Mark Soliman, an associate professor of accounting at the University of Washington Foster School of Business, has won the American Accounting Association’s 2009 Notable Contributions to Accounting Literature Award.
The award recognizes the impact of Soliman’s paper, “Accrual reliability, earnings persistence and stock prices,” published in the Journal of Accounting and Economics in 2005. Soliman collaborated with Scott Richardson, Richard Sloan and Irem Tuna on the study which created a lucrative investing strategy based on a firm’s reporting of accruals as earnings on the balance sheet.
The notion began with WorldCom. After the long distance telephone provider declared bankruptcy amid scandal in 2002, Soliman and his co-authors deconstructed the meltdown to learn how the company had manipulated its balance sheet to mask declining earnings.
“We expanded the WorldCom example to capture earnings manipulations in different forms on different parts of the balance sheet,” he says.
In particular, the researchers looked at accruals as a portion of earnings—and a predictor of future share prices. Some companies pump up reporting of accruals when they want to inflate their earnings (and thus their stock price). But Soliman found that high rates of accruals are not conducive to persistence of earnings—steady, predictable increase in a firm’s revenue. “And the market likes persistent earnings,” he says.
How it works
Take two firms in the same industry. Each reports one dollar of earnings. For one firm, 10 cents of that dollar are in accruals. But for the other, 40 cents of that dollar are in accruals. “The market sees both firms as having a dollar of earnings,” Soliman says. “But our research shows that the company with high accruals is going to have less than a dollar next year. You can’t pump up accounting forever. Eventually accruals unwind.”
And stock prices fall.
From that kernel of information grew a new, relatively simple investment strategy: analyze the reporting of accruals to predict the future direction of a firm’s stock price, then act accordingly. “So as an investor,” Soliman says, “you’d want to short the company with 40 cents in accruals and long the one with 10 cents in accruals. And if you do that, you make a lot of money.
“Using this measure of earnings manipulation, we were able to create a trading strategy that systematically beat the stock market over a long period of time.”
Beating the market being the name of the game for legions of investors, Soliman’s study packed value well beyond academia. “I think it was a unique idea,” he says, “and it was extremely applicable to practitioners, namely institutional investors. There were dozens of Wall Street papers on this, replicating results and endorsing the strategy.”
Soliman decided to try it out himself. He left the Stanford University Graduate School of Business in 2006 to join Citadel Investment Group as vice-president of accounting-based research. But he had no intention of staying.
“When I left Stanford to join Citadel, I assured them with certainty that I would be back in academics,” Soliman says. “They said, ‘No, you won’t come back. They never do.’ And I said, ‘With certainty, I’ll be back.’ I just wanted to try it. I was academically curious: Does this strategy work? Is it really possible to use accounting information to beat the market? What prevents these strategies from being unwound by others? Turns out you can use accounting information to beat the market, with some caveats. Once I got that out of my system and figured out how it worked, I was ready to come back.”
He made good on his promise. Soliman has been on faculty at the Foster School of Business since 2007. He now directs the Foster School’s CFO Forum, a topical round-table discussion of chief financial officers from leading firms in the Pacific Northwest. In his current research, Soliman is investigating the choices that CFOs make to meet or beat earnings expectations.