provide Tobu Railway Group with the opportunity to eliminate unrealized capital losses on land. However, land revaluation under the
Land Revaluation Law was restricted to one application per company. Also, when applying the Land Revaluation Law, companies were required to revaluate all owned
land; selective revaluation of only land with unrealized capital gains was not permitted. Since the Tobu Department Store subsidiary owned nearly no land with
unrealized capital gains, the Finance Department of the Tobu Railway Company considered the possibility of eliminating unrealized capital losses on land for business
use by skillfully applying the Land Revaluation Law.
Background
The area serviced by the Tobu Railway Company, which was founded more than 110 years ago in 1897 by the ―Railway King‖, Kaichiro Nezu
13
, is shown in Figure 1. Tobu Railway Company primarily services the Kanto Region where it operates routes
in 1 the Tokyo Metropolis and eastern Saitama Prefecture green area
14
, 2 central Gunma and Tochigi Prefectures, and 3 western Chiba Prefecture. By fiscal 2005,
Tobu Railway Company had consolidated net sales of 646.3 billion yen and 20,483
employees. Table 1 shows a fiscal 2005 ranking of Japanese railway companies on
the basis of net sales; Tobu Railway Company ranks 8
th
based on sales, and third
13
Kaichiro Nezu is often referred to as the ―Railway King‖ for having amassed considerable personal
wealth through rehabilitating railway companies that fell into financial difficulty. He also undertook education projects to return to society profits generated by his railway business activities and opened
Musashi University and Musashi High School.
14
The word ―Tobu‖ in Tobu Railway means ―Eastern Musashi‖. It is derived from ―Musashi,‖ the
former name for the area consisting of present-day Tokyo and Saitama Prefecture.
932
among railway companies that have routes in the Kanto Region company names shown in italics.
Figure 1 Service Area of the Tobu Railway Company
In addition to railways, the Company consists of a multifaceted corporate group that has operations in the leisure, real estate development, and retail distribution
business sectors. Specifically, these operations consist of: 1 the transportation
business, including rail, bus, and taxi services; 2 the leisure business, including tourism and hotels; 3 the real estate business, including property subdivision and
rental; and, 4 the distribution business, including department stores located primarily in front
of Tobu train stations. These four businesses are all closely related, and the business model employed
by the Tobu Railway Company is based on increasing customer traffic by encouraging railway use. Specifically, the business model promotes the use of
railways through the development and operation of amusement facilities, department stores, and residential
properties near train stations; people use these facilities because of their proximity to
Tobu Nikko Isesaki
Utunomiy a
Kashiwa Funabash
i Ikebukuro
池袋 Asakus
a Sakado
N
50km
933
38.9
32.3 13.1
8.3 7.4
Revenue total revenues : 646 billion yen
流通 運輸
レジャー 不動産
その他
Table 1 Revenues and Operating Profits of Japanese Railway Companies
Revenues Operating profits billion yen 1 East Japan Railway Company 2,592 396
2 Central Japan Railway Company 1,467 404 3 Tokyu Corporation 1,389 86
4 West Japan Railway Company 1,240 135 5 Kintetu Corporation 948 67
6 Hankyu Hanshin Holdings 799 87 7 Meitetu Group 740 39
8 Tobu Railway Company 646 48 9 Odakyu Electric Railway Company 610 36
10 Keio Corporation 438 40 11 Seibu Railway Company 435 30
※ fiscal year ending March 2006
Figure 2 Revenue And Operating Profit By Business
the railway. Figure β shows the breakdown of the company‘s activities in each business
segment with respect to revenue and operating profit. The pie charts show the railway and distribution businesses
15
to be the core businesses of the Group, accounting for approximately 70 of the revenue base. They also show that the
railway business alone accounts for approximately 60 of the operating profit of the
15
Since the products handled in the distribution business Tobu Department Store have high unit prices, revenues from this business segment are high.
10.7
58.1 2.7
21.4 7.1
Operating Profit total operating profts
：48 billion yen
distribution transportation
leisure real estate
the others
934
company. It should therefore come as no surprise that the Tobu Railway Group makes extensive areas of land in all of its business activities, particularly for the core
railway Tobu Railway Company and distribution businesses Tobu Department Store.
The Accounting Problem
In Japan, the implementation of asset impairment accounting in accordance with the Accounting Standards for Impairment of Fixed Assets was only made obligatory
from the fiscal year ending March 2006. At the time asset impairment accounting was implemented, in cases where the profit potential including the land disposal amount
of a fixed asset plants, land, etc. owned by a company decreased and the prospects for recovery of the invested funds disappeared, the company was required
to record this loss as the difference between the discounted present value of expected future cash flow generated by the fixed asset and the book value. On the
other hand, a company was not permitted to increase its valuation of fixed assets for which profit potential had increased. The implementation of asset impairment
accounting therefore posed a major problem for the Tobu Group given its considerable land holdings. In particular, Tobu Department Stores had unrealized
capital losses on land of fully 50.0 billion yen equivalent to the total consolidated net income for 5 to 10 years. The Tobu Railway Company realized that Tobu
Department Stores alone would incur considerable impairment losses if the company failed to deal with unrealized capital losses before fiscal year-end and the
introduction of impairment accounting. In anticipation of the potential difficulties associated with the introduction of the
asset impairment accounting system, the government enacted the Land Revaluation Law in March 1998. The Land Revaluation Law permitted revaluation of land for
business use at market prices by financial institutions and ordinary business corporations. However, the law, the purpose of which was to increase the
sustainability of financial institutions, especially banks and to improve the corporate management environment, limited companies to only one revaluation of land to
market prices. Corporations that applied the law were able to select one of five measures of market price: 1 the posted land price, 2 the benchmark land price as
given in the National Land Use Planning Act, 3 the assessed value of fixed assets,
4 the roadside land price used for the assessment of inheritance tax, and 5 the
appraised value by a real estate appraiser. The law required companies to record up to 60 of the difference between the market price and book value as the land
935
revaluation difference for use as shareholders‘ equity refer to the Appendix for a detailed description of the accounting treatment. There were two important
considerations at the time of implementation of the Land Revaluation Law: 1 a company could only revalue land once, and 2 a company had to revalue all of the
land that it owned. In other words, a company could not selectively revalue land from which unrealized capital gains had been generated.
Figure 3 depicts the implementation of the Land Revaluation Law and the implementation of the Accounting Standards for impairment of fixed assets over time.
On the one hand, the time limit for the implementation of the Land Revaluation Law was the fiscal year ending March 2002. On the other hand, the implementation of
asset impairment accounting was permitted from the fiscal year ending March 2004, and implementation was obligatory from the fiscal year ending March 2006 onward.
That is to say, if Tobu Railway wished to avoid recording an impairment loss at the time asset impairment accounting was implemented nationally, then it would be
necessary to implement the requirements of the Land Revaluation Law by the end of the fiscal year ending March 2002 in order to reduce, as far as possible, unrealized
capital losses on land for business use
16
.
Figure 3 Time Limits of the Law and Accounting Standard Implementation
| | | |
032002 032004 032005 032006
Aims
The objectives of the Tobu Ra ilway Group‘s Finance Department at the time of
implementation of the new accounting measures were as follows:
16
Other companies also postponed the introduction of impairment accounting and strategically utilized the Land Revaluation Law. In the fiscal year ending March 2002, 280 companies revalued land
according to the requirements of the Land Revaluation Law. A total of 453 companies revalued land using the Land Revaluation Law during the period leading up to the fiscal year ending March 2002.
Earlier implementation
早々期適用 Time limit for the
implementation of the Land Revaluation
Law Early
implementation Obligatory
implementation Implementation of the Accounting
Standards for impairment of fixed assets
936
Figure 4 Land Ownership Structure of the Tobu Railway Group
※ Parcel a: land having unrealized capital gains Parcel b: land having unrealized capital losses
1. To avoid incurring a substantial loss; 2. If possible, to achieve a year-on-year increase in profit; and
3. Selection of a method that would not have a major impact on earnings, taxable income, etc.
The most important consideration related to the implementation of the Land Revaluation Law by the Tobu Railway Group as a means of eliminating unrealized
capital losses on land for business use was the legal requirement to revaluate all of the land owned by a corporation. Figure 4 shows the land ownership structure of the
Tobu Railway Group. It can be seen that, whereas most of the land held by the parent company, Tobu Railway Company, had unrealized capital gains, Tobu
Department Store only owned land having unrealized capital losses. This meant that the elimination of unrealized capital losses would therefore be impossible with this
organizational structure, even if the requirements of the Land Revaluation Law were followed.
In response, Tobu Railway Company devised the plan shown in Figure 5, which involved selecting land owned by Tobu Railway Company with unrealized capital
gains
Tobu Railway Company
Parcel a Parcel
b1 Applying the
Land Revaluation Law
to this entity will increase equity
capital because of a positive land
revaluation difference
Tobu Depart- ment Store
Parcel b2
Applying the Land
Revaluation Law to this entity will
reduce equity capital because
of a negative land revaluation
difference
937
Figure 5 The Creation of a New Entity through the Contribution of Land
in Kind
※ Parcel a: land having unrealized capital gains Parcel b: land having unrealized capital losses
Parcel a2, and then donating this land to a newly-established company formed through a merger with Tobu Department Store.
17
Since the unrealized capital gains and losses would correspond Parcel a2 and Parcel b2 would correspond,
satisfaction of the requirements of the Land Revaluation Law following the merger would make it possible to offset unrealized capital losses using unrealized capital
gains.
18
Although the Land Revaluation Law required the revaluation of all of the land held by a corporation, the creation of a new accounting entity through the contribution
of land in kind would make the partial utilization of unrealized capital gains on land possible.
Tobu Railway Company devised a plan to use this technique at the start of the new financial year in April 2000 to eliminate unrealized capital losses on land incurred by
the companies in the group, including Tobu Department Store. Figure 6 shows the
17
Tobu Railway Company used the pooling of interest method as an accounting procedure for business combination. As no accounting standard for business combination existed at the time in Japan, there
was no need to satisfy particular requirements at the time of equity pooling; it was left to the discretion of companies as to whether or not they wished to adopt either the equity pooling method
or the purchase method.
18
Under Article 51 of the previous Corporation Tax Law and Article 93 of the previous Corporation Tax Law Enforcement Regulations, which prescribed accounting treatment concerning the
establishment of subsidiaries by means of contributions of land in kind, in the case where a company established a subsidiary in which it owned 95 or more of the shares and had a controlling interest,
transfers using the book value of the land as an equity contribution were permitted.
Parcel b1
Parcel a2
Parcel a1
Newly Established
Company
Parcel a2
Parcel b2
Contribution of Land in Kind
Tobu Railway Company
Tobu Depart- ment Store
Merger
938
planned corporate organization required to achieve this. The plan was for Tobu Railway Company to establish three types of subsidiary - a distribution company, a
hotel company, and a company for other business activities - and providing these with land Parcel a1, Parcel a2, and Parcel a3 with unrealized capital gains owned
by Tobu Railway Company as contributions in kind. Tobu Railway Company would then merge the companies having unrealized capital losses on land into the new
subsidiaries. The plan was thus to deal with unrealized capital losses on land by applying the Land Revaluation Law to the three new subsidiaries Tobu Commerce,
Tobu Hotel Assets, and Tobu Integrate after implementing the mergers. However, for the fiscal year ending March 2001 fiscal 2000, the unrealized capital
losses on land owned by Tobu Department Stores increased beyond initial projections, and it became highly unlikely that these losses could be offset using only
the unrealized capital gains on land from the new distribution subsidiary Tobu Commerce. In response to this situation, in its settlement of accounts for the fiscal
year ended March 2001, the Tobu Railway Group abandoned the idea of newly established subsidiaries receiving contributions in kind and applied the Land
Revaluation Law to the three new subsidiaries without implementing subsidiary mergers. That is to say, the settlement of accounts for the fiscal year ending March
2001 fiscal 2000 passed with no pooling of unrealized capital gains on land in the new subsidiaries Figure 7. Since the difference
Figure 6 First Plan for Organizational Restructuring
Parcel a1
Tobu Commerce
Distribution company
Tobu Hotel Assets
Hotel company
Tobu Integrate
Other business company
Parcel a2 Parcel a3
Parcel a1 Parcel a2
Parcel a3
Subsidiary A
Subsidiary B Subsidiary C
Parcel b1 Parcel b2
Parcel b3 Parcel b4
Merge r
Merger Merge
r
Tobu Railway Company
Tobu Depart-
ment Store
939 ※ Parcel a: land having unrealized capital gains Parcel b: land having unrealized
capital losses
in land revaluation amounted to approximately 81.8 billion yen in the consolidated financial statements for that fiscal year, a simple estimate suggests that the Tobu
Railway Group implemented a write-up under the Land Revaluation Law equivalent
to unrealized capital gains of approximately 136.3 billion yen
19
. Then, in preparation for the fiscal year ending March 2002 fiscal 2001, the deadline for implementation
of the Land Revaluation Law, Tobu Railway Group continued to search for ways to offset the unrealized capital losses on land carried by Tobu Department Stores. After
the new
Figure 7 Modification to the First Plan for Organizational Restructuring
fiscal year began in April 2001, Tobu Railway Company devised a new accounting method for dealing with the issue of unrealized capital losses on land. At that time,
the three newly established subsidiaries had already employed the Land Revaluation Law once. Since a company could only use the provisions of the Land Revaluation
Law once, these three subsidiaries could not use the Land Revaluation Law again. However, because Tobu Department Store had not previously employed the
provisions of the Land Revaluation Law, the Tobu Railway Company implemented the organizational restructuring changes shown in Figure 8 in preparation for the
fiscal year ending in March 2002 fiscal 2001, which was the deadline for the implementation of the Land
Revaluation Law. The restructuring involved first merging the three newly established
19
81.8 billion yen ’ 0.6
Positive land revaluation
difference Parcel a
Tobu Railway Company
Tobu Commerce
Distribution company
Tobu Hotel Assets
Hotel company
Tobu Integrate
Other business company
Positive land revaluation
difference Positive land
revaluation difference
940
subsidiaries into Tobu Department Store, and then revaluating the land belonging to the new Tobu Department Stores company.
Simultaneously, Tobu Railway Group then merged other less well performing subsidiaries, which had land with unrealized profits that were insufficient for covering
their own unrealized losses, into the Tobu Railway Company excluding Tobu Department Store, before applying the Land Revaluation Law to manage unrealized
capital losses. As a result of these organizational changes, it is estimated that a land revaluation difference amounting to approximately 64.7 billion yen was reversed, and
unrealized capital gains of approximately 107.8 billion yen
10
were applied to offset unrealized capital losses, even when the revaluation differences calculated of the
Tobu Railway Company approximately 34.1 billion yen were considered.
Figure 8 Second Plan for Organizational Restructuring
10
64.7 billion yen ’ 0.6
Parcel a
Parcel b1 Merge
r
Subsidiaries A, B, C
Merge r
Parcel b2 Parcel b3
Parcel b4
Tobu Railway Company
Tobu Depart-
ment Store
Tobu Commerce
Distribution company
Tobu Hotel Assets
Hotel company Positive land
revaluation difference
Positive land revaluation
difference
Tobu Integrate
Other business company
Positive land revaluation
difference
941
Figure 9 Change in Earnings
Figure 9 shows the changes in the earnings of the Tobu Railway Group. Earnings for the fiscal year ending March 2006 fiscal 2005, the year of compulsory
implementation of asset impairment accounting, showed an operating profit of 47,707 million yen, an ordinary profit of 41,294 million yen, and a net profit of 26,873 million
yen. Although impairment loss is an extraordinary loss item that has an impact on net profit, as a result of utilization of the Land Revaluation Law to deal with unrealized
capital losses in advance, the Tobu Railway Group limited the impairment loss in fiscal 2005 to 15,010 million yen, avoided recording a large net loss, and instead
achieved an earnings increase equalization of future earnings. Still, in the fiscal year ending March 2002 fiscal 2001, in addition to offsetting
unrealized capital losses by applying the Land Revaluation Law, the Tobu Railway
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Figure 10-1 Change in Net Profit
Figure 10-2 Net Profit after Eliminating Bias Introduced by Manipulation
of Entities
Group recorded significant losses due to the disposal or elimination of non- performing assets, which resulted in the Group recording a net loss for the fiscal year
ending March 2002 fiscal 2001.
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Figure 10-1 shows the change in net profit only; a financial indicator we selected for
analyzing the impact of Land Revaluation Law implementation. For purposes of comparison, Figure 10-2 shows the projected change in net profit that would have
occurred if the Tobu Railway Group had not applied land revaluation and the unrealized capital loss of approximately 107.8 billion yen had been actualized due to
compulsory implementation of asset impairment accounting in fiscal 2005. It can be estimated that, had the Tobu Railway Group not applied the Land
Revaluation Law, the Group would have posted a net loss of approximately 80.0 billion yen in
fiscal 2005. Next, we will consider how the stock market assessed this change in earnings
figures. Figure 11-1 shows change in the monthly price of Tobu Railway Company shares, and Figure 11-2 shows a comparison of the share price for Tobu Railway
Company blue with the TOPIX red
11
. The graphs confirm that the share price increased in the fiscal year ending March 2006 fiscal 2005, the year of obligatory
implementation of asset impairment accounting, both with respect to raw data and in comparison with the TOPIX. In Figure 10-1 and Figure 10-2 we show the projected
business results for the scenario in which the Tobu Railway Group did not deal with its unrealized losses on land through applying the Land Revaluation Law. Supposing
that Figure 10-2 provides a true picture of the earnings of Tobu Railway Group, it is possible that the stock market was misled. That is to say, it is conceivable that the
share price was decided on the basis of the
Figure 11-1 Change in Monthly Share Price of the Tobu Railway
Company
11
TOPIX is an abbreviation for Tokyo Stock Price Index, a share price index calculated as a weighted average using the magnitude the total market value of the share prices of all companies listed on
the First Section of the Tokyo Stock Exchange.
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Figure 11-2 Comparison of Tobu Railway Company Stock Price and
TOPIX
treatment of unrealized capital losses even though t he company‘s performance had
not actually changed in reality.
Learning Objectives
Four lessons can be obtained from this case study: 1. Earnings can be manipulated by changing entities and the scale of the
manipulations.
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2. The details of actual discretion with respect to accounting earnings can be demonstrated.
3. Bias introduced by actual discretion can be eliminated from accounting figures. 4. The likelihood of whether share mispricing has occurred can be assessed by
collating accounting figures after bias correction with the evaluation of the stock market.
Questions
1. If the Tobu Railway Group desired only to realize unrealized capital gains on land,
several other approaches are conceivable. Consider what other methods are available. Consider also the reasons for the adoption of the Land Revaluation Law
in this case rather than other methods. i If the Tobu Railway Group had adopted the purchase method at the time of the
merger with newly established subsidiaries by means of contributions of land in kind, land revaluation without implementation of the Land Revaluation Law would
have been possible. Goodwill amounting to tens of billions of yen would have been recorded, and
amortization of the goodwill would have become a drag on future earnings. ii The sale and repurchase of land with unrealized capital gains would have made
land revaluation possible. It would have been difficult to find a buyer, and profit on the sale of land and
taxable income would be generated in the fiscal year of the sale i.e. at a time when such a sale would not correspond to future impairment losses.
β. What do you think of the proposition, ―The unrealized capital losses could have been eliminated if all subsidiaries had been merged into Tobu Railway Company
and the δand Revaluation δaw had been applied?‖
3. A large net loss was recorded in the fiscal year ending March 2002 fiscal 2001. Might a big bath have occurred? Obtain the annual securities report and discuss
this possibility. 4. The railway industry is a regulated industry. Could the political costs hypothesis
not apply here as motivation for recording the enormous loss mentioned in 3 above? Through a discussion of what the political costs hypothesis is, examine
whether the receipt of government subsidies or an increase in railway fares occurred.
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Appendix
It is said that implementation of the Land Revaluation Law enabled corporations to deal with unrealized capital gains and unrealized capital losses on land with no
impact on the profit and loss statement. We journalize this below using a hypothetical example.
[Example]
Tobu Railway Company owns two parcels of land, Parcel A and Parcel B, and has applied land revaluation to the two parcels. The acquisition cost of Parcel A
and Parcel B, and the market price of the land at the time of revaluation are shown below:
acquisition cost market price difference Parcel A 500 800 +300
Parcel B 700 500 - 200
Time of Implementation of the Revaluation Method
Revaluation of Parcel A
Debit : Land 300 Credit : Land revaluation difference 180
Added to shareholders‘ equity Deferred tax assets liabilities land
related to
revaluation 120
Revaluation of Parcel B
Debit : Land revaluation difference 120 Credit : Land 200
Subtracted from shareholders‘ equity Deferred tax assets related to
land revaluation 80 Combined Journal Entries
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Debit: Land 100 Credit: Land revaluation difference 60
Deferred tax assets related to Deferred tax assets liabilities land revaluation 80 related to land revaluation 120
At the time of Parcel A revaluation, 60 of the unrealized capital gain is recorded as an increase in shareholders‘ equity added to the land revaluation difference account,
and 40 is treated as an increase in liabilities. At the time of Parcel B revaluation, 60 of the unrealized capital loss is recorded as a decrease sh
areholders‘ equity decrease in the land revaluation difference, and 40 is treated as an increase in
assets. That is to say, by pairing up Parcel A, which carries an unrealized capital gain, with Parcel B, which carries an unrealized capital loss, and applying the Land
Revaluation Law, it is possible to offset 60 of the unrealized capital loss by means of addition and subtraction to an item in shareholders‘ equity the land revaluation
difference account.
Reference
Ministry of Law 1998, Act Concerning Revaluation of Land, Ministry of Law. Ito, K. 2003, Introductory Financial Accounting 4
th
edition,Nikkei-Publishing, Inc. Palepu, K. G., P. M. Healy, and V. L. Bernard 1999, Business Analysis Valuation:
Using Financial Statements 2
nd
edition, South-Western College Publishing. Yamada, J. 2008, Accounting and Taxes for Organizational Restructuring 3
rd
edition, Zeimukeiri Kyokai Co., Ltd.
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3.4 Capital Markets
PROPERTIES OF FINANC IAL ANALYSTS‟ EARNINGS FORECAST VARIANCE
IN GOOD-NEWS AND BAD-NEWS ENVIRONMENTS: THEORY, EVIDENCE AND USEFULNESS
Davit Adut, University of Cincinnati P. K. Sen,University of Cincinnati
Praveen Sinha,California State University at Long Beach
Draft: June 2009.
Abstract
This study documents that the variance of analysts‘ forecast of earnings is smaller when the
expected or actual news about earnings is good relative to when it is bad. Together with the
observation that variance of forecast is larger for extreme news, this study offers evidence
consistent with the theory that larger variance is caused by higher private information of the
analysts. An examination over the entire fiscal year provides evidence of earlier consensus
building amongst analysts, as measured by reduction in variance over time in the good-news
environment. Forecasts of earnings can be
improved when variance of analysts‘ forecasts are used along with its mean. A trading strategy
based on the variance of analysts‘ forecasts earns positive abnormal returns, when conditioned upon
the nature of the news.
Keywords: Analyst forecasts; analyst forecast dispersion; earnings prediction.
JEL Classifications: M41, M49. Data Availability: Data available from public sources listed.
I. INTRODUCTION AND SUMMARY
Variance of analysts‘ forecasts
20
of earnings has been variously interpreted as a measure of risk and informational uncertainty in the prior
literature. For instance, Imhoff and Lobo 1992 have used it as a firm level
20
The term variance of analysts‘ forecasts of earnings is used interchangeably with terms variance of forecasts or variance of analysts‘ forecasts or analysts‘ forecast variance
throughout this paper.
949 proxy for differences in opinion amongst investors. In a similar vein, Bryan
and Tiras 2007 provide evidence that analyst forecasts are a proxy for other information and that higher level of dispersion indicates high information
asymmetry. Zhang 2006 also uses analyst forecast dispersion as a measure of information uncertainty. Gebhardt, Lee and Swaminathan 2001 on the
other hand, uses variance of analysts forecast as risk. These characterizations are not without problems and possible contradictions. For
example, Diether, Malloy and Scherbina 2002 show that higher analysts forecast variance generate a higher level of stock return, thus contradicting
the risk interpretation of the measure. Evidence consistent with the interpretation of informational uncertainty has been provided by many studies
such as Diether et al., 2002 and Han and Manry 2000 who document that firms with higher variance of analysts‘ earnings forecast have relatively lower
future stock returns and ROE. In another important paper, Easterwood and Nutt 1999 document that either extreme good news or extreme bad news is
associated with increased uncertainty about earnings. Consistent with Easterwood and Nutt 1999, Gu and Xue 2007 document that variances of
analysts forecasts are indeed higher for extreme good news and bad news, thus confirming the characterization of informational uncertainty. However, no
direct evidence of informational uncertainty has been documented so far. Theoretical models strive for rational explanations Trueman 1990;
Verrecchia 1983; Dye 1985 and empirical studies provide documentation Chambers and Penman 1984; Givoly and Palmon 1982; Kothari et al, 2007
that good news about corporate performance comes out earlier than the bad news. In the context of annual earnings, the implications of later arrival of bad
