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Do investors understand really dirty surplus?

Research output: Contribution to journalJournal article

Published

Journal publication date2011
JournalThe Accounting Review
Journal number1
Volume86
Number of pages22
Pages237-258
Original languageEnglish

Abstract

This study addresses whether firms’ share prices correctly reflect two accounting measures: dirty surplus and really dirty surplus. Dirty surplus is readily observable from the financial statements, but really dirty surplus, which arises from recognizing equity transactions such as employee stock option exercises at other than fair market value, is not. Findings show that dirty surplus and really dirty surplus are irrelevant for forecasting abnormal comprehensive income. However, findings also indicate that investors appear to undervalue really dirty surplus. Hedge returns are insignificant when portfolios are formed based on dirty surplus, but are significantly positive based on really dirty surplus. Really dirty surplus positive hedge returns are robust to a variety of sensitivity tests. Taken together, the findings are consistent with either investors over-valuing firms that have large negative really dirty surplus or really dirty surplus being correlated with an unmodeled risk factor.