Private lenders’ demand for audit

Why do CFOs become involved in material accounting manipulations?

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Why do CFOs become involved in material accounting manipulations?

Feng, Mei, Ge, Weili, Luo, Shuqing, Shevlin, Terry

Vol 51, Issue 1/2, 21-36 (2011)

Abstract: This paper examines why CFOs become involved in material accounting manipulations. We find that while CFOs bear substantial legal costs when involved in accounting manipulations, these CFOs have similar equity incentives to the CFOs of matched non-manipulation firms. In contrast, CEOs of manipulation firms have higher equity incentives and more power than CEOs of matched firms. Taken together, our findings are consistent with the explanation that CFOs are involved in material accounting manipulations because they succumb to pressure from CEOs, rather than because they seek immediate personal financial benefit from their equity incentives. AAER content analysis reinforces this conclusion. [Copyright &y& Elsevier]

Accounting standards and debt covenants: Has the "balance sheet approach" led to a decline in the use of balance sheet covenants?

Demerjian, Peter R.

Vol 52, Issue 2/3, 178-202 (2011)

Abstract: Recent years have seen a sharp decline in the use of balance sheet-based covenants in private debt contracts. I hypothesize that changes in accounting standards can explain part of this decline. Standard setting has shifted towards a "balance sheet approach", which I predict has made the balance sheet less useful for contracting. I measure the effect of the balance sheet approach on specific borrowers using a volatility ratio. I find that borrowers with greater volatility ratios are less likely to have balance sheet-based covenants. This evidence is consistent with reductions in the contracting usefulness of the balance sheet being associated with reductions in balance sheet covenants. [Copyright &y& Elsevier]

The effect of SOX on small auditor exits and audit quality

DeFond, Mark L., Lennox, Clive S.

Vol 52, Issue 1, 21-40 (2011)

Abstract: We find that over six hundred auditors with fewer than 100 SEC clients exit the market following SOX. Compared to the non-exiting auditors, the exiting auditors are lower quality, where quality is gauged by: (1) avoidance of AICPA peer reviews and failure to comply with PCAOB rules, and (2) severity of the peer review and inspection reports. In addition, clients of exiting auditors receive higher quality auditing from successor auditors, as captured by a greater likelihood of receiving going concern opinions. Our results suggest that the PCAOB inspections improve audit quality by incentivizing low quality auditors to exit the market. [Copyright &y& Elsevier]

The impact of mandatory IFRS adoption on foreign mutual fund ownership: The role of comparability

DeFond, Mark, Hu, Xuesong, Hung, Mingyi, Li, Siqi

Vol 51, Issue 3, 240-258 (2011)

Abstract: Proponents of IFRS argue that mandating a uniform set of accounting standards improves financial statement comparability that in turn attracts greater cross-border investment. We test this assertion by examining changes in foreign mutual fund investment in firms following mandatory IFRS adoption in the European Union in 2005. We measure improved comparability as a credible increase in uniformity, defined as a large increase in the number of industry peers using the same accounting standards in countries with credible implementation. Consistent with this assertion, we find that foreign mutual fund ownership increases when mandatory IFRS adoption leads to improved comparability. [Copyright &y& Elsevier]

Discussion of "Are voluntary disclosures that disavow the reliability of mandated fair value information informative or opportunistic?"

Core, John E.

Vol 52, Issue 2/3, 252-258 (2011)

Abstract: Blacconiere, Frederickson, Johnson, and Lewis identify an interesting disclosure and add to our understanding of firm disclosure of option expense. The disclosure is more nuanced than is suggested by the term "disavowal". Some disclosures are weak, almost tautological "not necessarily ... reliable" statements, whereas others are straightforward statements about the "subjective nature" of the inputs to the option valuation model. The "not necessarily ... reliable" language largely disappears after SFAS 123R, while stronger language persists. A striking finding in BFJL is lack of opportunism in disavowals, but I suggest that it is preliminary to conclude that there is no opportunism. [Copyright &y& Elsevier]

Pension plan accounting estimates and the freezing of defined benefit pension plans

Comprix, Joseph, Muller, Karl A.

Vol 51, Issue 1/2, 115-133 (2011)

Abstract: This study provides evidence that, when "hard" freezing their defined benefit pension plans, employers select downward biased accounting assumptions to exaggerate the economic burden of their benefit plans. Downward biased expected rates of return and discount rates allow managers to increase reported pension expenses and, for discount rates, allow managers to increase reported pension liabilities. We find that prior to the Sarbanes-Oxley Act, both rates are downward biased when firms freeze their plans, whereas after SOX the bias is lower. This finding is consistent with managers opportunistically biasing pension estimates to obtain labor concessions during periods of reduced regulatory scrutiny. [Copyright &y& Elsevier]

Understanding analysts' use of stock returns and other analysts' revisions when forecasting earnings

Clement, Michael B., Hales, Jeffrey, Xue, Yanfeng

Vol 51, Issue 3, 279-299 (2011)

Abstract: We investigate analysts'' use of stock returns and other analysts'' forecast revisions in revising their own forecasts after an earnings announcement. We find that analysts respond more strongly to these signals when the signals are more informative about future earnings changes. Although analysts underreact to these signals on average, we find that analysts who are most sensitive to signal informativeness achieve superior forecast accuracy relative to their peers and have a greater influence on the market. The results suggest that the ability to extract information from the actions of others serves as one source of analyst expertise. [Copyright &y& Elsevier]

Scale effects of R&D as reflected in earnings and returns

Ciftci, Mustafa, Cready, William M.

Vol 52, Issue 1, 62-80 (2011)

Abstract: Using returns to scale as a conceptual foundation, we explore how R&D-related earnings performance and earnings variability depend upon firm size. We find that the positive association between the level of future earnings and R&D intensity increases with firm size, and that the positive association between the volatility of future earnings and R&D intensity decreases with firm size, consistent with R&D productivity increasing with scale. We also show that R&D scale is associated with lower market returns, consistent with the idea that R&D investment risk declines with scale. [Copyright &y& Elsevier]

Evidence on differences between recognition and disclosure: A comparison of inputs to estimate fair values of employee stock options

Choudhary, Preeti

Vol 51, Issue 1/2, 77-94 (2011)

Abstract: I investigate reliability differences across recognition and disclosure regimes to shed light on differing incentives and reporting of employee stock option (ESO) fair values. I compare ESO fair values based on firm-reported inputs with ESO fair values based on benchmark inputs, estimated following authoritative guidance. On average, I find opportunism increases with recognition as compared with disclosure, and that it is associated with incentives to manage earnings. Despite the increase in opportunism, I find that accuracy does not decline for recognizers, and that accuracy differs across voluntary and mandatory recognition. [Copyright &y& Elsevier]

Is silence golden? An empirical analysis of firms that stop giving quarterly earnings guidance

Chen, Shuping, Matsumoto, Dawn, Rajgopal, Shiva

Vol 51, Issue 1/2, 134-150 (2011)

Abstract: We investigate firms that stop providing earnings guidance ("stoppers") either by publicly announcing their decision ("announcers") or doing so quietly ("quiet stoppers"). Relative to firms that continue guiding, stoppers have poorer prior performance, more uncertain operating environments, and fewer informed investors. Announcers commit to non-disclosure because they (i) do not expect to report future good news or (ii) have lower incentives to guide due to the presence of long-term investors. The three-day return around the announcement is negative. Stoppers subsequently experience increases in analyst forecast dispersion and decreases in forecast accuracy but no change in return volatility or analyst following. [Copyright &y& Elsevier]

The quality of accounting information in politically connected firms

Chaney, Paul K., Faccio, Mara, Parsley, David

Vol 51, Issue 1/2, 58-76 (2011)

Abstract: We document that the quality of earnings reported by politically connected firms is significantly poorer than that of similar non-connected companies. Our results are not due to firms with ex-ante poor earnings quality establishing connections more often. Instead, our results suggest that, because of a lesser need to respond to market pressures to increase the quality of information, connected companies can afford disclosing lower quality accounting information. In particular, lower quality reported earnings is associated with a higher cost of debt only for the non-politically connected firms in the sample. [Copyright &y& Elsevier]

Earnouts: A study of financial contracting in acquisition agreements

Cain, Matthew D., Denis, David J., Denis, Diane K.

Vol 51, Issue 1/2, 151-170 (2011)

Abstract: We empirically examine earnout contracts, which provide for contingent payments in acquisition agreements. Our analysis reveals considerable heterogeneity in the potential size of the earnout, the performance measure on which the contingent payment is based, the period over which performance is measured, the form of payment for the earnout, and the overall sensitivity of earnout payment to target performance. Our tests of the determinants of contract terms yield support for the view that earnouts are structured to minimize the costs of valuation uncertainty and moral hazard in acquisition negotiations. [Copyright &y& Elsevier]

The unintended consequences of PCAOB auditing Standard Nos. 2 and 3 on the reliability of preliminary earnings releases

Bronson, Scott N., Hogan, Chris E., Johnson, Marilyn F., Ramesh, K.

Vol 51, Issue 1/2, 95-114 (2011)

Abstract: Implementation of Public Company Accounting Oversight Board Auditing Standards No. 2 on internal control and No. 3 on documentation has delayed audit completion. However, due to market demand for timely disclosures, most firms maintain the same preliminary earnings release date even though the audit may not be complete as of that date. Results indicate revisions to preliminary announcements when filing the 10-K report would have been 35% lower during 2005 if the historical frequency of issuing earnings releases after the audit report date had not changed. Additionally, stock market reaction to impending revisions suggests lower reliability of preliminary earnings. [Copyright &y& Elsevier]

Target ratcheting and effort reduction

Bouwens, Jan, Kroos, Peter

Vol 51, Issue 1/2, 171-185 (2011)

Abstract: In this paper, we examine how retail store managers reduce their sales activity in response to target ratcheting. We find that managers with favorable sales performance in the first three quarters reduce their sales activity in the final quarter. We also document that managers who engage in sales reducing activities enhance their likelihood of meeting their next-year sales target, which is based on their current sales. That is, managers who reduce their sales activity in the final quarter are more likely to beat their next-year sales targets than managers who refrain from reducing their final-quarter sales. [Copyright &y& Elsevier]

Are voluntary disclosures that disavow the reliability of mandated fair value information informative or opportunistic?

Blacconiere, Walter G., Frederickson, James R., Johnson, Marilyn F., Lewis, Melissa F.

Vol 52, Issue 2/3, 235-251 (2011)

Abstract: One consequence of the shift to fair value measurement is the emergence of voluntary disclosures in audited financial statements that question the reliability of mandated fair value information. We refer to these disclosures as reliability disavowals. We examine stock option volatility estimates disclosed under SFAS 123 and test whether disavowals are informative (opportunistic) by examining whether ex ante firm characteristics, forecast bias, and prediction difficulty are consistent with informative (opportunistic) disclosure. Our results support the hypothesis that disavowals inform users about the reliability of volatility estimates, but there is also limited evidence consistent with managers using disavowals opportunistically. [Copyright &y& Elsevier]

Panacea, Pandora's box, or placebo: Feedback in bank mortgage-backed security holdings and fair value accounting

Bhat, Gauri, Frankel, Richard, Martin, Xiumin

Vol 52, Issue 2/3, 153-173 (2011)

Abstract: We examine the relation between bank holdings of mortgage-backed securities (MBS) and MBS prices. Theory suggests feedback between MBS holdings and underlying asset markets can be aggravated by mark-to-market accounting. We measure feedback by the relation between asset returns and the changes in bank MBS holdings. Consistent with the existence of feedback effects related to mark-to-market, we find that for banks with high MBS, more nonperforming loans, and lower total capital ratio, changes in bank MBS positions are positively associated with changes in MBS prices and that this relation is reduced after the April 2009 mark-to-market rule clarification. To assess the effect of feedback on shareholder value, we test whether the stock-price response of banks to the announcement of the mark-to-market accounting rule clarification is associated with the intensity of feedback behavior. We find that the stock market reaction to the rule change is more positive for banks with more MBS, higher nonperforming loans and higher pre-rule-change feedback. We also find positive bond-price reactions to the rule change. Overall, our results suggest feedback related to mark-to-market accounting had a measurable effect on shareholder value. [Copyright &y& Elsevier]

From low-quality reporting to financial crises: Politics of disclosure regulation along the economic cycle

Bertomeu, Jeremy, Magee, Robert P.

Vol 52, Issue 2/3, 209-227 (2011)

Abstract: This paper examines how financial reporting regulations affect, and respond to, macroeconomic cycles by exploring a positive framework in which regulators subject to political pressures respond to cyclical demands by borrowers and lenders. We establish that, as economic conditions initially decline, political power shifts toward interest groups favoring less financial transparency. What follows is a counter-cyclical increase in economic activity, as more non-reporting loans are financed, possibly coincidental with more aggregate uncertainty. During a recession, reporting quality is increased, potentially causing a crisis-like adjustment of economic activity to the cycle. We also discuss implications for event studies, bank lobbying, mark-to-market and cost of capital. [Copyright &y& Elsevier]

Challenges and opportunities in disclosure research--A discussion of 'the financial reporting environment: Review of the recent literature'

Berger, Philip G.

Vol 51, Issue 1/2, 204-218 (2011)

Abstract: review the financial reporting literature related to voluntary and mandatory firm disclosures, and sell-side analyst reports. The discussion summarizes their approach, highlights some of their main conclusions, and presents alternative ideas about promising avenues for future research. [Copyright &y& Elsevier]

Do delays in expected loss recognition affect banks' willingness to lend?

Beatty, Anne, Liao, Scott

Vol 52, Issue 1, 1-20 (2011)

Abstract: Banks can decrease their future capital inadequacy concerns by reducing lending. The capital crunch theory predicts that lending is particularly sensitive to regulatory capital constraints during recessions, when regulatory capital declines and external-financing frictions increase. Regulators and policy makers argue that the current loan loss provisioning rules magnify this pro-cyclicality. Exploiting variation in the delay in expected loss recognition under the current incurred loss model, we find that reductions in lending during recessionary relative to expansionary periods are lower for banks that delay less. We also find that smaller delays reduce the recessionary capital crunch effect. These results hold across management quality partitions. [Copyright &y& Elsevier]

Hometown advantage: The effects of monitoring institution location on financial reporting discretion

Ayers, Benjamin C., Ramalingegowda, Santhosh, Eric Yeung, P.

Vol 52, Issue 1, 41-61 (2011)

Abstract: We examine the impact of institutional ownership on financial reporting discretion, focusing on whether the impact varies with institutions'' cost of acquiring monitoring information. Using geographic distance between the firm and the institutional investor as a proxy for the cost of acquiring monitoring information, we find that corporate managers are less likely to use financial reporting discretion in the presence of local monitoring institutions than distant monitoring institutions. We also find that the impact of monitoring institutions on financial reporting discretion varies with the costs and benefits of financial reporting discretion. [Copyright &y& Elsevier]

Do management earnings forecasts incorporate information in accruals?

Xu, Weihong

Vol 49, Issue 3, 227-246 (2010)

Abstract: I investigate whether management earnings forecasts fully reflect the implications of accruals for future earnings. I find that managers overestimate accrual persistence in range forecasts but not in point forecasts and that managers' accrual-related forecast bias in range forecasts increases with forecast range and forecast horizon. My results suggest that managers overestimate accrual persistence when faced with greater difficulty forecasting earnings. Moreover, I find that managers' accrual-related forecast bias in range forecasts is somewhat affected by managerial opportunism and fear of litigation. Finally, I find accrual mispricing for firms issuing range forecasts but not for firms issuing point forecasts. [Copyright &y& Elsevier]

Corporate compensation policies and audit fees

Wysocki, Peter

Vol 49, Issue 1/2, 155-160 (2010)

Abstract: Recent accounting research has started to investigate the links between corporate compensation and auditor compensation. take a first step to connect these previously distinct literatures by investigating the association between audit committee pay and audit fees. I discuss the findings of this study and then present complementary empirical evidence on the association between CEO compensation and audit fees. My descriptive empirical evidence suggests economically large co-variation in CEO compensation and audit fees. I conclude with suggestions for future research on the links between firms' corporate compensation and auditor compensation policies. [Copyright &y& Elsevier]

Discussion of: "Acquisition profitability and timely loss recognition" by J. Francis and X. Martin

Roychowdhury, Sugata

Vol 49, Issue 1/2, 179-183 (2010)

Abstract: Francis and Martin (2009) test whether accounting conservatism induces managers to make better acquisition decisions. This discussion highlights three main issues. First, the hypothesized links between conservatism and future investments are potentially incomplete. In particular, the possibility that conservatism can have dysfunctional outcomes if acquisition decisions are based on anticipated earnings effects is ignored. Second, the evidence is insufficient to infer a causal relation between conservatism and acquisition profitability. Third, the hypothesis development fails to indicate whether timely loss recognition or the asymmetric timeliness of loss versus gain recognition is the more appropriate measure of conservatism given the context. [Copyright &y& Elsevier]

Accounting anomalies and fundamental analysis: A review of recent research advances

Richardson, Scott, Tuna, Irem, Wysocki, Peter

Vol 50, Issue 2/3, 410-454 (2010)

Abstract: We survey recent research in accounting anomalies and fundamental analysis. We use forecasting of future earnings and returns as our organizing framework and suggest a roadmap for research aiming to document the forecasting benefits of accounting information. We combine this with opinions from the academic and practitioner communities to critically evaluate key clusters of papers about accounting anomalies and fundamental analysis disseminated over the last decade. Finally, we provide a new analysis on how an ex ante and ex post treatment of risk and transaction costs affects the accrual and PEAD anomalies, and offer suggestions for future research. [ABSTRACT FROM AUTHOR]

Executive pay and "independent" compensation consultants

Murphy, Kevin J., Sandino, Tatiana

Vol 49, Issue 3, 247-262 (2010)

Abstract: Executive compensation consultants face potential conflicts of interest that can lead to higher recommended levels of CEO pay, including the desires to "cross-sell" services and to secure "repeat business." We find evidence in both the US and Canada that CEO pay is higher in companies where the consultant provides other services, and that pay is higher in Canadian firms when the fees paid to consultants for other services are large relative to the fees for executive-compensation services. Contrary to expectations, we find that pay is higher in US firms where the consultant works for the board rather than for management. [Copyright &y& Elsevier]

Materiality and voluntary disclosures

Lo, Kin

Vol 49, Issue 1/2, 133-135 (2010)

Abstract: Materiality has important implications for voluntary disclosures when there is an affirmative duty to disclose. Using a change in rules on the disclosure of advertising costs, empirically demonstrate that, indeed, it is important to factor in the effect of the materiality constraint on firms' disclosure behavior. This discussion reviews the contributions and limitations of . [Copyright &y& Elsevier]

Financial executive qualifications, financial executive turnover, and adverse SOX 404 opinions

Li, Chan, Sun, Lili, Ettredge, Michael

Vol 50, Issue 1, 93-110 (2010)

Abstract: This study attempts to provide a comprehensive understanding of the interrelationships among chief financial officers' (CFOs') professional qualifications, SOX Section 404 internal control weakness, CFOs' turnover, CFOs' qualification improvement, and correction of material weaknesses. We find that firms receiving initial adverse SOX 404 opinions for 2004 have less qualified CFOs. Adverse SOX 404 opinion recipients experience more CFO turnover in 2005, and these firms are more likely to hire CFOs having improved qualifications. Results show that simply hiring a new CFO is not associated with SOX 404 opinion improvement. Opinion improvement requires hiring a better qualified CFO. [Copyright &y& Elsevier]

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