Richard Sloan
University of Michigan
Abstract: This session will describe techniques for evaluating the quality of earnings and then show how these techniques can be used to forecast future earnings performance and stock returns. The session will focus on two broad categories of techniques:
1. Techniques exploiting differences between earnings and cash flows Following Sloan (1996), these techniques use differences between earnings and cash flows as an indicator of earnings quality. We will look at several extensions of Sloans original paper, including controlling for legitimate differences between earnings and cash flows (see Xie, 2001), using a modified version of cash flows that more closely approximates free cash flows and pinpointing the accounting accruals that have the lowest quality (see Richardson, Sloan, Soliman and Tuna, 2002). We will also look at how these techniques successfully forecast several recent accounting debacles.
2. Techniques exploiting accounting conservatism Following Penman and Zhang (2002), these techniques identify situations where conservative accounting for investment expenditures (e.g., immediate expensing of R&D) creates temporary distortions in earnings.
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