Published Issues
Review of
Accounting Studies
Volume 14, Issue 4, December 2009
The pricing of
earnings and cash flows and an affirmation of accrual accounting
Stephen H Penman and Nir
Yehuda
Changes in bonus
contracts in the post-Sarbanes-Oxley era
Mary Ellen Carter, Luann
J. Lynch and Sarah Zechman
Managerial incentives
for discretionary disclosure: evidence from management leveraged buyouts
Nader M. Hafzalla
Bankruptcy
prediction: the case of Japanese listed companies
Ming Xu and
Financial reporting complexity
and investor under-reaction to 10-K information
Hiafeng You and Xiao-Jun
Zhang
Team earnings
forecasting
Lawrence D. Brown and
Artur Hugon
Abstracts
Volume 14, Issue 4, December 2009
The pricing of
earnings and cash flows and an affirmation of accrual accounting
Stephen H Penman and Nir
Yehuda
Under accrual accounting, earnings add to shareholders’ equity. Cash flow generated by a business has no effect on the book value of shareholders’ equity, but reduces the book value of net assets employed in business operations. In short, accrual accounting rules prescribe that earnings add to shareholder value but cash flow is irrelevant to the valuation of equity. This paper documents that the stock market prices equity shares according to this prescription. Earnings are priced positively but, given earnings, a dollar more of free cash flow from a business – cash from operations minus cash investment – is, on average, associated with approximately a dollar less in the market value of the business, and has no association with changes in the market value of the equity claim on the business. Further, controlling for the cash investment component of free cash flow, “cash flow from operations” also reduces the market value of the business dollar-for-dollar, and is unrelated to the changes in market value of the equity.
Changes in bonus
contracts in the post-Sarbanes-Oxley era
Mary Ellen Carter, Luann
J. Lynch and Sarah Zechman
We examine whether the relation between earnings and bonuses changes after Sarbanes–Oxley. Theory predicts that, as the financial reporting system reduces the discretion allowed managers, firms will put more weight on earnings in compensation contracts to encourage effort. However, the increased risk imposed by Sarbanes–Oxley on executives may cause firms to temper this contracting outcome. We examine and find support for the joint hypothesis that the implementation of Sarbanes–Oxley and related reforms led to a decrease in earnings management and that firms responded by placing more weight on earnings in bonus contracts. We find no evidence that firms changed compensation contracts to compensate executives for assuming more risk.
Managerial incentives
for discretionary disclosure: evidence from management leveraged buyouts
Nader M. Hafzalla
Managers in management leveraged buyout (MBO) firms prefer to purchase their firms at a low offer price. This motive gives them a clear incentive to make pessimistic discretionary disclosures. Using a sample of press releases, I find that managers involved in their firms’ MBO selectively release negative disclosures to denigrate their firm just before the MBO transaction when compared with prior period: they issue more bad news disclosures and more pessimistic quotes. Additionally, they issue less optimistic quotes, fewer good news disclosures, less positive earnings forecasts, and they manage earnings downwards. I control for factors that may not be caused by managers’ purchase motives by comparing the MBO sample with a third-party leveraged buyout sample where management is not involved in the buyout and with a performance-matched control sample. I find that the disclosure of MBO firms becomes significantly more pessimistic than the leveraged buyout firms where management is not involved in the transaction and significantly more pessimistic than the performance-matched control sample.
Bankruptcy
prediction: the case of Japanese listed companies
Ming Xu and
This paper investigates if bankruptcy of Japanese listed companies can be predicted using data from 1992 to 2005. We find that the traditional measures, such as Altman’s (J Finance 23:589–609, 1968) Z-score, Ohlson’s (J Accounting Res 18:109–131, 1980) O-score and the option pricing theory-based distance-to-default, previously developed for the U.S. market, are also individually useful for the Japanese market. Moreover, the predictive power is substantially enhanced when these measures are combined. Based on the unique Japanese institutional features of main banks and business groups (known as Keiretsu), we construct a new measure that incorporates bank dependence and Keiretsu dependence. The new measure further improves the ability to predict bankruptcy of Japanese listed companies.
Financial reporting
complexity and investor under-reaction to 10-K information
Hiafeng You and Xiao-Jun
Zhang
We study the immediate and delayed market reaction to U.S. Securities and Exchange Commission (SEC) EDGAR 10-K filings. Unusual trading volumes and stock-price movements are documented during the days around the 10-K filing dates. The abnormal price movements are positively associated with future accounting profitability, indicating that 10-K reports contain useful information about future firm performance. In addition, investors’ reaction to 10-K information seems sluggish, as demonstrated by the stock-price drift during the 12-month period after 10-K filing. We find that investors’ underreaction tends to be stronger for firms with more complex 10-K reports.
Team earnings
forecasting
Lawrence D. Brown and
Artur Hugon
While brokerage houses use both teams of sell-side analysts and individual analysts to conduct earnings research, there is no empirical research examining whether teams and individuals differ with regard to their forecasting performance or purpose. We first examine the most-often researched dimension of forecasting performance, earnings forecast accuracy, and show that teams are less accurate than individual analysts in general and their own individual team members in particular. We conjecture that teams focus their efforts on an alternative dimension of forecasting performance, timeliness, and show that team forecasts are timelier than those of individual analysts in general and their own individual team members in particular. Consistent with the notion that teams trade-off forecast accuracy for timeliness to comply with a market research demand, we show that team forecast revisions are associated with larger market responses than those of individuals. Finally, we illuminate the nature of team assignments by documenting that the firms that teams follow are in greater financial distress and larger in size.
Review of
Accounting Studies
Volume 14, Issue 2/3, June/September 2009
This double issue
contains papers presented at a conference entitled, Current Topics in
Accounting Research, which was held at the Fuqua School of Business, Duke University,
Durham, NC in October, 2008.
Editorial
Are special items
informative about future profit margins?
Patricia M.
Discussion of “Are special items informative about future profit margins?”
Richard M. Frankel
On the relation
between expected returns and implied cost of capital
John S. Hughes, Jing Liu
and Jun Liu
Discussion of
“On the relation between expected returns and implied cost of
capital”
Richard Lambert
Explicit relative
performance evaluation in performance-vested equity grants
Mary Ellen Carter, Christopher D. Ittner and Sarah
L.C. Zechman
Discussion of
“Explicit relative performance evaluation in performance-vested equity
grants”
Fabrizio Ferri
Dynamic performance
measurement with intangible assets
Carlos Corona
Discussion of
“Dynamic performance measurement with intangible assets”
Sunil Dutta
Are analysts’
earnings forecasts more accurate when accompanied by cash flow forecasts?
Andrew Call, Shuping Chen
and Yen H. Tong
Discussion of
“Are analysts’ earnings forecasts more accurate when accompanied by
cash flow forecasts?”
Reuven Lehavy
The Robustness of the
Sarbanes Oxley Effect on the
Bowe Hansen, Grace Pownall
and Xue Wang
Discussion of
“The Robustness of the Sarbanes Oxley Effect on the
Trevor Harris
Abstracts
Volume 14, Issue 2/3, June/September 2009
This double issue
contains papers presented at a conference entitled, Current Topics in
Accounting Research, which was held at the Fuqua School of Business, Duke
University, Durham, NC in October, 2008.
Are special items
informative about future profit margins?
Patricia M.
Most proponents of using profit margins in forecasting models suggest that unusual items be removed from income to create a core profit margin. We investigate the appropriateness of this assumption over short and long horizons. Specifically, we explore the association between profit margins and special items over windows of increasing length, from one to five years.
We find that the association between past special items and future profit margins differs markedly between firms with low and high core profitability. For low profitability firms, past special items have no association with future profit margins, even over windows of five years. In sharp contrast, for high profitability firms, negative special items are associated with lower future profit margins. This suggests that some firms maintain high core profitability by becoming serial chargers and special items differ from core earnings only to the extent that the allocation process induces timing errors in reported earnings.
Discussion of “Are special items informative about future profit
margins?”
Richard M. Frankel
On the relation
between expected returns and implied cost of capital
John S. Hughes, Jing Liu and
Jun Liu
We examine the relation
between implied cost of capital and expected returns under an assumption that
expected returns are stochastic, a property supported by theory and empirical
evidence. We demonstrate that implied
cost of capital differs from expected return, on average, by a function
encompassing volatilities of, as well as correlation between, expected returns
and cash flows, growth in cash flows, and leverage. These results provide
alternative explanations for findings from empirical studies employing implied
cost of capital on the magnitude of the market risk premium; predictability of
future returns; and the relations between cost of capital and a host of firm
characteristics, such as growth, leverage, idiosyncratic risk and the firm’s
information environment.
Discussion of
“On the relation between expected returns and implied cost of
capital”
Richard Lambert
This paper discusses the paper “On the relationship between expected returns and implied cost of capital” by Hughes, Liu, and Liu. The discussion focuses on developing the intuition behind the mathematical results and on extensions of the analysis that future research could address.
Explicit relative
performance evaluation in performance-vested equity grants
Mary Ellen Carter, Christopher D. Ittner and Sarah
L.C. Zechman
Using
data from FTSE 350 firms, we examine factors influencing explicit relative
performance evaluation (RPE) conditions in performance-vested equity
grants. We provide exploratory evidence
on whether the use or characteristics of RPE are associated with efforts to
improve incentives by removing common risk, other economic factors discussed in
the RPE literature, or external pressure to implement RPE. We find that many of these economic factors,
including common risk reduction, are more closely related to specific relative
performance conditions than to the firm-level decision to use RPE in some or
all of their equity grants. We also find
that greater external monitoring by institutional investors or others is associated
with plans with more stringent overall RPE conditions. The relative performance conditions are
binding in most RPE plans, with nearly two-thirds of the grants vesting only
partially or not vesting at all. And, we
find evidence that vesting percentages vary in RPE and non-RPE plans.
Discussion of
“Explicit relative performance evaluation in performance-vested equity
grants”
Fabrizio Ferri
Carter, Ittner, and Zechman (2009) examine the use of
explicit relative performance evaluation (RPE) conditions in performance-vested
equity plans in a sample of United Kingdom (U.K.) firms in 2002. They find that
factors suggested by economic theories (for example, removal of common shocks,
tournament theory) are more closely associated with specific features of the
plan than with the firm-level decision to use an RPE equity plan. My discussion
focuses on the interpretation of these findings and the opportunities and
implications for future research. I also summarize the views of five
Dynamic performance
measurement with intangible assets
Carlos Corona
The increasing
importance of intangible assets in modern economies is driving companies to
include measures of intangible assets in managerial performance evaluations.
For the multiperiod principal-agent model analyzed in this paper, a manager
must be motivated to invest in intangible assets like customer satisfaction or
product quality. The intangible asset is not verifiable for contracting
purposes, but the parties can rely on a noisy indicator of the current asset
value. I derive a class of value added performance measures, which effectively
aggregate the current cash flow and consecutive realizations of the noisy indicator
of the intangible asset. This class of performance measures is shown to be
optimal for different scenarios regarding contract commitment and observability
of the actual investment decisions. Long-term contracts are examined as a
baseline. However, in practice firms usually adopt shorter medium-term
contracts that are periodically renegotiated. I show that this more realistic
contracting scenario yields the same investment patterns and efficiency levels
as those obtained under long-term commitment.
Discussion of
“Dynamic performance measurement with intangible assets”
Sunil Dutta
Are analysts’
earnings forecasts more accurate when accompanied by cash flow forecasts?
Andrew Call, Shuping Chen
and Yen H. Tong
We
examine whether analysts’ earnings forecasts are more accurate when they
also issue cash flow forecasts. We find
that (i) analysts’ earnings forecasts issued together with cash flow
forecasts are more accurate than those not accompanied by cash flow forecasts,
and (ii) analysts’ earnings forecasts reflect a better understanding of
the implications of current earnings for future earnings when they are accompanied
by cash flow forecasts. These results
are consistent with analysts adopting a more structured and disciplined
approach to forecasting earnings when they also issue cash flow forecasts. Finally, we find that more accurate cash flow
forecasts decrease the likelihood of analysts being fired,
suggesting that cash flow forecast accuracy is relevant to analysts’
career outcomes.
Discussion of
“Are analysts’ earnings forecasts more accurate when accompanied by
cash flow forecasts?”
Reuven Lehavy
Call, Chen, and Tong (2009, Review of Accounting Studies, this issue) demonstrate that, relative to analysts who issue earnings but not cash flow forecasts, analysts who issue both forecasts (i) produce relatively more accurate earnings forecasts, (ii) have a better understanding of the persistence of current earnings, and (iii) are less likely to get fired. In my discussion, I highlight some general challenges facing research on analyst cash flow forecasts, demonstrate the diminishing difference in the relative accuracy over time (including its compete elimination by 2004), and examine the sensitivity of some of the evidence in Call et al. (2009) to the age of the forecast and to the presence of extreme bad-news earnings surprises.
The Robustness of the
Sarbanes Oxley Effect on the
Bowe Hansen, Grace Pownall
and Xue Wang
We examine the incidence of new
listings and delistings on
Discussion of
“The Robustness of the Sarbanes Oxley Effect on the
Trevor Harris
In this paper, I use anecdotal evidence and logical reasoning to suggest that, despite the use of an extensive database, it is not possible to conclude that passage of the Sarbanes Oxley Act did not have an impact on companies’ delisting decisions. Moreover, the instrumental variables used to proxy for SOX effects are too weak and suffer from a significant endogeneity problem given that passage of SOX was driven by many of the economic and control problems that are used to control for market and company factors. I also discuss some broader issues about the trade-off between large sample statistical inference and anecdotal analysis foraddressing practical questions.
Review of
Accounting Studies
Volume 14, Number 1, March 2009
What drives the
increased informativeness of earnings announcements over time?
Daniel W. Collins, Oliver
Zhen Li and Hong Xie
How Does the Corporate
Bond Market Value Capital Investments and Accruals
Sanjeev Bhojraj and
Bhaskaran Swaminathan
Experimental Evidence
of How Prior Experience as an Auditor Influences Managers' Strategic Reporting
Decisions
Publicly-Traded
versus Privately-Held: Implications for Conditional Conservatism in Bank
Financial Reporting
D. Craig Nichols, Jim
Wahlen and Matthew M. Wieland
Tightening Credit
Standards: The Role of Accounting Quality
Philippe Jorion, Charles
Shi and Sanjian Zhang
Accounting
Conservatism and Corporate Governance
Juan Garcia Lara, Beatriz
García Osma and Fernando Penalva
Abstracts
Volume 14, Number 1, March 2009
What drives the
increased informativeness of earnings announcements over time?
Daniel W. Collins, Oliver
Zhen Li and Hong Xie
Landsman and Maydew (J Acc Res 40:797–808, 2002) document that the information content of earnings announcements has increased over the past three decades, and Francis et al. (Acc Rev, 77:515–546, 2002) conclude that expanded concurrent disclosures in firms’ earnings announcements, especially the inclusion of detailed income statements, explain this increase. We posit and find that the temporal increase in the intensity of the market’s reaction to Street earnings offers a competing explanation for the Landsman and Maydew finding. We also find that expanded concurrent disclosure of GAAP-based information contributes to the temporal increase in the information content of earnings announcements. However, unlike Francis et al., we find that the temporal increase in concurrent balance sheet and cash flow statement information dominates concurrent income statement information once we control for Street earnings.
How Does the
Corporate Bond Market Value Capital Investments and Accruals
Sanjeev Bhojraj and
Bhaskaran Swaminathan
This paper examines whether the mispricing of accruals documented in equity markets extends to bond markets. The paper finds that corporate bonds of firms with high operating accruals underperform corporate bonds of firms with low operating accruals. In the first year after portfolio formation, the underperformance is 115 basis points using an accrual measure that includes capital investments and 93 basis points using an accrual measure that is based only on working capital investments. The Sharpe ratios of the zero-investment bond accrual portfolios are comparable to those of the corresponding zero-investment stock accrual portfolios. The results are also robust to risk adjustments based on both a factor model consisting of the Fama and French (J. Financial Econ 33 (1993) 3) stock and bond market factors and a characteristics model based on bond ratings and duration. Cross-sectional Fama–MacBeth regressions that use individual bond data and control for stock and bond issuances in addition to ratings and duration also confirm the time-series portfolio findings. Overall, our results reveal an accrual anomaly among bonds similar to that observed among stocks.
Experimental Evidence
of How Prior Experience as an Auditor Influences Managers' Strategic Reporting
Decisions
We design an experiment to examine the influence of audit experience on subsequent reporting decisions when auditors become managers of audited firms. In contrast to the independence issues that can arise when auditors and their clients are related by prior affiliation, we focus this study on the more common case in which auditors assume subsequent employment with other firms’ clients. In a bi-matrix experimental game that captures key features of the strategic tension between auditors and reporters, we find that reporters who have prior experience as an auditor, particularly the experience of having been a diligent auditor, are more sensitive to large penalties for aggressive reporting than are reporters whose experience is exclusively as a reporter. Our results suggest implications for regulators in predicting the effects of reporting penalties and for firms in considering the effects of CPA experience when hiring for reporting positions.
Publicly-Traded
versus Privately-Held: Implications for Conditional Conservatism in Bank
Financial Reporting
D. Craig Nichols, Jim
Wahlen and Matthew M. Wieland
Compared with privately held banks, publicly traded banks face greater agency costs because of greater separation of ownership and control but enjoy greater benefits from access to the equity capital market. Differences in control and capital market access influence public versus private banks’ accounting. We predict and find that public banks exhibit greater degrees of conditional conservatism (asymmetric timeliness of the recognition of losses versus gains in accounting income) than private banks. We predict and find that public banks recognize more timely earnings declines, less timely earnings increases, and larger and more timely loan losses. Although public ownership gives managers greater ability and incentive to exercise income-increasing accounting, our findings show that the demand for conservatism dominates within public banks and that the demand for conservatism is greater among public banks than private banks. Our results provide insights for accounting and finance academics, bank managers, auditors, and regulators concerning the effects of ownership structure on conditional conservatism in banks’ financial reporting.
Tightening Credit
Standards: The Role of Accounting Quality
Philippe Jorion, Charles
Shi and Sanjian Zhang
Over the latest 20 years, the average credit rating of
Accounting
Conservatism and Corporate Governance
Juan Garcia Lara, Beatriz
García Osma and Fernando Penalva
We predict that firms with stronger corporate governance will exhibit a higher degree of accounting conservatism. Governance level is assessed using a composite measure that incorporates several internal and external characteristics. Consistent with our prediction, strong governance firms show significantly higher levels of conditional accounting conservatism. Our tests take into account the endogenous nature of corporate governance, and the results are robust to the use of several measures of conservatism (market-based and nonmarket-based). Our evidence is consistent with the direction of causality flowing from governance to conservatism, and not vice versa, indicating that governance and conservatism are not substitutes. Finally, we study the impact of earnings discretion on the sensitivity of earnings to bad news across governance structures. We find that, on average, strong-governance firms appear to use discretionary accruals to inform investors about bad news in a timelier manner.
Review of
Accounting Studies
Volume 13, Issue 4, December 2008
Rewriting earnings
history
Baruch Lev, Stephen G.
Ryan and Min Wu
Tax incentives for
inefficient executive pay and reward for luck
Robert F. Göx
Does acquirer cash
level predict post-acquisition returns?
Derek K. Oler
The relevance of
quantifiable audit qualifications in the valuation of IPOs
Dimitrios C. Ghicas,
Are executive stock
option exercises driven by private information?
David Aboody, John Hughes,
Jing Liu and Wei Su
Investor reactions to
derivative use and outcomes
Lisa Koonce, Marlys Gascho
Lipe and MaryLea McAnally
Abstracts
Volume 13, Issue 4, December 2008
Rewriting earnings
history
Baruch Lev, Stephen G.
Ryan and Min Wu
Research on the usefulness of financial information generally focuses on the innovation in the information examined, such as an earnings surprise or cash flow growth. Consequently, prior research sheds little light on the role of the rich historical record of financial information in users’ decision-making. Using a sample of published restatements of earnings, we show that the revision of the historical pattern of earnings, distinct from the magnitude of the restatement and its impact on current earnings, significantly affects investors’ decisions and predicts class action lawsuits. Specifically, we find that restatements that eliminate or shorten histories of earnings growth or positive earnings have significantly more adverse effects for investor valuations and the likelihood of lawsuits than other restatements. This evidence about the value-relevance of refreshing the historical record of earnings is pertinent to the FASB’s recent cautious expansion of the scope of circumstances that require a restatement of financial information in FAS 154.
Tax incentives for
inefficient executive pay and reward for luck
Robert F. Göx
I study the economic consequences of tax deductibility limits on salaries for the design of incentive contracts. The analysis is based on an agency model in which the firm's cash flow is a function of the agent's effort and an observable random factor beyond the agent's control. According to my analysis, limiting the tax deductibility of fixed wages has two consequences. The principal rewards the agent on the basis of the observable random factor and adjusts the amount of performance-based pay in the optimal incentive contract. The new contract can have weaker or stronger work incentives than without the tax. The theoretical findings have implications for empirical compensation research. First, the analysis shows that reward for luck can be the optimal response to recent tax law changes, whereas earlier empirical literature has attributed this phenomenon to managerial entrenchment. Second, I demonstrate that a simple regression analysis that fails to control for separable measures of luck is likely to find an increased pay for performance sensitivity as a response to the introduction of tax deductibility limits on salaries even if the pay for performance sensitivity has actually declined.
Does acquirer cash
level predict post-acquisition returns?
Derek K. Oler
This paper investigates whether an acquirer’s pre-announcement cash level can predict post-acquisition returns. Harford (1999, Journal of Finance, 54, 1969–1997) shows that some cash-rich acquirers have lower announcement period returns than other acquirers, suggesting the market partially anticipates poor future performance. This paper shows that the acquirer’s cash level is also strongly and negatively predictive of post-acquisition returns, indicating that the announcement response is incomplete. Post-acquisition return on net operating assets (RNOA) is significantly decreasing in acquirer cash, suggesting that the market responds to subsequent poor operating performance as it is reported. Overall, these results are consistent with the market’s inattention to a less prominent accounting signal (acquirer cash) but attentiveness to a more prominent accounting signal (RNOA), as proposed by Hirshleifer and Teoh (2003, Journal of Accounting Economics, 36, 337–386).
The relevance of
quantifiable audit qualifications in the valuation of IPOs
Dimitrios C. Ghicas,
How useful are audit qualifications to financial statement users? We analyze a sample of 204 firms that went public at the Athens Stock Exchange over the period 1987–2002. For 149 of these firms, auditors report quantitative estimates of the amount by which assets are overstated and/or liabilities are understated in reported financial statements. We find that underwriters and their affiliated analysts do not incorporate the negative information provided by these qualifications into offer prices and earnings forecasts. Investors, however, appear to efficiently impound the negative implications of the audit qualifications into stock market prices within the first day of trading. The results suggest that underwriters tend to align their interests with the interests of their clients, the old stockholders, at the expense of the new stockholders. They also suggest that the practice of reporting quantifiable qualifications in audit reports is valuable to investors given that they are disclosed by an expert.
Are executive stock
option exercises driven by private information?
David Aboody, John Hughes,
Jing Liu and Wei Su
In this study, we investigate the extent to which exercise of executive stock options is based upon private information. Contrary to popular belief, we find that shares are held more than 30 days following over a quarter of options exercised. Partitioning the data, we find weak evidence that decisions to exercise and sell immediately are prompted by bad news and stronger evidence that decisions to exercise and hold for at least 30 days are prompted by good news. Enhancing the power of our tests by considering several factors important to exercise decisions, we find that the higher the opportunity costs of early exercise as measured by the time-value of options, the greater the trading profits to executives. We also find that the greater the disguise provided by incentives to diversify and consume as measured by the depth of options in the money, the greater the trading profits to executives who exercise and sell. Turning to non-exercise decisions, we find that a strategy of holding options rather than shares to exploit good news yields positive abnormal returns consistent with theoretical predictions in the absence of dividends.
Investor reactions to
derivative use and outcomes
Lisa Koonce, Marlys Gascho
Lipe and MaryLea McAnally
How do investors evaluate managers who choose to use or not use derivatives once the outcomes of those decisions become known? Different theories offer different predictions, and we test these in three experiments. Results show that investors are more satisfied with firm managers and assign a higher value to firms when managers use derivatives (that address firm risks) than when they do not. This result occurs even though we hold constant the economic differences typically present when comparing derivative use versus non-use (i.e., ex-ante risk and ex-post outcome), suggesting that investors reward those firms that use derivatives. Additional tests reveal that investors believe that firm managers who use derivatives in these situations exhibit a higher level of decision-making care than those who do not use derivatives. We also document that these inferences about greater decision-making care do not apply to the speculative use of derivatives. Overall, our study adds to our understanding of how investors judge companies who use derivatives, given the outcomes that result from such use.
Review of
Accounting Studies
Volume 13, Issue 2/3, June/September 2008
This double issue
contains papers presented at a conference entitled Uses of Accounting Data for
Firm Valuation and Performance Measurement, which was held at the School of
Accountancy, W.P. Carey School of Business, Arizona State University, in Tempe
Arizona, in October 2007.
Editorial
Is financial
reporting shaped by equity markets or by debt markets? An international study
of timeliness and conservatism
Ray Ball, Ashok J. Robin
and Gil Sadka
Discussion of “Is
financial reporting shaped by equity markets or by debt markets? An
international study of timeliness and conservatism”
Steve Monahan
Executive stock-based
compensation and firms’ cash payout: the role of shareholders’
tax-related payout preferences
David Aboody and Ron
Kasznik
Discussion of
“Executive stock-based compensation and firms’ cash payout: the
role of shareholders’ tax-related payout preferences”
Terry Shevlin
On the relation
between predictable market returns and predictable analyst forecast errors
John S. Hughes, Jing Liu
and Wei Su
Discussion of
“On the relation between predictable market returns and predictable
analyst forecast errors”
Gerald T. Garvey
Evidence of differing
market responses to beating analysts' targets through tax expense decreases
Cristi A. Gleason and
Lillian F. Mills
Discussion of
“Evidence of differing market responses to beating analysts' targets
through tax expense decreases”
Theodore E. Christensen
Investor recognition
and stock returns
Reuven Lehavy and Richard
G. Sloan
Discussion of
“Investor recognition and stock returns”
Eli Bartov
Inventory policy,
accruals quality and information risk
Gopal Krishnan, Bin
Srinidhi and Lixin Su
Discussion of
“Inventory policy, accruals quality and information risk”
Per Olsson
Abstracts
Volume 13, Issue 2/3, June/September 2008
This double issue
contains papers presented at a conference entitled Uses of Accounting Data for
Firm Valuation and Performance Measurement, which was held at the School of Accountancy,
W.P. Carey School of Business, Arizona State University, in Tempe Arizona, in
October 2007.
Is financial
reporting shaped by equity markets or by debt markets? An international study
of timeliness and conservatism
Ray Ball, Ashok J. Robin
and Gil Sadka
We hypothesize debt markets—not equity markets—are the primary influence on “association” metrics studied since Ball and Brown (1968 J Account Res 6:159–178). Debt markets demand high scores on timeliness, conservatism and Lev’s (1989 J Account Res 27(supplement):153–192) R 2, because debt covenants utilize reported numbers. Equity markets do not rate financial reporting consistently with these metrics, because (among other things) they control for the total information incorporated in prices. Single-country studies shed little light on debt versus equity influences, in part because within-country firms operate under a homogeneous reporting regime. International data are consistent with our hypothesis. This is a fundamental issue in accounting.
Discussion of
“Is financial reporting shaped by equity markets or by debt markets? An
international study of timeliness and conservatism”
Steve Monahan
Using country-level data, Ball et al. (2008, Review of Accounting Studies) (BRS hereafter) demonstrate that debt-market (equity-market) size is (is not) positively associated with measures of timely loss recognition and asymmetric timely loss recognition. They argue that these results imply that debt holders—not equity holders—are the primary source of demand for timely accounting reports. They also argue that their results support the notion that the “costly contracting” school of thought is more descriptive than the “value relevance” perspective and that general purpose financial statements are of questionable value. I argue that, while their results are novel and relevant to both academia and practice, their conclusions are premature for at least three reasons (1) their research design is inefficient and may lead to biased inferences, (2) additional evidence on the relation between timeliness and the benefits of leverage as well as debt-instrument attributes is needed, and (3) factors other than timeliness also impact the quality of financial reporting and thus may be of value to equity holders or other interested parties.
Executive stock-based
compensation and firms’ cash payout: the role of shareholders’
tax-related payout preferences
David Aboody and Ron
Kasznik
We hypothesize that the structure of executive stock-based compensation helps to align managers’ payout choices with shareholders’ tax-related payout preferences. Specifically, stock options, which are not dividend-protected, can deter self-interested executives from using dividends as a form of payout. In contrast, restricted stock, which is dividend-protected, is more likely to induce the use of dividends. Relatedly, shareholders’ preferences for dividends, which are taxed as ordinary income, can depend on the income tax consequences of dividends relative to those of long-term capital gains. To test our hypothesis, we investigate whether the exogenous changes in shareholders’ tax-related payout preferences following the 2003 dividend tax rate reduction result in predictable shifts in executive stock-based compensation and in managers’ payout choices. Consistent with our prediction, we find a positive relation between the increased use of dividends in firms’ payouts and the increased (decreased) use of restricted stock (stock options) in executive compensation, particularly for firms with a greater percentage ownership by individual investors and with lower costs associated with modifying the structure of their compensation plans. Our investigation of the role of shareholders’ tax-related payout preferences in the design of executive stock-based compensation extends the prior literature that has largely focused on the role of incentive contracts in inducing managerial effort, risk taking, and retention.
Discussion of
“Executive stock-based compensation and firms’ cash payout: the
role of shareholders’ tax-related payout preferences”
Terry Shevlin
Aboody and Kasznik (Rev Acc Stud, this issue, 2008) develop and test cross-sectional predictions about how firms might respond to the 2003 dividend tax cuts. My discussion suggests some alternative firm responses, a restructuring of the main tests to be consistent with the theory and predictions, and an interpretation of the magnitude of the observed associations. Overall, the paper addresses an interesting issue, recognizes that executive compensation is endogenous in this event, and adds to the long literature on dividend payout policy.
On the relation
between predictable market returns and predictable analyst forecast errors
John S. Hughes, Jing Liu
and Wei Su
We investigate the relation between predictable market returns and predictable analyst forecast errors. Perfect correlation between predictable components of forecast errors and abnormal returns would lend credence to the view that pricing anomalies are not merely an artifact of inadequately controlled risk. Our evidence implies an imperfect correlation. Moreover, we find that while the predictable component of abnormal returns is significantly associated with future forecast errors, trading strategies based directly on the predictable component of forecast errors are not profitable. Further implications of our findings are that predictable components of analysts’ forecast errors are robust with respect to loss functions and analysts’ earnings forecasts may significantly diverge from the market expectations.
Discussion of
“On the relation between predictable market returns and predictable
analyst forecast errors”
Gerald T. Garvey
This paper furthers our understanding of two major issues in financial accounting. Most directly, the results undermine the validity of using analyst earnings forecasts as proxies for market expectations. The paper’s main results are also informative about the relative reliability of some well-known return anomalies.
Evidence of differing
market responses to beating analysts' targets through tax expense decreases
Cristi A. Gleason and
Lillian F. Mills
Returns are positive when firms meet or beat analysts’ consensus forecasts, but negative when firms miss. Prior research finds little substantial discount for managing earnings to beat the forecasts via accruals generally. We consider whether the market reward for beating the forecast is smaller when firms use tax expense decreases, which are visible and transparent at the earnings announcement date, unlike accruals. When firms beat analysts’ forecasts by decreasing their tax expense relative to the third-quarter rate, the market discounts the reward by an economically significant amount: approximately 86%. We document lower persistence of current-year tax changes for those firms that decrease tax expense to beat the target. The observed discount for beating the forecast only because of a third to fourth quarter tax decrease may reflect market perceptions of the lack of persistence of the decrease.
Discussion of
“Evidence of differing market responses to beating analysts' targets
through tax expense decreases”
Theodore E. Christensen
Gleason and Mills (2008) extend prior research investigating whether investors detect obvious earnings management. They improve on previous efforts to answer this question by examining firms with a clear motivation to manage earnings and by investigating a specific earnings management tool. They investigate firms that fall short of analysts’ expectations when income tax expense is based on the third quarter effective tax rate but meet expectations by reducing the fourth quarter tax expense below predicted tax expense. Their results suggest that investors are sophisticated enough to identify a transparent earnings management tool and that they discount the fact that firms meet expectations using such an obvious tactic. Specifically, the authors find evidence suggesting that the reward for meeting analysts’ expectations is 86 percent lower when managers use the tax expense as an earnings management tool to meet expectations. The puzzling feature of their results is that, although it is diminished, investors still reward firms for meeting expectations when they can only do so through an apparently obvious manipulation of tax expense.
Investor recognition
and stock returns
Reuven Lehavy and Richard
G. Sloan
It is well established that investment fundamentals, such as earnings and cash flows, can explain only a small proportion of the variation in stock returns. We find that investor recognition of a firm’s stock can explain relatively more of the variation in stock returns. Consistent with Merton’s (J Finance 42(3):483–510, 1987) theoretical analysis, we show that (i) contemporaneous stock returns are positively related to changes in investor recognition, (ii) future stock returns are negatively related to changes in investor recognition, (iii) the above relations are stronger for stocks with greater idiosyncratic risk and (iv) corporate investment and financing activities are both positively related to changes in investor recognition. Our research suggests that investors and managers who are concerned with firm valuation should consider investor recognition in addition to accounting information and related investment fundamentals.
Discussion of
“Investor recognition and stock returns”
Eli Bartov
Lehavy and Sloan (2008, Review of Accounting Studies) note that prior studies find that earnings and cash flows explain only a small portion of the cross-sectional variation in stock return. This motivates them to investigate empirically the ability of a behavioral model of capital market equilibrium proposed by Merton (1987, Journal of Finance, 42, 483–510) to explain the remaining variation in stock returns. Their primary findings show that security value is, as predicted, increasing in investor recognition of the security and that investor recognition is incremental to and more important than cash flows in explaining the cross-sectional variation of stock returns. While the research question is intriguing and well motivated, a number of methodological limitations may limit the reliability of the findings/interpretations. In this paper, I first evaluate the motivation and potential contribution of the Lehavy and Sloan (2008) study. I then outline methodological limitations underlying the study and offer ways of overcoming them. In the final section, I state my conclusions.
Inventory policy,
accruals quality and information risk
Gopal Krishnan, Bin
Srinidhi and Lixin Su
This paper provides evidence consistent with firms with Last-in-first-out (LIFO) inventory policy being priced by the market as having lower information risk than First-in-first-out (FIFO) firms. Furthermore, the paper shows that this pricing differential is sustained after controlling for accruals quality, suggesting that the inventory policy signals some information risk characteristics that are not captured by accruals quality measure. We investigate the relation between inventory policy and accruals quality and find that accruals quality is systematically worse for FIFO firms than for LIFO firms after controlling for correlated omitted variables and known firm attributes. These findings complement the currently established relationship between the cost of capital, market pricing and accruals quality by focusing on the need for understanding the incremental effects of individual accounting policies.
Discussion of
“Inventory policy, accruals quality and information risk”
Per Olsson
Krishnan, Srinidhi, and Su (2008) investigate how the choice of LIFO vs. FIFO affects firms’ accruals quality and cost of capital. The authors show that LIFO firms have better accruals quality and lower cost of capital than FIFO firms and that the cost of capital effect associated with the inventory valuation method is not subsumed by differences either in fundamental risk or accruals quality between LIFO and FIFO firms. This discussion is focused on key design choices and underlying assumptions.
Review of
Accounting Studies
Volume 13, Issue 1, March 2008
Voluntary disclosure
of accruals in earnings press releases and the pricing of accruals
Shai Levi
An integrated
analysis of the association between accrual disclosure and the abnormal accrual
barrier
Henock Louis, Dahlia
Robinson and Andrew M. Sbaraglia
The hiring of
accounting and finance officers from audit firms: how did the market react?
Marshall A. Geiger, Clive
S. Lennox and David S. North
GAAP goodwill and
debt contracting efficiency: evidence
from net-worth covenants
Richard M. Frankel,
Chandra Seethamraju and Tzachi Zach
Performance
measurement manipulation: cherry-picking
what to correct
Anil Arya and Jonathan
Glover
Market reactions to the
disclosure of internal control weaknesses and to the characteristics of those
weaknesses under section 302 of the Sarbanes Oxley Act of 2002
Jacqueline S. Hammersley,
Linda A. Myers and Catherine Shakespeare
Abstracts
Volume 13, Issue 1, March 2008
Voluntary disclosure
of accruals in earnings press releases and the pricing of accruals
Shai Levi
This study investigates firms’ decisions to disclose accruals information in earnings press releases versus to provide it only in 10-Q filings and the impact of this disclosure on the pricing of accruals. I find that firms disclose accruals in their press releases when earnings alone are a weak indication of cash flow performance and that following these disclosures the accruals information is fully impounded into stock prices. The evidence suggests that when investor demand for accruals is likely to exist and firms disclose the information in earnings press releases, the mispricing typically associated with accruals is mitigated.
An integrated
analysis of the association between accrual disclosure and the abnormal accrual
barrier
Henock Louis, Dahlia
Robinson and Andrew M. Sbaraglia
We find no evidence of accrual mispricing for firms that disclose accrual information at earnings announcements. For these firms, the market differentiates the discretionary from the nondiscretionary components of the earnings surprise. In contrast, the market fails to distinguish between the discretionary and the nondiscretionary components of the earnings surprise for firms that do not disclose accrual information at earnings announcements. These firms experience some stock price correction around the filing date. However, the correction is only partial, resulting in a post-filing drift.
The hiring of
accounting and finance officers from audit firms: how did the market react?
Marshall A. Geiger, Clive
S. Lennox and David S. North
This study investigates the market’s reaction to companies hiring accounting and finance officers directly from their external audit firms—the auditor-to-client hiring practice referred to as the “revolving door.” The Sarbanes-Oxley Act (SOX) eliminated this hiring practice, reflecting concerns that such appointments may impair audit and financial reporting quality. However, it was also argued that companies may have benefited from hiring individuals already familiar with their systems, organization and personnel. To determine the prevalence of this hiring practice and how shareholders viewed these appointments, we examine 3-day cumulative abnormal returns around the announcements of newly appointed accounting and finance officers over the period 1985–2002. We find that the proportion of revolving door hires is relatively low (only 6.1% of all hires in our sample), but that when they did occur the market valued the revolving door appointments more positively than other appointments. Further tests reveal that the positive market reaction to revolving door appointments is driven mainly by smaller companies, and that these appointments are not associated with lower financial reporting quality when assessing subsequent discretionary accruals or the receipt of an Accounting and Auditing Enforcement Release (AAER). Overall, the low frequency of occurrence, investors’ positive perceptions, and the lack of association with deteriorated reporting quality indicate that the SOX restriction on revolving door appointments may have been unnecessary and will do little to protect shareholders.
GAAP goodwill and
debt contracting efficiency: evidence
from net-worth covenants
Richard M. Frankel,
Chandra Seethamraju and Tzachi Zach
We study the role of goodwill in promoting contracting efficiency and the effect of SFAS 141 and 142 on this role. We provide three main results. First, when a lending agreement contains some type of minimum net-worth covenant, the probability of a tangible net-worth covenant is decreasing in the borrower’s goodwill. Second, the use of tangible net-worth covenants has increased since the promulgation of SFAS 141 and 142. Finally, covenant slack is not significantly related to the use of tangible net-worth covenants relative to net-worth covenants. These results suggest that contracting parties realize efficiency gains by permitting borrowers’ actions to be restricted by the value of GAAP goodwill. However, recent changes in GAAP have reduced the contracting usefulness of goodwill.
Performance
measurement manipulation: cherry-picking
what to correct
Anil Arya and Jonathan
Glover
A common feature of managerial and financial reporting is an iterative process wherein various parties selectively correct particular measurements by challenging them and subjecting them to increased scrutiny. We model this feature by adding an agent appeal stage to the standard moral hazard model and show that it can be optimal to allow the agent to decide which performance measures to appeal, despite the agent’s incentive to cherry-pick. In the presence of measurement errors, the agent is incentivized by increased opportunities for cherry-picking that arise if he chooses the “right” vs. the “wrong” acts.
Market reactions to
the disclosure of internal control weaknesses and to the characteristics of
those weaknesses under section 302 of the Sarbanes Oxley Act of 2002
Jacqueline S. Hammersley,
Linda A. Myers and Catherine Shakespeare
We examine the stock price reaction to management’s disclosure of internal control weaknesses under §302 of the Sarbanes Oxley Act and to the characteristics of these weaknesses, controlling for other material announcements in the event window. We find that some characteristics of the weaknesses—their severity, management’s conclusion regarding the effectiveness of the controls, their auditability, and the vagueness of the disclosures—are informative. We also find that the information content of internal control weakness disclosures depends on the severity of the internal control weakness. Moreover, in a sub-sample uncontaminated by other announcements in the event window, we find negative price reactions to the disclosure of internal control weaknesses and material weaknesses
Review of
Accounting Studies
Volume 12, Issue 4, December 2007
Economic consequences
of financial reporting changes: diluted EPS and contingent convertible
securities
Carol A. Marquardt and
Christine I. Wiedman
An alternative
interpretation of the discontinuity in earnings distributions
William Beaver, Maureen F.
McNichols and Karen Nelson
An evaluation of SFAS
No. 130 comprehensive income disclosures
Dennis J. Chambers, Thomas
J. Linsmeier, Catherine Shakespeare and Theodore Sougiannis
Disagreement over the
persistence of earnings components: evidence on the properties of
management-specific adjustments to GAAP earnings
Young-Soo Choi, Stephen W.
Lin, Martin Walker and Steven Young
Financial statement
effects of adopting international accounting standards: the case of
Mingyi Hung and K.R.
Subramanyam
Make or buy new
technology: the role of CEO compensation contract in a firm’s route to
innovation
Yanfeng Xue
Abstracts
Volume 12, Issue 4, December 2007
Economic consequences
of financial reporting changes: diluted EPS and contingent convertible
securities
Carol A. Marquardt and
Christine I. Wiedman
This paper examines the economic
consequences of changes in the financial reporting requirements for contingent
convertible securities (COCOs). Using a sample of 199
An alternative
interpretation of the discontinuity in earnings distributions
William Beaver, Maureen F.
McNichols and Karen Nelson
We show that the asymmetric effects of income taxes and
special items for profit and loss firms contribute to a discontinuity at zero
in the distribution of earnings. Income
taxes draw profit observations towards zero while negative special items pull
loss observations away from zero. These
earnings components are thus expected to contribute to a discontinuity even in
the absence of discretion. We show our results
are not an artifact of deflation and that other common components of earnings
do not have similar effects on the earnings distribution around zero.
An evaluation of SFAS
No. 130 comprehensive income disclosures
Dennis J. Chambers, Thomas
J. Linsmeier, Catherine Shakespeare and Theodore Sougiannis
In this study, we provide evidence on the pricing of other comprehensive income (OCI) that differs from most evidence in prior research. Prior archival research has largely concluded that OCI is not priced by investors. In contrast, we provide evidence in the post-SFAS 130 period that OCI is priced on a dollar-for-dollar basis as is predicted by economic theory for transitory income items. We attribute this finding to our use of post-SFAS 130 as-reported measures of OCI rather than pre-SFAS 130 as-if estimates of OCI measures. Furthermore, we document that two components of OCI, foreign currency translation adjustment and unrealized gains/losses on available-for-sale securities, are priced by investors. In the post-SFAS 130 period, we also find that the type of financial statement in which firms report OCI and its components affects pricing, consistent with the conclusions of prior experimental research. However, our evidence suggests that investors pay greater attention to OCI information reported in the statement of changes in equity, rather than in a statement of financial performance. This could be attributed to investors becoming more familiar in the post-SFAS 130 period with the predominant reporting of OCI and its components in the statement of changes in equity. These findings may be relevant to both the Financial Accounting Standards Board and the International Accounting Standards Board, which jointly are undertaking a new project that, in part, is addressing financial statement presentation of OCI items.
Disagreement over the
persistence of earnings components: evidence on the properties of
management-specific adjustments to GAAP earnings
Young-Soo Choi, Stephen W.
Lin, Martin Walker and Steven Young
We examine disagreement between management and Thomson Datastream over the persistence of earnings components. Using income statement and footnote disclosures, we identify the source and properties of disputed items. Disagreements typically reflect opaque reporting practices (for example, in the case of transitory operating items) and restrictive classification rules (for example, in the case of discontinued operations). Incremental and relative value relevance tests suggest that the majority of management-specific adjustments reflect appropriate classification of earnings components by insiders. Nevertheless, evidence consistent with strategic disclosure does emerge for a subset of management adjustments.
Financial statement
effects of adopting international accounting standards: the case of
Mingyi Hung and K.R.
Subramanyam
Using a sample of German firms, we investigate the financial
statement effects of adopting International Accounting Standards (IAS) during 1998
through 2002. We find that total assets and book value of equity, as well as
variability of book value and income, are significantly higher under IAS than
under German GAAP (HGB). In addition, book value and income are no more value
relevant under IAS than HGB, and HGB (IAS) income is highly persistent
(transitory). Finally, we find weak evidence that IAS income exhibits greater
conditional conservatism than HGB income. Our results are consistent with the
fair-value (income smoothing) orientation of IAS (HGB).
Make or buy new
technology: the role of CEO compensation contract in a firm’s route to
innovation
Yanfeng Xue
A firm’s board of directors, based on its risk
tolerance or “appetite,” sets the corporate objectives. It is then
the management’s job to meet the objectives by adopting appropriate
strategies. However, the board can design compensation policies to encourage
desired management strategy choices. This paper explores the extent to which
management compensation policies are aligned with strategy choices for
obtaining new technology. Firms obtain new technology either through internal
R&D or through acquisitions, often labeled “make” and
“buy” strategies, respectively. The “make” strategy is
inherently more risky, with much of the high risk idiosyncratic. Furthermore,
U.S. GAAP requires that R&D expenditures be expensed but allows
capitalization of acquisition costs, thus a firm using the “make”
as opposed to the “buy” strategy will experience a greater negative
effect on accounting earnings. I hypothesize that these differences will lead
risk-averse and utility-maximizing managers to implement the “buy”
strategy if their compensation is heavily weighted on accounting-based
performance measures. Conversely, managers with more stock-based compensation,
especially stock options, are more likely to choose to develop new technology
internally. Using data from
Review of Accounting
Studies
Volume 12, Issue 2/3, June/September 2007
This double issue
contains papers presented at a conference entitled, European-American
Conference on Accounting Research, which was held at INSEAD in Fontainebleau,
France in September 2006.
Editorial
Biases in Multi-Year
Management Financial Forecasts: Evidence from Private Venture-Backed U.S.
Companies
Christopher Armstrong,
Antonio Davila, George Foster and John R.M. Hand
Discussion of
“Biases in Multi-Year Management Financial Forecasts: Evidence from
Private Venture-Backed U.S. Companies”
Elizabeth Anne Demers
Using Accounting
Information for Consumption Planning and Equity Valuation
Kenton K Yee
Discussion of “Using
Accounting Information for Consumption Planning and Equity Valuation”
Peter Ove Christensen
Another Look at GAAP
versus The Street: An Empirical Assessment of
Measurement Error Bias
Daniel A Cohen, Rebecca N
Hann and Maria Ogneva
Discussion of “Another
Look at GAAP versus The Street: An Empirical
Assessment of Measurement Error Bias”
Theodore E. Christensen
Conservatism, Growth
and Return on Investment
Madhav Rajan, Stefan
Reichelstein and Mark Soliman
Discussion of
“Conservatism, Growth and Return on Investment”
Frøystein Gjesdal
Investor Protection
and Analysts’ Cash Flow Forecasts Around the
World
Mark L. DeFond and Mingyi
Hung
Discussion of
“Investor Protection and Analysts’ Cash Flow Forecasts Around the World”
Luzi Hail
How Disclosure Quality
Affects the Level of Information Asymmetry
Stephen Brown and Stephen A Hillegeist
Discussion of
“How Disclosure Quality Affects the Level of Information Asymmetry”
Yonca Ertimur
Abstracts
Volume 12, Issue 2/3, June/September 2007
This double issue
contains papers presented at a conference
entitled, European-American Conference on Accounting Research, which was
held at INSEAD in Fontainebleau, France in September 2006.
Biases in Multi-Year
Management Financial Forecasts: Evidence from Private Venture-Backed U.S.
Companies
Christopher Armstrong,
Antonio Davila, George Foster and John R.M. Hand
This paper studies the properties and determinants of managers’ multi-year financial forecasts. Using one- to five-year-ahead forecasts reported by private venture-backed firms, we ask whether, by how much, and why biases in managers’ forecasts of revenues, expenses and profits depend on the forecasting horizon and the verifiability of assets. We find that profitability forecasts contain a strategic component, in that [1] one-year-ahead revenue (expense) forecasts are slightly and asymmetrically pessimistic (optimistic), while five-year-ahead forecasts are hugely and asymmetrically optimistic (pessimistic); and [2] biases in revenue and expense forecasts are larger, the harder to verify or more intangible-intensive are firms’ assets.
Discussion of
“Biases in Multi-Year Management Financial Forecasts: Evidence from
Private Venture-Backed U.S. Companies”
Elizabeth Anne Demers
Armstrong, Dávila, Foster, and Hand (“ADFH”) use a proprietary venture capital database of revenue and profit projections submitted by young firms seeking financing to attempt to address a number of questions related to forecasts by managers of early stage, venture-backed, private entrepreneurial firms. The proprietary dataset together with the creative use of a “historically-grounded conditional projections” methodology are the most interesting features of ADFH’s study. However, these same aspects give rise to empirical design constraints that the study does not fully overcome. In addition, there are numerous leaps of logic required to arrive at some of ADFH’s conclusions and there are alternative explanations for ADFH’s findings that have not been entirely refuted. This leaves the reader with some doubt as to whether all of ADFH’s conclusions are fully substantiated. Nevertheless, the evidence presented makes an interesting contribution to our understanding of the forecasting behavior of young, private, rapidly growing, VCbacked firms, and provides some natural economic and methodological leads into further studies of these issues.
Using Accounting
Information for Consumption Planning and Equity Valuation
Kenton K Yee
This article develops a consumption-based valuation model that treats earnings and cash flow as complementary information sources. The model integrates three ideas that do not appear in traditional valuation models: (i) earnings provide information about future shocks to cash flow; (ii) earnings contain indiscernible transient accruals; and (iii) investors use cash flow and earnings to make allocation and consumption decisions and set price. Accordingly, the quality of earnings affects production and consumption as well as price. Among other implications, the model reveals that a valuation coefficient is not just a capitalization factor; it is the product of a capitalization factor and a structural factor reflecting earnings quality and accounting bias.
Discussion of
“Using Accounting Information for Consumption Planning and Equity
Valuation”
Peter Ove Christensen
This paper discusses Yee (2007), who investigates the role of accounting information for consumption planning and equity valuation. Higher earnings quality increases investor welfare and ex ante stock prices as well as the weight on earnings in valuation equations based on both cash flows and earnings. The former is due to improved consumption smoothing through more informed production choices, while the latter is due to the impact on the relative information content of current cash flows versus earnings about future cash flows.
Another Look at GAAP
versus The Street: An Empirical Assessment of
Measurement Error Bias
Daniel A Cohen, Rebecca N
Hann and Maria Ogneva
Bradshaw and Sloan (2002) document a significant increase in the difference between the earnings response coefficients (ERCs) for GAAP and Street (I/B/E/S) earnings over the 1990s, suggesting that the market has become increasingly reliant or fixated on Street earnings. In this study we investigate whether, alternatively, an “errors in variables” problem caused by a mismatch between the definitions of realized and expected earnings drives the ERC divergence. Our findings suggest that results from conventional analyses of GAAP and Street ERCs, including the ERC divergence pattern, are significantly contaminated by measurement errors in earnings surprises.
Discussion of
“Another Look at GAAP versus The Street: An
Empirical Assessment of Measurement Error Bias”
Theodore E. Christensen
Cohen, Hann, and Ogneva [(2007) Review of Accounting Studies, Forthcoming] provide evidence on how measurement error affects inferences this literature. In particular, they provide a theoretical framework for understanding (1) the source of differences in market reactions to GAAP and Street earnings and (2) why we observe a divergence over time between ERCs based on these two earnings metrics. Moreover, they present empirical evidence on practical solutions researchers can use to mitigate the effects of measurement error. I discuss the implications of their results and provide new empirical evidence to highlight how their results apply to future research. In particular, I use a large sample of manager-adjusted “pro forma” earnings numbers voluntarily disclosed in quarterly earnings press releases to provide additional evidence about the implications of their research. Descriptive statistics based on these data illustrate the degree of measurement error in different earnings metrics. The results suggest that additional research is needed to determine the extent to which a random walk earnings expectation and reverse regression can mitigate the effects of measurement error.
Conservatism, Growth
and Return on Investment
Madhav Rajan, Stefan
Reichelstein and Mark Soliman
Return on Investment (ROI) is widely regarded as a key measure of firm profitability. The accounting literature has long recognized that ROI will generally not reflect economic profitability, as determined by the internal rate of return (IRR) of a firm’s investment projects. In particular, it has been noted that accounting conservatism may result in an upward bias of ROI, relative to the underlying IRR. We examine both theoretically and empirically the behavior of ROI as a function of two variables: past growth in new investments and accounting conservatism. Higher growth is shown to result in lower levels of ROI provided the accounting is conservative, while the opposite is generally true for liberal accounting policies. Conversely, more conservative accounting will increase ROI provided growth in new investments has been “moderate” over the relevant horizon, while the opposite is true if new investments grew at sufficiently high rates. Taken together, we find that conservatism and growth are “substitutes” in their joint impact on ROI.
Discussion of
“Conservatism, Growth and Return on Investment”
Frøystein Gjesdal
Providing data for the measurement of financial performance is a key objective of financial reporting. Rajan, Reichelstein, and Soliman (2007, Conservatism, growth and return on investment, Review of Accounting Studies, this issue) provide new insights into the well known biases involved in measuring return on investment (ROI) on the basis of accrual accounting. They analyze the relationships among ROIs, growth rates, accrual policies and cash flow profiles in a fairly general steadystate model (only the last parameter is severely restricted). New and interesting results outside steady-state are presented as well. In the empirical part of the paper Rajan et al. demonstrate that the biases involved are systematic and economically significant. Hence empiricists must pay attention (whatever their sample sizes). Hopefully this paper will generate renewed interest in the analytical aspects of accrual accounting.
Investor Protection
and Analysts’ Cash Flow Forecasts Around the
World
Mark L. DeFond and Mingyi
Hung
We find that analysts are more likely to provide cash flow forecasts in countries with weak investor protection institutions, suggesting that market participants demand (and analysts supply) cash flow information when earnings are less likely to reflect underlying economic performance. Consistently, we also find that analysts are more likely to provide cash flow forecasts in countries where earnings are more likely to be managed and have less value relevance. Overall, our results suggest that information intermediaries respond to market-based incentives to help investors attenuate the adverse affects of institutional factors on earnings’ usefulness. These findings contribute to the literature by shedding light on the institutional determinants of analysts’ research activities, and on the nature of the financial information they generate.
Discussion of
“Investor Protection and Analysts’ Cash Flow Forecasts Around the World”
Luzi Hail
DeFond and Hung [DeFond, M., & Hung, M. (2007).
Review of Accounting Studies, 12 (this issue)] test the conjecture whether
financial analysts, due to demand-side pressure, compensate for the limited
usefulness of reported earnings by issuing cash flow forecasts. They find that
analysts supplement their earnings forecasts more frequently with cash flow
forecasts in countries where antidirector rights and legal enforcement quality
are poor. In my discussion, I examine their hypothesis development and
empirical research design and try to extend their arguments to a time-series
setting. As it turns out, the paper’s main contention critically hinges
on two assumptions: (1) investors’ unsatisfied demand for accounting
information and (2) their willingness to rely on cash flow forecasts as
valuable information signals. The descriptive validity of these assumptions in
an international context is a priori not obvious. I then test whether
substantial changes in investor protection and/or earnings quality relate to
changes in the frequency of cash flow forecasts. My analyses show that
analysts’ propensity to issue cash flow forecasts increases after the
first prosecution under insider trading laws, after non-U.S. firms have
cross-listed their shares on a
How Disclosure
Quality Affects the Level of Information Asymmetry
Stephen Brown and Stephen A Hillegeist
We examine two potential mechanisms through which disclosure quality is expected to reduce information asymmetry: (1) altering the trading incentives of informed and uninformed investors so that there is relatively less trading by privately informed investors, and (2) reducing the likelihood that investors discover and trade on private information. Our results indicate that the negative relation between disclosure quality and information asymmetry is primarily caused by the latter mechanism. While information asymmetry is negatively associated with the quality of the annual report and investor relations activities, it is positively associated with quarterly report disclosure quality. Additionally, we hypothesize and find that that the negative association between disclosure quality and information asymmetry is stronger in settings characterized by high levels of firm-investor asymmetry.
Discussion of “How
Disclosure Quality Affects the Level of Information Asymmetry”
Yonca Ertimur
Brown and Hillegeist (2007) examine how disclosure quality relates to information asymmetry. Specifically, the authors show that the negative association between the overall quality of a firm’s disclosures and the average level of information asymmetry is primarily driven by the negative association between disclosure quality and the frequency of information events. My discussion focuses on issues surrounding proxies for information asymmetry and disclosure quality the authors use. I also suggest some venues for future research.
Review of
Accounting Studies
Volume 12, Issue 1, March 2007
Performance Measurement for Investment: Decisions under
Capital Constraints
Alwine Mohnen and Moshe
Bareket
Underwriter Choice and Earnings Management: Evidence from
Seasoned Equity Offerings
Yongtae Kim, Hoje Jo and
Valuation of Loss Firms in a Knowledge-Based Economy
Masako Darrough and Jianming (Jim) Ye
Asymmetric Timeliness Tests of Accounting Conservatism
J Richard Dietrich, Karl A. Muller and Edward
Riedl
Demand for the Truth in Principal-Agent Relationships
Joshua Ronen and Varda Lewinstein Yaari
Managerial Discretion and the Economic Determinants of the Disclosed Volatility
Parameter for Valuing ESOs
Eli Bartov, Partha S. Mohanram and Doron
Nissim
Abstracts
Volume 12, Issue 1, March 2007
Performance Measurement for Investment: Decisions under
Capital Constraints
Alwine Mohnen and Moshe
Bareket
An owner delegates investment decisions to a better informed manager whose time preferences are unknown to the owner. Due to exogenous capital constraints, not all profitable projects can be undertaken, and therefore the owner wants the manager to select the NPV-maximizing set of projects. We show that the relative benefit cost allocation scheme proposed by prior literature does not solve this problem. Adopting the same information structure as in Rogerson (1997) and Reichelstein (1997), we demonstrate how to obtain robust goal congruence using residual income. The resulting revenue recognition and cost allocation rules lead to a performance measure reflecting the expected NPV-ranking of projects in each and every period.
Underwriter Choice and Earnings Management: Evidence from
Seasoned Equity Offerings
Yongtae Kim, Hoje Jo and
Using a sample of seasoned equity offerings (SEOs), this paper examines the association between the choice of financial intermediary and earnings management. We contend that with more stringent standards for certification and intense monitoring, highly prestigious underwriters restrict firms’ incentives for earnings management to protect their reputation and to avoid potential litigation risks, while firms with greater incentives for earnings management avoid strict monitoring by choosing low-quality underwriters. Consistent with our predictions, we find an inverse association between underwriter quality and issuers’ earnings management. In addition, we find that underwriter quality is positively related to SEOs’ post-issue performance, even after controlling for the effect of earnings management. We also find that firms with low underwriter prestige and high levels of earnings management under-perform the most. However, the effect of underwriter choice on post-issue performance does not last long.
Valuation of Loss Firms in a Knowledge-Based Economy
Masako Darrough and Jianming (Jim) Ye
Recent research in accounting has documented a
substantial increase in the number of loss firms. Existing theories on the
valuation of loss firms are based on adaptation/abandonment options or limited
liability, assuming that these firms are operationally distressed. In this
paper, we show that many loss firms do not fit this stereotype and identify the
primary value drivers of this new type of loss firms. Our analysis helps
resolve the puzzling negative relation between earnings and market value
documented in prior research. Overall, our findings underscore the importance
of "hidden assets" or intangibles in the study of loss firms.
Asymmetric Timeliness Tests of Accounting Conservatism
J Richard Dietrich, Karl A. Muller and Edward
Riedl
Recent accounting research
employs an asymmetric timeliness measure to test the hypothesis that reported
accounting earnings are “conservative.” This research design
regresses earnings on stock returns to examine whether “bad” news
is incorporated into earnings on a more timely basis
than “good” news. We identify properties of the asymmetric
timeliness estimation procedure that will result in biases in the test
statistics except under very restrictive conditions that are rarely met in
typical empirical settings. Using data series that are devoid of asymmetric
timeliness in reported earnings, we show how these biases result in evidence
consistent with conservatism. We conclude that the biased test statistics
inherent in the asymmetric timeliness research design preclude using this
method to measure conservatism; that these biases are irresolvable as they originate
in the test’s specification; and that studies employing asymmetric
timeliness tests cannot be interpreted as providing evidence of conservatism.
Demand for the Truth in Principal-Agent Relationships
Joshua Ronen and Varda Lewinstein Yaari
Consider the following puzzle: If earnings management is
harmful to shareholders, why don't they design contracts that induce managers
to reveal the truth? To answer this question, we model the shareholders-manager
relationship as a principal-agent game in which the agent (the manager) alone
observes the economic outcome. We show that the limited liability of the agent,
defined as the agent's feasible minimum payment, might explain the demand for
earnings management by the principal. Specifically, when the limited-liability
level is high (low), a contract that induces earnings management may be less
(more) costly than a truth-revealing contract. This finding offers a new
explanation of the demand for earnings management.
Managerial Discretion and the Economic Determinants of
the Disclosed Volatility Parameter for Valuing ESOs
Eli Bartov, Partha S. Mohanram and Doron
Nissim
This study investigates the
determinants of the expected stock-price volatility assumption that firms use
in estimating ESO values and thus option expense. We find that, consistent with
the guidance of FAS 123, firms use both historical and implied volatility in
deriving the expected volatility parameter. We also find, however, that the
importance of each of the two variables in explaining disclosed volatility
relates inversely to their values, which results in a reduction in expected
volatility and thus option value. This can be interpreted as managers
opportunistically use the discretion in estimating expected volatility afforded
by FAS 123. Consistent with this, we find that managerial incentives or ability
to understate option value play a key role in this behavior. Since discretion
in estimating expected volatility is common to both FAS 123 and 123(R), our
analysis has important implications for market participants as well as
regulators.
Review of
Accounting Studies
Volume 11, Issue 4, December 2006
Do Firms Understate Stock Option-Based Compensation
Expense
David Aboody, Mary E.
Barth and Ron Kasznik
Governance Structure and the Weighting of Performance
Measures
Fernando Penalva and
Antonio Davila
Disclosure of Fees Paid to Auditors and the Market Valuation of Earnings
Surprises
Jere Francis and Bin Ke
Organized Labor and Information Asymmetry in the Financial Markets
Gilles Hilary
SEC interventions and the frequency and usefulness of non-GAAP financial
measures
Ana C. Marques
Trading Incentives to Meet Earnings Thresholds
Sarah E. McVay, Venky Nagar, Vicki Tang
Abstracts
Volume 11, Issue 4, December 2006
Do Firms Understate Stock Option-Based Compensation
Expense
David Aboody, Mary E.
Barth and Ron Kasznik
Focusing on the four key option pricing model inputs – expected option life, expected stock price volatility, expected dividend yield, and the risk-free interest rate for the expected life of the option – this study finds that firms understate option value estimates and, thus, stock-based compensation expense disclosed under SFAS 123. As predicted based on incentives and opportunities for management to understate SFAS 123 expense, the understatement of option value estimates is increasing in proxies for the magnitude of the expense, is greater for firms with weaker corporate governance, and, to a lesser extent, is increasing in the excessiveness of executive pay. The findings are strongest for the expected option life and expected stock price volatility input assumptions, consistent with firms’ greater latitude in determining these inputs. We find weaker evidence of understatement associated with the expected dividend yield assumption, and none for the interest rate assumption, consistent with these inputs being less amenable to discretion. Taken together, our findings raise some concern that the exercise of management discretion adversely affects the overall reliability of SFAS 123 expense.
Governance Structure and the Weighting of Performance
Measures
Fernando Penalva and
Antonio Davila
We empirically examine how governance structure affects the design of executive compensation contracts and in particular, the implicit weights of firm performance measures in CEO’s compensation. We find that compensation contracts in firms with higher takeover protection and where the CEO has more influence on governance decisions put more weight on accounting-based measures of performance (return on assets) compared to stock-based performance measures (market returns). In additional tests, we further find that CEO compensation in these firms has lower variance and a higher proportion of cash (versus stock-based) compensation. We further find that CEOs’ incentives (measured as changes in CEO annual wealth which includes expected changes in the value of the CEO’s equity holdings in addition to yearly compensation) do not vary across governance structures. These findings are consistent with CEOs in firms with high takeover protection and where they have more influence on governance negotiating different contracts.
Disclosure of Fees Paid to Auditors and the Market Valuation
of Earnings Surprises
Jere Francis and Bin Ke
We
investigate if the SEC’s recently mandated disclosure of fees for audit
and nonaudit services paid by firms to their incumbent auditors affected the
market’s perception of auditor independence and earnings quality.
Following the initial fee disclosures in 2001, we find that the market
valuation of quarterly earnings surprises (earnings response coefficient) was
significantly lower for firms with high levels of nonaudit fees than for firms
with low levels of such fees. In contrast, in the year prior to the new fee
disclosures, there was no reduction in earnings response coefficients for firms
that subsequently reported high nonaudit fees. Our evidence suggests that
mandated fee disclosures provided new information that was viewed by the market
as relevant to appraising auditor independence and earnings quality.
Organized Labor and Information Asymmetry in the
Financial Markets
Gilles Hilary
Prior results from the labor
relations literature suggest that revealing information weakens
management’s position in collective bargaining. Thus, when facing
organized labor, management has an incentive to preserve the information
asymmetry with outsiders. This study uses a sample from a large cross-section
of the economy over several years to test this relation. Results are consistent
with this prediction. Strong organized labor is associated with higher bid-ask
spreads, higher probability of informed trading, lower trading volume and lower
analyst coverage. These relations hold after controlling for numerous factors
such as growth opportunities or risk.
SEC interventions and the frequency and usefulness of
non-GAAP financial measures
Ana C. Marques
This paper examines the effect of two SEC regulatory
interventions related to disclosure of non-GAAP financial measures. There are
three main results. First, the probability of disclosure of non-GAAP earnings
declines in 2003, but the probability of disclosure of other non-GAAP financial
measures has an accelerated decline after the first intervention. Second, all
else equal, after Regulation G, investors have a positive market reaction to
the disclosure of non-GAAP earnings. Finally, investors react to the
adjustments made by I/B/E/S financial analysts as they do to the GAAP surprise,
but they do not react to the additional adjustments made by firms.
Trading Incentives to Meet Earnings Thresholds
Sarah E. McVay, Venky Nagar, Vicki Tang
We examine stock sales as a
managerial incentive to help explain the discontinuity around the analyst
forecast benchmark. We find that the likelihood of just meeting versus just
missing the analyst forecast is strongly associated with subsequent managerial
stock sales. Moreover, we provide evidence that managers manage earnings prior
to just meeting the threshold and selling their shares. Finally, the relation
between just meeting and subsequently selling shares does not hold for
non-manager insiders, who arguably cannot affect the earnings outcome, and is
weaker in the presence of an independent board, suggesting that good corporate
governance mitigates this strategic behavior.
Review of
Accounting Studies
Volume 11, Issue 2/3, June/September 2006
This double issue publishes papers presented at a
conference on Earnings Measurement & Performance Reporting at the
Editorial
Stephen Penman
Over-investment of free cash flow
Scott Richardson
Discussion of “Over-investment of free cash flow”
Daniel Bergstresser
Which approach to accounting for employee
stock options best reflects market pricing?
Wayne R. Landsman, Ken V. Peasnell, Peter F.
Pope, Shu Yeh
Discussion of “Which approach to accounting for employee stock
options best reflects market pricing?”
David Aboody
The persistence of earnings and cash flows and the role of special items:
Implications for the accrual anomaly
Patricia M. Dechow and Weili Ge
Discussion of “The persistence of earnings and cash flows and the role
of special items: Implications for the accrual anomaly”
Patricia M. Fairfield
Performance, Growth and Earnings Management
Chi-Wen Jevons Lee, Laura Yue Li, Heng Yue
Discussion of “Performance, Growth and Earnings Management”
Venky Nagar
Divisional performance measurement and transfer pricing for intangible
assets
Nicole Bastian Johnson
Discussion of “Divisional performance measurement and transfer
pricing for intangible assets”
Tim Baldenius
Feedback loops, fair value accounting and correlated investments
Robert J. Bloomfield, Mark W. Nelson, Steven
D. Smith
Discussion of “Feedback loops, fair value accounting and correlated
investments”
Lisa Koonce
Abstracts
Volume 11, Issue 2/3, June/September 2006
This double issue publishes papers presented at a conference
on Earnings Measurement & Performance Reporting at the
Over-investment of free cash flow
Scott Richardson
This paper examines the extent of firm level over-investment of free cash flow. Using an accounting-based framework to measure over-investment and free cash flow, I find evidence that, consistent with agency cost explanations, over-investment is concentrated in firms with the highest levels of free cash flow. Further tests examine whether firms’ governance structures are associated with over-investment of free cash flow. The evidence suggests that certain governance structures, such as the presence of activist shareholders, appear to mitigate over-investment.
Discussion of “Overinvestment of free cash
flow”
Daniel Bergstresser
Which approach to accounting for employee stock options
best reflects market pricing?
Wayne R. Landsman, Ken V. Peasnell, Peter F.
Pope, Shu Yeh
We use a residual income valuation framework to compare equity valuation implications of four approaches to employee stock options (ESOs) accounting: APB 25 “recognize nothing”, SFAS 123 (revised) “recognize ESO expense”, FASB Exposure Draft “recognize and expense ESO asset” and “recognize ESO asset and liability”. Theoretical analysis shows only grant date recognition of an asset and liability, and subsequent marking-to-market of the liability, results in accounting numbers that capture the dilution effects of ESOs on current shareholder value. Out-of-sample equity market value prediction tests and in-sample comparisons of model explanatory power also support the “recognize ESO asset and liability” method.
Discussion of “Which approach to accounting for employee stock
options best reflects market pricing?”
David Aboody
The objective of the Landsman, Peasnel, Pope and Yeah paper (in this issue) is to compare, for current shareholders, the value relevance of four methods of accounting for employee stock options (ESOs). My discussion provides a unifying framework for the theoretical analyses and the link between the theoretical analyses and the empirical investigation.
The persistence of earnings and cash flows and the role
of special items: Implications for the accrual anomaly
Patricia M. Dechow and Weili Ge
We
argue that high accruals are likely to be the outcome of rules with an income
statement perspective, while low accruals are likely to be the outcome of rules
with a balance sheet perspective, and that this has implications for the
properties of earnings. Specifically, earnings persistence is affected both by
the magnitude and sign of the accruals. Accruals improve the persistence of
earnings relative to cash flows in high accrual firms, but reduce earnings
persistence in low accrual firms. We show that the low persistence of earnings
in low accrual firms is primarily driven by special items. We then show that
special item-low accrual firms have higher future stock returns than other low
accrual firms. This is consistent with investors misunderstanding the
transitory nature of special items. Further analysis reveals that special
item-low accrual firms have poor past performance and declines in investor
recognition (analyst coverage and institutional holdings). Special items
continue to explain future returns after controlling for these factors.
Discussion of “The persistence of earnings and cash
flows and the role of special items: Implications for the accrual
anomaly”
Patricia Fairfield
Dechow
and Ge (2006, Review of Accounting Studies, 11) add new descriptive evidence to
the literature on earnings behavior and investor reaction to earnings.
Specifically, they find that low accrual firms with negative special items have
higher returns on assets and higher market returns in future years. Their paper
raises interesting questions about conservative accounting and about the effect
of special items on the future performance of distressed firms. However,
because the authors position their paper as an investigation of the accruals
anomaly they don’t explore many of the issues they raise, and so miss an
opportunity to make a more substantive contribution to our understanding of the
behavior of and reaction to accounting information.
Performance, Growth and Earnings Management
Chi-Wen Jevons Lee, Laura Yue Li, Heng Yue
We
study the relationship between the amount of managed earnings and firms’
earnings performance and expected growth in a reporting model, where managers
manipulate earnings to influence the valuation of firms’ equity while
bearing a cost that is increasing and convex in the amount of managed earnings.
In the unique revealing equilibrium to the model, firms with higher performance
and growth over-report earnings by a larger amount because price responsiveness
increases with earnings performance and growth. And earnings quality, defined
as the proportion of true economic earnings in total reported earnings,
increases with earnings performance but decreases with earnings growth. We
conduct empirical tests on a large sample and a restatement sample using
different proxies for earnings management. Results from the large sample tests
support our predictions while results from the restatement sample tests are
mixed. Our study provides an alternative explanation to the positive
relationship between discretionary accruals estimated from the Jones model and
firms’ performance and growth.
Discussion of “Performance, Growth and Earnings
Management”
Venky Nagar
In
an economy of firms with varying levels of performance, which firms are more
likely to manage their earnings? The conference paper by Lee, Li, and Yue
provides a promising approach to disentangle economic performance from earnings
management in large-sample settings. The authors develop an analytical
signaling model of earnings management in an economy and confront its
equilibrium predictions with the data.
Divisional performance measurement and transfer pricing
for intangible assets
Nicole Bastian Johnson
This paper examines the effectiveness of three transfer
pricing methodologies for an intangible asset that is developed through
bilateral, sequential investment. In general, a royalty-based transfer price
that can be renegotiated provides better investment incentives than either a
non-negotiable royalty-based transfer price or a purely negotiated transfer
price, and in some cases induces first-best investment. This result contrasts
with previous research that finds that the inability to limit renegotiation of
initial contracts reduces investment efficiency. Further, I examine how tax
transfer pricing rules inform optimal internal transfer prices when the firm
decouples internal and external transfer prices.
Discussion of “Divisional performance measurement
and transfer pricing for intangible assets”
Tim Baldenius
The conference paper by Johnson (2006, Review of Accounting
Studies, forthcoming) develops an incomplete-contracting transfer pricing model
with a number of novel features: taxation, sequential investments, and
intangible assets being transferred. This discussion aims to disentangle these
features so as to highlight those that are the key drivers of the results.
Moreover, I show that some of the results can be generalized to settings
involving a greater level of technological interdependency between the
divisions.
Feedback loops, fair value accounting and correlated
investments
Robert J. Bloomfield, Mark W. Nelson, Steven
D. Smith
This paper presents and tests
a model of the price dynamics that arise when investors fail to recognize the
redundancy of unrealized gains and losses (“UGLs”) that are
correlated with the firm’s past returns. Consistent with the predictions
of our model, our experiment shows that a firm’s prices and earnings
become highly volatile when correlated investment is large and correlated UGLs
are made salient by comprehensive income reporting. The results suggest that
including correlated UGLs in performance numbers could induce violations of weak-form
efficiency that exacerbate volatility in share prices and earnings.
Discussion of “Feedback loops, fair value
accounting and correlated investments”
Lisa Koonce
My paper discusses
Bloomfield, Nelson, and Smith’s (BNS) model and experimental study of the
price dynamics that arise when a firm’s accounting reports are
predictable from its stock returns. This phenomenon occurs when the firm takes
a position in an asset that generates unrealized gains and losses (UGL’s)
that are correlated with the firm’s own returns. My discussion of BNS
focuses on three features that are often used to evaluate
research—namely, potential for falsification, internal validity, and
external validity. I view and evaluate the BNS paper in light of each of these
features. I also briefly comment on how well the paper addresses issues related
to fair value accounting.
Review of
Accounting Studies
Volume 11, Issue 1, March 2006
Stock Price Reaction to Evidence of Earnings Management Implications for Supplementary
Financial Disclosure
William R. Baber, Shuping
Chen and Sok-Hyon Kang
A Political—Economic Analysis of Auditor Reporting
and Auditor Switches
K. Hung Chan, Kenny Z. Lin
and Phyllis Lai-lan Mo
Stock Market Anomalies: What can we Learn from
Repurchases and Insider Trading?
John E. Core, Wayne R. Guay, Scott A. Richardson and Rodrigo S. Verdi
Do Short Sellers Target Firms with Poor Earnings Quality? Evidence from
Earnings Restatements
Hemang Desai, Srinivasan Krishnamurthy and
Kumar Venkataraman
The Effect of SFAS No. 131 on the Cross-Segment Variability of Profits
Reported by Multiple Segment Firms
Michael L. Ettredge, Soo Young Kwon, David B. Smith and Mary S. Stone
Venture-Backed Private Equity Valuation and Financial Statement Information
Chris Armstrong, Antonio Davila and George
Foster
Abstracts
Volume 11, Issue 1, March 2006
Stock Price Reaction to Evidence of Earnings Management
Implications for Supplementary Financial Disclosure
William R. Baber, Shuping
Chen and Sok-Hyon Kang
We condition security price reactions to quarterly earnings announcements on whether firms disclose supplementary balance sheet and/or cashflow information that can be used to estimate the consequences of earnings management. Disclosure of supplementary information is voluntary, and thus, we consider the possibility that firms that disclose balance sheet and/or cashflow information differ systematically from firms that do not disclose. Results indicate that investors discount evidence of earnings management at the disclosure date when supplementary information is disclosed. Such results indicate more informed earnings interpretations of quarterly earnings when firms provide balance sheet and/or cashflow information concurrently.
A Political—Economic Analysis of Auditor Reporting
and Auditor Switches
K. Hung Chan, Kenny Z. Lin
and Phyllis Lai-lan Mo
This study examines whether auditor opinions are affected by
political and economic influences from governments. We use auditor locality (local
versus non-local) to capture such influences from local governments in
qualified opinions are more likely
to switch from a non-local auditor to a local auditor than companies with
unqualified opinions. Contrary to some prior studies, we find that in
Stock Market Anomalies: What can we Learn
from Repurchases and Insider Trading?
John E. Core, Wayne R. Guay, Scott A. Richardson and Rodrigo S. Verdi
We
examine whether managers’ trading decisions (both at a firm and personal
level) are correlated with trading strategies suggested by the operating
accruals and the post-earnings announcement drift (SUE) anomalies. We discuss
advantages and disadvantages of the use of managerial trading activity to infer
managers’ private valuation about their own securities. Our results
provide corroborative evidence for the accruals anomaly, i.e., managers’
repurchase and insider trading behavior varies consistently with the
information underlying the operating accruals trading strategy. On the other
hand, we do not find corroborative evidence for the SUE anomaly.
Do Short Sellers Target Firms with Poor Earnings Quality?
Evidence from Earnings Restatements
Hemang Desai, Srinivasan Krishnamurthy and
Kumar Venkataraman
We
study the behavior of short sellers around earnings restatements. We find that
short sellers accumulate positions in restating firms several months in advance
of the restatement and subsequently unwind these positions after the drop in
share price induced by the restatement. The increase in short interest is
larger for firms with high levels of accruals prior to restatement. We document
that heavily shorted firms experience poor subsequent performance and a higher
‘rate of delisting. Overall, these results suggest that the motive for
short selling is, at least in part, related to suspect financial reporting and
that short sellers pay attention to information being conveyed by accruals.
The Effect of SFAS No. 131 on the Cross-Segment
Variability of Profits Reported by Multiple Segment Firms
Michael L. Ettredge, Soo Young Kwon, David B. Smith and Mary S. Stone
Our study assesses whether SFAS No. 131 improved disclosure about the diversity of multiple segment firms’ operations. We find a post-SFAS No. 131 increase in cross-segment variability of segment profits, an increase in the association between reported and inherent cross-segment variability, and an increase in association between reported variability and capital market incentives to disclose. We interpret the results as evidence that SFAS No. 131 increased the transparency of segment profitability disclosures, and as indicating SFAS No. 131 allowed firms depending more on external financing to disclose more about differences in segment profitability.
Venture-Backed Private Equity Valuation and Financial
Statement Information
Chris Armstrong, Antonio Davila and George
Foster
The relationship between (a)
private and public equity market valuations and (b) financial statement
information is examined for a sample of 502 venture capital backed companies
from six different industries over the 1993–2003 period.
Financial statement information explains a sizable component of the levels of
and changes in valuation in both the Pre-IPO and Post-IPO periods. The findings
support prior research for Post-IPO companies that revenues are value enhancing
and costs are value diminishing. For the Pre-IPO period, we find that cost of
sales; sales, marketing, general and administrative; and research and
development are value enhancing—even when revenues are included in the
analysis. This is consistent with costs incurred by early-stage, venture-backed
companies having a strong ‘‘investment aspect’’ as the
companies build a platform/infrastructure to grow revenue and validate their
business model(s). We document the growth of early stage companies for revenues
and costs in both calendar time (by round of private equity financing) and
event time (relative to their eventual IPO).
Review of
Accounting Studies
Volume 10, Issue 4, December 2005
Earnings Components, Accounting Bias and Equity Valuation
Peter F. Pope &
Pengguo Wang
An Empirical Test of the Feltham-Ohlson (1995) Model
Jeffery Callen & Dan
Segal
Bonuses and Non-Public Information in Publicly Traded Firms
Rachel Hayes & Scott Schaefer
Abnormal Returns from Predicting Earnings Thresholds
Lynn Rees
Market Reaction to Multiple Contemporaneous Earnings Signals: Earnings Announcements and Future Earnings
Guidance
Rowland Atiase, Haidan Li, Somchai Supattarakul
& Senyo Tse
Perspectives
Accrual Accounting for Performance Evaluation
Sunil Dutta & Stefan Reichelstein
Abstracts
Volume 10, Issue 4, December 2005
Earnings Components, Accounting Bias and Equity Valuation
Peter F. Pope &
Pengguo Wang
In this paper we address three issues in accounting-based equity valuation: (i) How are valuation parameters related to earnings persistence and accounting conservatism when earnings components aggregate, or “add up”, in valuation? (ii) What does aggregation of earnings components in valuation imply for abnormal earnings dynamics? and (iii) When is an earnings component “irrelevant” and “core” earnings the relevant construct for valuation? Assuming linear valuation, no-arbitrage, dividend irrelevance and clean surplus accounting, we show that when earnings components aggregate, valuation expressions and abnormal earnings dynamics are generalizations of the Ohlson (1995) model, incorporating simple adjustments for accounting conservatism. When “core” earnings is the relevant earnings construct, valuation expressions closely resemble the aggregation case, but core (abnormal) earnings replaces clean surplus (abnormal) earnings. We demonstrate that an earnings component can be irrelevant in valuation even when it is predictable.
An Empirical Test of the Feltham-Ohlson (1995) Model
Jeffery Callen & Dan
Segal
This paper tests the Feltham-Ohlson (1995) model by transforming the undefined “other information” variables into expectational variables, as suggested by Liu and Ohlson (2000). The signs of the estimated coefficients conform to the model’s predictions using panel data techniques, non-parametric estimation, reverse regressions and portfolio regressions. The tests reject the Ohlson model in favor of Feltham-Ohlson. Nevertheless, the estimated leverage coefficient takes a value of three instead of one for most variations of the model. Also, the one-year-ahead price predictions of the Feltham-Ohlson model are no more accurate than those of the Ohlson model or a naive earnings valuation model.
Bonuses and Non-Public Information in Publicly Traded
Firms
Rachel Hayes & Scott Schaefer
Recent
research in accounting explores how firms use \individual" or
\non-financial" measures of performance in executive compensation
contracts. We model a
firm that conditions bonus payments to executives on information that is not
available to those outside the firm. This raises two issues. First, market
participants may use the magnitude of such payments to infer the non-public information.
Second, because information that is non-public is, by extension,
non-verifiable, the firm cannot write explicit contracts based on it. Combining
the relational incentive contracts and financial signaling literatures, we
examine equilibria of a signaling game in which bonus payments from a firm to a
manager convey non-public information regarding the firm's future cash flows.
Our main result is that increases in corporate myopia can, under some
conditions, lead to increased profits. This finding is contrary to that
typically found in financial signaling models.
Abnormal Returns from Predicting Earnings Thresholds
Lynn Rees
This
paper examines the performance of a trading strategy based on the prediction of
firms concurrently reporting a positive earnings change and meeting or beating
analysts’ earnings forecasts. The
study extends prior research that examines excess returns based only on
earnings changes (e.g., Ou and Penman, 1989; Penman and Zhang, 2002a). The evidence indicates that a model predicting
forecast errors concurrently with earnings changes can yield excess returns
that are incremental to predicting only one earnings threshold. Moreover, I find that the prediction of
forecast errors is relatively more important than predicting earnings
changes. The incremental benefit from
predicting earnings changes concurrently with forecast errors is small relative
to a model that predicts only forecast errors.
The results hold after controlling for various risk factors and known
anomalies.
Market Reaction to Multiple Contemporaneous Earnings
Signals: Earnings Announcements and
Future Earnings Guidance
Rowland Atiase, Haidan Li, Somchai
Supattarakul & Senyo Tse
We examine market reactions to contemporaneous announcements of current earnings and future earnings guidance for evidence on how investors trade off relevance and reliability. Current earnings are more reliable than future earnings guidance, but future earnings guidance may be more relevant for predicting future performance. We find that current earnings are more strongly associated with announcement-period returns than concurrently-disclosed future earnings guidance, consistent with investors’ relative preference for reliability. We find similar return reactions to stand-alone earnings and to earnings released with guidance. In contrast, return reactions are lower for guidance announced simultaneously with current earnings than for stand-alone guidance.
Perspectives
Accrual Accounting for Performance Evaluation
Sunil Dutta & Stefan Reichelstein
This paper examines
alternative accrual accounting rules from an incentive and control perspective.
For a range of common production, financing and investment decisions we
consider alternative asset valuation rules. The criterion for distinguishing
among these rules is that the corresponding performance measure should provide
managers with robust incentives to make present value maximizing decisions.
Such goal congruence is shown to require intertemporal matching of revenues and
expenses, though the specific form of matching needed for control purposes
generally differs from GAAP. The practitioner oriented literature on economic
profit plans has made various, and at times conflicting, recommendations
regarding adjustments to the accounting rules used for external financial
reporting. Our goal congruence approach provides a framework for comparing and
evaluating these recommendations.
Review of
Accounting Studies
Volume 10, Issue 2/3, June/September 2005
Special Double Issue on Financial Statement Analysis and
Valuation:
This double issue publishes papers presented at a
conference on Financial Statement Analysis and Valuation at the
Editorial
Stephen Penman
Separating Winners from Losers among Low Book-to-Market
Stocks using Financial Statement Analysis
Partha Mohanram
Discussion of "Separating Winners from Losers among Low
Book-to-Market Stocks using Financial Statement Analysis"
Joe Piotroski
Information Uncertainty and Expected Returns
Guohua Jiang, Charles Lee, and Grace Zhang
Discussion of “Information Uncertainty and Expected Returns”
Paul Schultz
Conservatism, Growth and the Role of Accounting Numbers in the Fundamental
Analysis Process
Steve Monahan
Discussion of “Conservatism, Growth and the Role of Accounting Numbers
in the Fundamental Analysis Process”
Xiao-Jun Zhang
Conditional and Unconditional Conservatism: Concepts and Modeling
Bill Beaver and Stephen Ryan
Discussion of “Conditional and Unconditional Conservatism: Concepts
and Modeling”
Sudipta Basu
On Accounting-based Valuation Formulae
James Ohlson
Expected EPS and EPS Growth as Determinants of Value
James Ohlson and Beate Juettner-Nauroth
Discussion of “On Accounting-based Valuation Formulae” and
“Expected EPS and EPS Growth as Determinants of Value”
Stephen Penman
Abstracts
Volume 10, Issue 2/3, June/September 2005
Editorial
Stephen Penman
This double issue publishes papers presented at a conference on Financial Statement Analysis and Valuation at the Mendoza College of Business, University of Notre Dame in September 2004. Review of Accounting Studies editor, Peter Easton organized this conference. His fellow editors thank him, his staff and his colleagues for their kind hospitality. We also thank the Mendoza College of Business for financial assistance. Our thanks go also to the paper discussants who brought critical insight. Their discussions are published alongside the papers in this issue.
Barclays Global Investors sponsored a cash prize for the best paper at the conference, as they have generously done at previous conferences. This year, the best paper (selected by secret ballot from conference attendees) was shared. The winners were: “Conservatism, Growth and the Role of Accounting Numbers in the Fundamental Analysis Process” by Steve Monahan; “Conditional and Unconditional Conservatism: Concepts and Modeling” by Bill Beaver and Stephen Ryan; “On Accounting-based Valuation Formulae” by James Ohlson; and “Expected EPS and EPS Growth as Determinants of Value” by James Ohlson and Beate Juettner-Nauroth. The Morgan Stanley prize for the best discussion was awarded to Joseph Piotroski for his commentary, published in this issue, on “Separating Winners from Losers among Low Book-to-Market Stocks using Financial Statement Analysis” by Partha Mohanram. Congratulations to these winners, and thanks to the sponsors for the awards: Barclays Global Investors and Morgan Stanley.
Separating Winners from Losers among Low Book-to-Market
Stocks using Financial Statement Analysis
Partha Mohanram
This paper tests whether a strategy based on financial statement analysis of low book-to-market (growth) stocks is successful in differentiating between winners and losers in terms of future stock performance. Piotroski (2000) finds that traditional fundamental analysis is effective in a sample of high BM (value) stocks. This paper tailors fundamental analysis for the specific context of low BM (growth) stocks. I create an index (GSCORE) based on a combination of traditional fundamentals such as earnings and cash flows and measures appropriate for growth firms such as the stability of earnings and growth and the intensity of R&D, capital expenditure and advertising. A strategy based on buying high GSCORE firms and shorting low GSCORE firms consistently earns significant excess returns, though most of the returns are on the short side. The results are robust to a variety of partitions based on size, analyst following and liquidity and persist after controlling for well documented risk and anomaly factors such as momentum, book-to-market, accruals and size. The stock market in general and analysts in particular are much more likely to be positively surprised by firms whose growth oriented fundamentals are strong, indicating that the stock market fails to grasp the future implications of current fundamentals. Further, the results do not support a risk based explanation for the book-to-market effect as the strategy returns positive returns in all years, and firms with lower systematic, unsystematic and ex-ante risk have better future returns. Finally, tests indicate support for a contextual approach to fundamental analysis with traditional fundamental analysis working best for high BM (value) stocks and the modified fundamental analysis developed in this paper working best for low BM (growth) stocks.
Discussion of "Separating Winners from Losers among
Low Book-to-Market Stocks using Financial Statement Analysis"
Joe Piotroski
The
conference paper by Mohanram (2005) provides evidence on the success of
contextual financial statement analysis in the low book-to-market (i.e.,
glamour) stock setting. The economic benefits of the strategy are concentrated
in the identification of glamour firms that will ultimately underperform the
market. However, in contrast to traditional accounting-based anomalies, the
returns to Mohanram’s growth-based trading strategy are stronger among
large, heavily followed firms, suggesting that the mechanisms behind the
mispricing of glamour firms are different than the traditional information
environment and dissemination arguments found in other settings. Despite the
robustness of the reported results, the strategy may face implementation
constraints due to (1) the relative costs associated with gathering
industry-adjusted data and (2) the frictions and costs associated with
capitalizing on expected price declines over a long horizon. Finally, the
relative benefits of contextual analysis need to be assessed against the
predictive benefits accruing to traditional financial statement analysis-based
investment techniques.
Information Uncertainty and Expected Returns
Guohua Jiang, Charles Lee, and Grace Zhang
This
study examines the role of information uncertainty (IU) in predicting
cross-sectional stock returns. We define
IU in terms of “value ambiguity,” or the precision with which firm
value can be estimated by knowledgeable investors at reasonable cost. Using several different proxies for IU, we
show that: (1) On average, High-IU firms earn lower future returns (the
“mean” effect), and (2) Price and earnings momentum effects are
much stronger among high-IU firms (the “interaction” effect). These findings are consistent with analytical
models in which high IU exacerbates investor overconfidence and limits rational
arbitrage.
Discussion of “Information Uncertainty and Expected
Returns”
Paul Schultz
Jiang, Lee, and Zhang (2005, this issue) show that stock returns are smaller for young firms, volatile stocks, high volume stocks, and stocks with long equity durations. In addition to having lower returns, momentum effects are particularly strong in these stocks. The focus of this discussion is on the informal behavioral model that is used to explain these results and the how well the variables used in the study proxy for information uncertainty, the model=s focus.
Conservatism, Growth and the Role of Accounting Numbers
in the Fundamental Analysis Process
Steve Monahan
In
this study I evaluate the effects of conservative accounting for research and
development (R&D) and past growth in R&D on two phenomena that are
pertinent to the fundamental analysis process: (1) the relation between
aggregate earnings (deflated by price) and contemporaneous stock return, and
(2) the association between estimates of value derived from the residual income
valuation model (i.e., RIV estimates) and equity market value. I show that the conservative treatment of
R&D affects the earnings/return relation only for firms that experience
high growth in R&D during the return interval of interest. I also demonstrate that the effect of
conservative accounting for R&D on the association between RIV estimates
and equity market values is increasing in past growth in R&D.
Discussion of “Conservatism, Growth and the Role of
Accounting Numbers in the Fundamental Analysis Process”
Xiao-Jun Zhang
This paper discusses Professor Monahan’s empirical
study of how conservative accounting of R&D affects the relations (i)
between earnings and stock return; (ii) between estimates of value using the
residual income valuation model and equity market value. My discussion focuses
on the underlying mechanism of why growth matters and how the growth rate
should be measured. In particular, I argue that different aspects of growth
(e.g., short-term growth versus long-term growth) matter under different
circumstances, depending on the intended use of accounting data. Failure to
adjust for these differences affects the effectiveness of the empirical tests.
The discussion also considers the impacts of potential noise in the R&D
capitalization procedure and the presence of other intangible assets.
Conditional and Unconditional Conservatism: Concepts and Modeling
Bill Beaver and Stephen Ryan
We
develop a general model that captures the distinct natures of two general types
of accounting conservatism: (1) unconditional conservatism, meaning that aspects
of the accounting process determined at the inception of assets or liabilities
tend to yield understatement of the book value of net assets relative to their
market value (i.e., unrecorded goodwill), and (2) conditional conservatism,
meaning that the book value of net assets is written down under sufficiently
adverse circumstances but not written up under favorable circumstances. The
model captures how the two types of conservatism interact, most notably, how
unconditional conservatism yields unrecorded goodwill that preempts the
application of conditional conservatism unless news is sufficiently bad to use
up that goodwill. The model yields a specification of earnings that we analyze
conceptually and using simulations to develop hypotheses about how
unconditional conservatism affects the asymmetric response of earnings to
positive and negative share returns, both current and lagged, documented by
Basu (1995, 1997) and the subsequent literature on conditional conservatism.
Discussion of “Conditional and Unconditional
Conservatism: Concepts and Modeling”
Sudipta Basu
Beaver & Ryan (2004) algebraically model, simulate and
graph the effects of various factors on the non-linear earnings-return relation
induced by conditional conservatism.
Their analysis clarifies how conditional and unconditional conservatism
are inter-related. I discuss why
unconditional and conditional conservatism are more than mere substitutes, and
provide evidence from the historical record.
I highlight a few areas for future modeling before moving on to discuss
potential empirical tests of their predicted relations. I identify some research questions and
opportunities for future investigation.
On Accounting-based Valuation Formulae
This paper considers
accounting-based valuation formulae. Its
initial focus is on two problems related to residual income valuation (RIV). First, insofar valuation depends on the
present value of expected dividends per share,
applying RIV requires clean surplus accounting on a per share
basis. Awkwardly, equity transactions
that change the number of shares outstanding generally imply
. A
clean surplus equality holds only if one “re-conceptualizes” either
end-of-period bvps or eps as a forced “plug”. Second,
one cannot circumvent the per share issue by evaluating RIV on a total
dollar value basis unless one introduces relatively subtle MM-type
restrictions. In light of RIV’s
unsatisfactory aspects, the paper proposes an alternative to RIV. This new approach maintains a strict eps-focus.
It derives by replacing bvpst in RIV with 
capitalized (i.e. divided by r). One
obtains a formula such that the current market price equals next-period
expected earnings capitalized plus the present value of expected abnormal
earnings growth, referred to as AEG. A number of propositions then
demonstrate the advantages of the AEG approach as compared to RIV. These results follow because capitalized generally approximates market
price better than 
.
Expected EPS and EPS Growth as Determinants of Value
James Ohlson and Beate Juettner-Nauroth
This paper develops a parsimonious model relating a firm’s price per share to, (i), next year expected earnings per share (or 12 months forward eps), (ii), short term growth (FY-2 vs. FY.1) in eps, (iii), long-term (asymptotic) growth in eps, and, (iv), cost-of-equity capital. The model assumes that the present value of dividends per share (dps) determines price, but it does not restrict how the dps-sequence is expected to evolve. All of these aspects of the model contrast sharply with the standard (Gordon/Williams) text-book approach, which equates the growth rates of expected dps and eps and fixes the growth rate and the payout rate. Though the constant growth model arises as a peculiar special case, the analysis in this paper rests on more general principles, including dividend policy irrelevancy. A second key result inverts the valuation formula to show how one expresses cost-of-capital as a function of the forward eps to price ratio and the two measures of growth in expected eps. This expression generalizes the text-book equation in which cost-of-capital equals the dps-yield plus the growth in expected eps.
Discussion of “On Accounting-based Valuation
Formulae” and “Expected EPS and EPS Growth as Determinants of
Value”
Stephen Penman
This discussion
evaluates the abnormal earnings growth valuation model (AEG) of Ohlson and
Juettner-Nauroth and, in similar vein to the Ohlson review paper at this
conference, compares the model to the residual income valuation model (RIV)
that has been the centerpiece of accounting-based valuation in recent years.
The discussion begins with a statement of what one looks for in a practical
valuation model. The innovations of the AEG model, well stated by Ohlson, are
acknowledged. A comparison of the advantages and disadvantages of the
alternative approaches provides some qualification, however, and draws out the
utility of a residual income valuation approach.
Review of
Accounting Studies
Volume 10, Issue 1, March 2005
The Role of Analysts’ Forecasts in Accounting-Based Valuation: A
Critical Evaluation
Qiang Cheng
Sustained Earnings and Revenue Growth, Earnings Quality, and Earnings
Response Coefficients
Aloke Ghosh, Zhaoyang Gu
and Prem C. Jain
Auditor Size, Market Segmentation and Litigation Patterns: A Theoretical
Analysis
Sasson Bar-Yosef and Bharat Sarath
Have Financial Statements Become Less Informative? Evidence from the Ability
of Financial Ratios to Predict Bankruptcy
William H. Beaver, Maureen F. McNichols and
Jung-Wu Rhie
Abstracts
Volume 10, Issue 1, March 2005
The Role of Analysts’ Forecasts in Accounting-Based
Valuation: A Critical Evaluation
Qiang Cheng
This paper critically evaluates the use of analysts’ forecasts in accounting-based valuation. Specifically, I assess the usefulness and the limitation of analysts’ forecasts in predicting future earnings and in explaining the market-to-book ratio, in light of a comprehensive set of 22 explicit information items, including: economic rent proxies, conservative accounting proxies, earnings quality signals, transitory earnings proxies, industry characteristics, and risk and growth proxies. While analysts’ forecasts capture 45–83% of the information from these sources depending on model specifications, they do not appear to fully incorporate certain information items. In particular, proxies for conservative accounting and transitory earnings are incrementally useful in predicting future earnings; proxies for economic rents, conservative accounting, and risk are incrementally useful in explaining the market-to-book ratio. Collectively, these results validate the use of analysts’ forecasts as a parsimonious proxy for forward-looking information in accounting-based valuation and suggest how to improve on their use.
Sustained Earnings and Revenue Growth, Earnings Quality,
and Earnings Response Coefficients
Aloke Ghosh, Zhaoyang Gu
and Prem C. Jain
We
show that firms reporting sustained increases in both earnings and revenues
have (1) higher quality earnings and (2) larger earnings response coefficients
(ERCs) in comparison to firms reporting sustained increases in earnings alone.
With respect to earnings quality, firms with revenue-supported increases in
earnings have more persistent earnings, exhibit less susceptibility to earnings
management, and have higher future operating performance. With respect to
response coefficients, firms with revenue-supported increases in earnings have
both higher ERCs and lower book value response coefficients, consistent with
the implications of the Ohlson (1995, Contemporary Accounting Research 12,
661–687) model.
Auditor Size, Market Segmentation and Litigation
Patterns: A Theoretical Analysis
Sasson Bar-Yosef and Bharat Sarath
We
provide a theoretical rationale for the observed audit industry structure where
well-capitalized auditors hold an extremely large market share. Our analysis
focuses on the economics of trading in an adverse selection market where audit
quality is unobservable. We show that concentration of market share can arise
even if well-capitalized auditors have no relative advantage with regard to
supplying high-quality audits, and that the strategy of attracting a narrow
base of high-margin clients is typically unsustainable in rational expectations
equilibrium. Other results derived from our analysis of strategic competition
for clients also conform (qualitatively) with empirical findings regarding
audit fee structures and litigation rates. In particular, we show that
better-capitalized auditors get a dominant market share, produce more accurate
reports and are more profitable. In addition, we show that the imposition of
high minimum standards increases the market power of wealthy auditors, even
though smaller auditors can potentially provide the same level of audit quality
at lower fees. All these results are demonstrated within a framework that
endogenizes both a securities trading market and profit-maximizing auditors who
strategically compete for clients.
Have Financial Statements Become Less Informative?
Evidence from the Ability of Financial Ratios to Predict Bankruptcy
William H. Beaver, Maureen F. McNichols and
Jung-Wu Rhie
Using a hazard model, we examine secular changes in the ability of financial statement data to predict bankruptcy from 1962 to 2002. We identify three trends in financial reporting that could influence predictive ability with respect to bankruptcy: FASB standards, the perceived increase in discretionary financial reporting behavior, and the increase in unrecognized assets and obligations. A parsimonious three-variable model provides significant explanatory power throughout the time period, with only a slight deterioration in predictive power from the first to the second time period. The striking feature of the results is the robustness of the predictive models over a forty-year period.
Review of
Accounting Studies
Volume 9, Issue 4, December 2004
Residual Income Valuation: Are
Inflation Adjustments Necessary?
John O'Hanlon and Ken Peasnell
The Disciplining Role of Accounting in the Long Run
Anil Arya, Jonathan Glover, Brian Mittendorf,
and Li Zhang
Accounting-Based Valuation with Changing Interest Rates
Dan Gode and James Ohlson
The Relevance of Non-financial Performance Measures for CEO Compensation:
Evidence from the Airline Industry
Antonio Davila and Mohan Venkatachalam
Going-Public and the Influence of Disclosure Environments
Teye Marra and Jeroen Suijs
Accounting Conservatism and the Relation Between Returns and Accounting Data
Peter Easton and Jinhan Pae
Abstracts
Volume 9, Issue 4, December 2004
Residual Income Valuation: Are Inflation Adjustments Necessary?
John O'Hanlon and Ken
Peasnell
This paper explores the question of whether the residual income valuation relationship (RIVR) should be written in inflation-adjusted terms. This question is of particular interest in the light of Ritter and Warr's (2002) claim that the standard nominal historical cost formulation of RIVR misvalues firms because it fails to deal properly with inflation. We present two inflation-adjusted formulations of RIVR, each of which is based on an income measure from the inflation accounting literature, and one of which is a general case of a formulation proposed by Ritter and Warr. We show that neither of these formulations is any more or less correct than the standard formulation of RIVR, and find no support for the view that it is necessary to write RIVR in inflation-adjusted terms. Finally we argue that, in a setting in which accounting numbers and forecasts thereof are normally presented in historical cost terms, the inflation adjustment of RIVR is likely to bring unnecessary complication to the valuation process, with increased scope for error.
The Disciplining Role of Accounting in the Long Run
Anil Arya, Jonathan Glover, Brian Mittendorf,
and Li Zhang
One
role of accounting is to discipline softer (more manipulable) sources of
information. We use a principal-agent model of hidden actions and hidden
information to study this role. In our model, there is both a verifiable signal
(a publicly observed output) and an unverifiable signal (a productivity
parameter privately observed by the agent). In a one-period setting, the
optimal contract does not make use of the agent’s report on the private
signal. However, when the output is tracked over two periods, the agent’s
communication can be valuable. This reversal of results suggests uncovering the
disciplining role of accounting may require a long-term perspective
Accounting-Based Valuation with Changing Interest Rates
Dan Gode and James Ohlson
This
paper generalizes Ohlson’s [Contemporary Accounting Research Vol. 11 No.
2. 661–687 (1995)] equity valuation framework to allow for stochastic
interest rates. Much of this analysis initially deals with the specialized
setting in which earnings suffice for cum-dividend value. In such a case, the
beginning-of-period (lagged) rate determines the capitalization factor, not the
current rate. The underlying earnings dynamic modifies the traditional random
walk model via an additional term, namely current earnings multiplied by the
percentage change in interest rates. The general model retains these basic
aspects of the earnings-sufficiency setting. Empirical implications bear on the
returns-to-earnings regression: The earnings-response coefficient decreases as
the beginning-of-period rate increases
The Relevance of Non-financial Performance Measures for
CEO Compensation: Evidence from the Airline Industry
Antonio Davila and Mohan Venkatachalam
This paper investigates the role of non-financial performance measures in executive compensation. Using a sample of airline firms we document that passenger load factor, an important non-financial measure for firms in this industry, is positively associated with CEO cash compensation. This association is significant after controlling for traditional accounting performance measures (return on assets) and financial performance measures (stock returns). This evidence is consistent with the hypothesis that non-financial measures provide incremental information about CEOs’ actions over financial measures and hence, receive a positive weight in compensation contracts. We also explore cross-sectional differences in the importance of non-financial performance measures. We find weak evidence that CEO power and the noise of financial performance measures impact the relationship between non-financial performance measures and cash compensation.
Going-Public and the Influence of Disclosure Environments
Teye Marra and Jeroen Suijs
This
paper analyzes how differences in disclosure environments affect the
firm’s choice between private and public capital. Disclosure requirements
prescribe to what extent the firm has to release private information that may
lead to the firm incurring proprietary costs. We examine which firm types go
public in equilibrium, and how the equilibrium outcomes change with changes in
the disclosure environments. Our findings show that in a partial financing
equilibrium, should such an equilibrium exist, good
firms finance privately. This result is robust to changes in the disclosure
environment.
Accounting Conservatism and the Relation Between Returns and Accounting Data
Peter Easton and Jinhan Pae
This study adds change in cash
investments and change in lagged operating assets to the regression of returns
on earnings levels and earnings changes examined in
Review of
Accounting Studies
Volume 9, Issues 2 and 3, June/September 2004
Editorial
Stephen Penman
The Role of Expectations Explaining the Cross-Section of Stock Returns
Tom Copeland, Aaron Dolgoff, Alberto Moel
Discussion of “The Role of Expectations Explaining the Cross-Section
of Stock Returns”
Jing Liu
Implied Equity Duration: A New
Measure of Equity Risk
Patricia Dechow, Richard Sloan, Mark Soliman
Discussion of “Implied Equity Duration: A New Measure of Equity Risk”
Pedro Santa-Clara
The Role of Information Precision in Determining the Cost of Equity Capital
Christine A.
Botosan, Marlene A. Plumlee, Yuan Xie
Discussion of “The Role of Information Precision in
Determining the Cost of Equity Capital”
Michael Williams
How Banks' Value-at-Risk Disclosures Predict Their Total
and Priced Risk: Effects of Bank
Technical Sophistication and Learning over Time
Bin Ke
Forward Versus Trailing Earnings in Equity Valuation
Kenton K. Yee
Discussion of “Forward Versus Trailing Earnings in
Equity Valuation”
Peter Easton
The Effect of Accounting Restatements on Earnings
Revisions and the Estimated Cost of Capital
Paul Hribar, Nicole Thorne Jenkins
Discussion of “The
Effect of Accounting Restatements on Earnings Revisions and the Estimated Cost
of Capital”
Ron Kasznik
Review of
Accounting Studies
Volume 9, Issue 1, March 2004
Assessing the Probability of Bankruptcy
Stephen A. Hillegeist, Elizabeth K. Keating,
Donald P. Cram, Kyle G. Lundstedt
Audit Firm Industry Specialization and Client Disclosure Quality
Kimberly A. Dunn, Brian W. Mayhew
Analyst Earnings Forecast Revisions and the Pricing of Accruals
Mary E. Barth, Amy P. Hutton
Inter-Departmental Cost Allocation and Investment Incentives
Donna Wei
The Profitability and Pricing of Major Customers
Marty Gosman, Trish Kelly, Per Olsson, Terry
Warfield
Review of
Accounting Studies
Volume 8, Issue 4, December 2003
Inferring the Cost of Capital Using the Ohlson-Juettner Model
Dan Gode, Partha Mohanram
Got Information? Investor Response to Form 10-K and Form 10-Q EDGAR Filings
Paul A. Griffin
Does the Stock Market Fully Appreciate the Implications of Leading
Indicators for Future Earnings? Evidence from Order Backlog
Shivaram Rajgopal, Terry Shevlin, Mohan
Venkatachalam
Accounting Returns Revisited: Evidence of their Usefulness in Estimating
Economic Returns
Morris G. Danielson, Eric Press
Financial Statement Analysis of Leverage and How it Informs About
Profitability and Price-to-Book Ratios
Doron Nissim, Stephen Penman
Comparing the Value Relevance of Two Operating Income Measures
Lawrence D. Brown, Kumar Sivakumar
Review of
Accounting Studies
Volume 8, Issues 2 and 3, 2003
Editorial
The Predictive Value of Expenses Excluded from Pro Forma Earnings
Jeffrey T. Doyle, Russell J. Lundholm, Mark
T. Soliman
Discussion of “The Predictive Value of Expenses Excluded from Pro
Forma Earnings”
Peter Easton
Differential Market Reactions to Revenue and Expense Surprises
Yonca Ertimur, Joshua Livnat, Minna
Martikainen
Discussion of “Differential Market Reactions to Revenue and Expense
Surprises”
Philip G. Berger
The Differential Persistence of Accruals and Cash Flows for Future Operating
Income versus Future Profitability
Patricia M. Fairfield, Scott Whisenant, Teri
Lombardi Yohn
Discussion of “The Differential Persistence of Accruals and Cash Flows
for Future Operating Income versus Future Profitability”
Ilia D. Dichev
Investor Sophistication and the Mispricing of Accruals
Daniel W. Collins, Guojin Gong, Paul Hribar
Discussion of “Investor Sophistication and the Mispricing of
Accruals”
Eli Bartov
Performance Evaluation and Corporate Income Taxes in a Sequential Delegation
Setting
Tim Baldenius, Amir Ziv
Discussion of “Performance Evaluation and Corporate Income Taxes in a
Sequential Delegation Setting”
Madhav V. Rajan
Post-Earnings Announcement Drift and Market Participants’ Information
Processing Biases
Lihong Liang
Discussion of “Post-Earnings Announcement Drift and Market
Participants’ Information Processing Biases”
Jacob K. Thomas
Why Are Earnings Kinky? An Examination of the Earnings Management
Explanation
Patricia M. Dechow, Scott A. Richardson, Irem
Tuna
Discussion of “Why are Earnings Kinky? An Examination of the Earnings
Management Explanation”
Maureen F. McNichols
Abstracts
The Predictive Value of Expenses
Excluded from Pro Forma Earnings
We investigate the informational properties of pro forma earnings. This increasingly popular measure of earnings excludes certain expenses that the company deems non-recurring, non-cash, or otherwise unimportant for understanding the future value of the firm. We find, however, that these expenses are far from unimportant. Higher levels of exclusions lead to predictably lower future cash flows. We also find that investors do not fully appreciate the lower cash flow implications at the time of the earnings announcement. A trading strategy based on the excluded expenses yields a large positive abnormal return in the years following the announcement, and persists after controlling for various risk factors and other anomalies.
Differential Market Reactions to
Revenue and Expense Surprises
This study investigates
investors’ reactions to revenue and expense
surprises around preliminary earnings announcements. Results show that
investors value more highly a dollar of revenue surprise than a dollar of
expense surprise. Results further show that these differential market reactions
to revenue and expense surprises vary systematically for growth versus value
firms and depend on (a) the proportion of variable to total costs, (b) the
relative persistence of sales and expenses, and (c) the proportion of operating
to total expenses. Results highlight the importance of interpreting the
earnings surprise in the context of its sources—e.g.
surprise in revenues or in total expenses.
The Differential Persistence of
Accruals and Cash Flows for Future Operating Income versus Future Profitability
Prior research provides evidence that a higher proportion of accrued relative to cash earnings is associated with lower earnings performance in the subsequent fiscal year. The result has been widely interpreted as indicative of higher levels of operating accruals relative to cash flows foreshadowing a subsequent “earnings reversal,” and thus signaling earnings management. We note, however, that earnings performance in prior studies is typically defined as one-year-ahead operating income divided by one-year-ahead invested capital, or a measure of profitability. We find that accruals are more highly associated than cash flows with invested capital in the denominator of the profitability measure. In contrast, accruals and cash flows have no differential relation to one-year-ahead operating income. The evidence is not consistent with accruals having a reversal effect on earnings. This suggests that the lower persistence of accruals versus cash flows may not be due to earnings management but may rather be due to the effect of growth on future profitability.
Investor Sophistication and the
Mispricing of Accruals
This paper examines the role of institutional investors in the pricing of accruals. Using Bushee’s (1998) classification of institutional investors, we show that firms with a high level of institutional ownership and a minimum threshold level of active institutional traders have stock prices that more accurately reflect the persistence of accruals. This result holds after controlling for differences in the persistence of accruals between firms with high and low institutional ownership, and after controlling for other characteristics that are correlated with institutional ownership and future returns. Additionally, firms with low institutional ownership are smaller, less profitable, and have lower share turnover, suggesting that limits to arbitrage impede institutional investors from exploiting the seemingly large abnormal returns for these firms.
Performance Evaluation and Corporate
Income Taxes in a Sequential Delegation Setting
We consider a setting where a firm delegates an investment
decision and, subsequently, a sales decision to a privately informed manager.
For both decisions corporate income taxes have real effects. We show that
compensating the manager based on pre-tax residual income can ensure after-tax
NPV-maximization (“goal congruence”) for each decision problem in isolation.
However, this metric fails if both decisions are nontrivial, since it requires
asset-specific hurdle rates and hence precludes asset aggregation. After-tax
residual income metrics (e.g., EVA) allow the firm to consistently apply its
after-tax cost of capital as the hurdle rate to its aggregate asset base. We
show that existing tax depreciation schedules may explain why firms in practice
use more accelerated depreciation schedules than those suggested by previous
studies. Our findings also rationalize the widespread use of “dirty surplus”
accounting for windfall gains and losses for managerial retention purposes.
Post-Earnings Announcement Drift and
Market Participants’ Information Processing
Biases
Prior research has been unable to explain the phenomenon known as post-earnings announcement drift, raising questions concerning the semi-strong form efficiency of the market typically assumed in capital market research. This study contributes to our understanding of this anomaly by examining drift in the context of theories that consider investors’ non-Bayesian behaviors. The empirical evidence reveals that investors’ overconfidence about their private information and the reliability of the earnings information are two important factors that explain drift. Finally, this study also provides insight into the puzzling relationship between dispersion and drift discussed in prior research.
Why Are Earnings Kinky? An Examination
of the Earnings Management Explanation
Prior research has documented a “kink” in the earnings distribution: too few firms report small losses, too many firms report small profits. We investigate whether boosting of discretionary accruals to report a small profit is a reasonable explanation for this “kink.” Overall, we are unable to confirm that boosting of discretionary accruals is the key driver of the kink. We caution the use of the ratio of small profit firms to small loss firms as a measure of earnings management. We investigate and discuss a number of alternative explanations for the kink.
Review of
Accounting Studies
Volume 5, Issue 1, 2000
Earnings Preannouncement Strategies
Leonard Soffer, S. Ramu Thiagarajan, and Beverly Walther
Intrafirm Trade, Bargaining Power and Specific Investments
Tim Baldenius
Competitive Effects of Disclosure in a Strategic Entry Model
Yuhchang Hwang and Alison Kirby
Abstracts
Earnings Preannouncement Strategies
Leonard Soffer
S. Ramu Thiagarajan
Beverly Walther
Abstract. We examine the disclosure strategies managers follow
when they "preannounce" quarterly earnings shortly before formal
earnings announcements. We document that managers with bad news release
essentially all of their news at the preannouncement date, while managers with
good news only release about half of their news. Controlling for the
combined news released at the preannouncement and earnings announcement dates,
firms with negative earnings announcement surprises have significantly lower
excess returns for the period from just before the preannouncement to just
after the earnings announcement. This finding is consistent with the
observed disclosure strategies whereby managers attempt to avoid negative
earnings announcement surprises, and suggests that how information is presented
can affect the market's reaction to that information.
Intrafirm Trade, Bargaining Power and Specific Investments
Tim Baldenius
Abstract. This paper compares the performance of standard-cost versus
negotiated transfer pricing under asymmetric information. Negotiated transfer
pricing generally achieves higher expected contribution margins, as this method
tends to be more efficient in aggregating private information into a single
transfer price. While standard-cost transfer pricing generates better
incentives for the supplying division to undertake specific investments, the opposite
holds for buyer investments, because this method confers more bargaining power
to the supplier. If a corporate controller has disaggregated information about
divisional costs and revenues, then the firm can improve upon the performance
of standard-cost transfer pricing by setting a centralized transfer price equal
to expected cost plus a suitably chosen mark-up.
Competitive Effects of Disclosure in a Stragetic Entry Model
Yuhchang Hwang
Alison Kirby
Abstract. We investigate the welfare consequences of incumbent firms' mutual disclosure of cost information when there is a threat of entry from a firm not required to disclose its private cost information. New effects of disclosure are observed relative to no-entry models, with the result that incumbents' expected output is a decreasing function of the disclosure level. However, further analysis shows that increased disclosure usually increases incumbent expected profits and decreases expected consumer surplus, despite the additional entry effect of disclosure. Such analytical derivations provide objective input to the FASB as they attempt to predict the competitive effects of changing mandated disclosure requirements.
Review of
Accounting Studies
Volume 4, Issues 3 and 4, 1999
Special Conference Issue: The Impact of Accounting Rules on Valuation and Management Control
Editorial
On Transitory Earnings.
James Ohlson
Discussion: William Beaver
Evidence on the Usefulness of Capital Expenditures as
an Alternative Measure of Depreciation.
Dennis Chambers, Ross Jennings and Robert Thompson
Discussion: Jeffrey Abarbanell
Accruals, Cash Flow and Equity Values.
Mary Barth, William Beaver, John Hand and Wayne Landsman
Discussion: Richard Sloan
Asset Valuation and Performance Measurement in a
Dynamic Agency Setting.
Sunil Dutta and Stefan Reichelstein
Discussion: Richard Lambert
Comparing Alternative Hedge Accounting Standards:
Shareholders’ Perspective.
Nahum Melumad, Guy Weyns and Amir Ziv
Discussion: Chandra Kanodia
The Effects of Taxes, Agency Costs and Information Asymmetry on Earnings
Management: A Comparison of Public and Private Firms.
Anne Beatty and David G. Harris
Discussion: Douglas Shackelford
Abstracts
ON TRANSITORY EARNINGS
Abstract: The paper develops a concept of transitory earnings
and contrasts this source of earnings to “core” (or recurring)
earnings. It is shown that any two of the following three attributes of
transitory earnings imply the third: (i) fore
casting irrelevance with respect to next-period aggregate earnings, (ii)
value irrelevance, and (iii) unpredictability. The paper makes the
case that the current “dirty surplus” items make sense, especially
if one expands the valuation perspective to also allow for agency
considerations.
EVIDENCE ON THE USEFULNESS OF CAPITAL EXPENDITURES AS AN ALTERNATIVE MEASURE OF DEPRECIATION
Robert B. Thompson II
Virginia Commonwealth University
Abstract: Investment professionals often suggest that
accounting earnings is a more useful indicator of share value if adjusted by
substituting current capital expenditures for reported depreciation. We
investigate the usefulness of this alternative depreciation measure by
comparing the ability of reported earnings and adjusted earnings to explain the
cross-sectional distribution of stock prices for a large sample of
manufacturing firms. We find that adjusted earnings explains a much
smaller fraction of the variation in share prices than earnings based on
reported depreciation, and provide evidence on the reasons for this difference.
ACCRUALS, CASH FLOW, AND EQUITY VALUES
Abstract: This paper tests predictions regarding the
characteristics of two key components of net income: Accounting accruals
and cash flow from operations. Our tests use a cross-sectional valuation
framework based on Ohlson (1999) and employ Compustat firms with SFAS No. 95
annual data available between 1987-1996. We
report three major findings. First, when forecasting abnormal earnings is
it important to condition on the cash flow and accrual components of
earnings. Second, in explaining equity value, it is also important to
condition on these earnings components. Third, the cash flow and accrual
coefficients estimated in the valuation equation are positively correlated with
a theoretical coefficient that is a function of the forecasting relevance and
predictability of each component.
ASSET VALUATION AND PERFORMANCE MEASUREMENT IN A DYNAMIC AGENCY SETTING
Abstract: This paper examines the choice of asset valuation
rules from a managerial control perspective. A manager creates value for
a firm through his effort choices. To support its operating activities,
the firm also engages in financing activities such as credit sales to its
customers. Since such financing activities merely change the pattern of cash
flows across periods, an optimal compensation scheme must shield the manager
from the risk associated with the financing activities. We show that
residual income combined with fair value accounting for receivables eliminates
this risk and provides an optimal performance measure. In contrast,
compensation schemes based only on realized cash flows can be optimal only
under exceptional circumstances. We also consider a setting in which
there is sufficiently disaggregated information about periodic cash flows so as
to eliminate not only the risk associated with financing activities but also
the risk associated with customer defaults. The principal then wants to
depart from fair value accounting.
COMPARING ALTERNATIVE HEDGE ACCOUNTING STANDARDS: SHAREHOLDERS’ PERSPECTIVE
Guy Weyns
Goldman Sachs,
Abstract: We study the economic consequences of alternative
hedge accounting rules in terms of managerial hedging decisions and wealth
effects for shareholders. The rules we consider include the
“fair-value” and “cash-flow” hedge accounting methods
prescribed by the recent SFAS No. 133. We illustrate that the accounting
method used influences the manager’s hedge decision. We show that
under no-hedge accounting, the hedge choice is different from the optimal
economic hedge the firm would make under symmetric and public
information. However, under a certain definition of fair-value hedge
accounting, the hedging decision preserves the optimal economic hedge. We
then demonstrate that long-term and future shareholders prefer a certain
definition of fair-value hedge accounting to no-hedge accounting, while
short-term shareholders prefer either approach depending on risk preferences
and the level of uncertainty. We speculate about circumstances in which a
manager would choose not to adopt fair-value hedge accounting when he has the
option not to do so.
THE EFFECTS OF TAXES, AGENCY COSTS AND INFORMATION ASYMMETRY ON EARNINGS MANAGEMENT: A COMOPARISON OF PUBLIC AND PRIVATE FIRMS
Abstract: The realization of security gains and losses to manage earnings in publicly-traded bank holding companies has been documented in a large number of studies, but very little is known about why managers engage in this behavior. Two possible explanations for earnings management put forth by Warfield, Wild, and Wild (1995) are that managers engage in this behavior either to circumvent accounting-based contracts designed to mitigate agency problems or to reduce information asymmetry.
We compare public and private banks’ security gain/loss realizations to determine how their earnings management differs. We find that public banks consistently engage in more earnings management than private banks and that the portion of their current period securities gains and losses realizations attributable to earnings management is more highly associated with next period’s earnings before security gains and losses. These findings are consistent with earnings management occurring due to greater information asymmetry in public firms, and suggest that earnings management may not necessarily lead to the erosion in the quality of earnings suggested by Levitt (1988).