Private lenders’ demand for audit

Accounting anomalies and fundamental analysis: An alternative view

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Accounting anomalies and fundamental analysis: An alternative view

Lewellen, Jonathan

Vol 50, Issue 2/3, 455-466 (2010)

Abstract: The literature on accounting anomalies and fundamental analysis provides important insights into the behavior of stock prices and the relation between accounting numbers and firm value. My review discusses five key topics from this literature: (1) discriminating between risk and mispricing explanations for return anomalies; (2) estimating the implied cost of capital; (3) inferring investors' perceptions of the earnings process; (4) understanding the importance of trading costs and firm size; and (5) improving the construction of characteristic-based trading strategies. My discussion highlights important challenges facing the literature and offers suggestions for improving empirical tests. [ABSTRACT FROM AUTHOR]

Auditing the auditors: Evidence on the recent reforms to the external monitoring of audit firms

Lennox, Clive, Pittman, Jeffrey

Vol 49, Issue 1/2, 84-103 (2010)

Abstract: This paper analyzes audit firm supervision since the Public Company Accounting Oversight Board (PCAOB) began conducting inspections. First, we find that audit clients do not perceive that the PCAOB''s inspection reports are valuable for signaling audit quality. Second, we document that the information content of peer review reports fell after they became narrower in scope with the initiation of PCAOB inspections. Third, we isolate that the signaling role of peer review reports mainly stems from information that PCAOB inspectors do not publicly disclose. Collectively, our evidence implies that less is known about audit firm quality under the new regulatory regime. [Copyright &y& Elsevier]

On the use of instrumental variables in accounting research

Larcker, David F., Rusticus, Tjomme O.

Vol 49, Issue 3, 186-205 (2010)

Abstract: Instrumental variable (IV) methods are commonly used in accounting research (e.g., earnings management, corporate governance, executive compensation, and disclosure research) when the regressor variables are endogenous. While IV estimation is the standard textbook solution to mitigating endogeneity problems, the appropriateness of IV methods in typical accounting research settings is not obvious. Drawing on recent advances in statistics and econometrics, we identify conditions under which IV methods are preferred to OLS estimates and propose a series of tests for research studies employing IV methods. We illustrate these ideas by examining the relation between corporate disclosure and the cost of capital. [Copyright &y& Elsevier]

Discussion of "Implications for GAAP from an analysis of positive research in accounting"

Lambert, Richard

Vol 50, Issue 2/3, 287-295 (2010)

Abstract: This paper discusses the paper "Implications for GAAP from an Analysis of Positive Research in Accounting," by . I discuss the role that information can play in efficiently allocating capital in the economy, and I argue that the GAAP is not primarily designed with the objective of addressing "control" issues, i.e., resolving contracting problems between shareholders and managers or between shareholders and bondholders. I also discuss the impact that conservatism has on the properties of accounting numbers, and on how it affects the usefulness of these numbers in managerial incentive contracts and in contracts with bondholders. [ABSTRACT FROM AUTHOR]

The federal deposit insurance corporation improvement act, bank internal controls and financial reporting quality

LaFond, Ryan, You, Haifeng

Vol 49, Issue 1/2, 75-83 (2010)

Abstract: examine financial reporting quality before and after the Federal Deposit Insurance Corporation Improvement Act (FDICIA). They document increases in the validity of the loan-loss provision, earnings persistence, predictability of future cash flows and reductions in benchmark-beating for banks complying with FDIC''s internal control regulations relative to non-complying banks. Our discussion focuses on Altamuro and Beatty''s interpretation of the results, specifically that the internal control provision of FDICIA improved financial reporting quality. In this paper, we provide a brief overview of FDICIA in an attempt to assess the importance of FDIC''s internal control regulations. We then review the findings of other studies on internal control regulations with the goal of evaluating what new insights we gain from Altamuro and Beatty. Next, we report new evidence relating to the sub-groups driving the changes in financial reporting quality surrounding the FDICIA. Finally, we discuss the results in the context of the current financial crisis and suggest avenues for future research. [Copyright &y& Elsevier]

Implications for GAAP from an analysis of positive research in accounting

Kothari, S. P., Ramanna, Karthik, Skinner, Douglas J.

Vol 50, Issue 2/3, 246-286 (2010)

Abstract: Based on extant literature, we review the positive theory of GAAP. The theory predicts that GAAP's principal focus is on control (performance measurement and stewardship) and that verifiability and conservatism are critical features of a GAAP shaped by market forces. We recognize the advantage of using fair values in circumstances where these are based on observable prices in liquid secondary markets, but caution against expanding fair values to financial reporting more generally. We conclude that rather than converging U.S. GAAP with IFRS, competition between the FASB and the IASB would allow GAAP to better respond to market forces. [ABSTRACT FROM AUTHOR]

Market demand for conservative analysts

Hugon, Artur, Muslu, Volkan

Vol 50, Issue 1, 42-57 (2010)

Abstract: Sell-side analysts, on balance, have incentives to emphasize good company news and downplay the bad, resulting in inefficient forecasts. We conjecture that this behavior generates a demand for forecasts from conservative analysts who unwind this pattern, at least in part, resulting in more efficient forecasts. To investigate, we introduce a measure of analyst conservatism and assess the market reaction to analysts' forecast revisions conditioned on their past levels of conservatism. We find a stronger market reaction to forecast revisions by more conservative analysts, and that this result is heightened for companies with greater institutional investor following. [Copyright &y& Elsevier]

The joint effects of materiality thresholds and voluntary disclosure incentives on firms' disclosure decisions

Heitzman, Shane, Wasley, Charles, Zimmerman, Jerold

Vol 49, Issue 1/2, 109-132 (2010)

Abstract: Under GAAP, SEC and exchange listing rules, managers must disclose material information. We construct a disclosure specification incorporating managers' obligation to disclose material information and voluntary disclosure incentives. We demonstrate that tests of the incentives to voluntarily disclose information must recognize such information is often disclosed because of an underlying duty to disclose. Our empirical tests isolating the impact of materiality on firms' disclosures have greater explanatory power over empirical tests that do not. Voluntary disclosure incentives better explain disclosure when the information is less likely to be material. Tests of voluntary disclosure theories ignoring materiality likely lead to incorrect inferences. [Copyright &y& Elsevier]

A review of tax research

Hanlon, Michelle, Heitzman, Shane

Vol 50, Issue 2/3, 127-178 (2010)

Abstract: In this paper, we present a review of tax research. We survey four main areas of the literature: (1) the informational role of income tax expense reported for financial accounting, (2) corporate tax avoidance, (3) corporate decision-making including investment, capital structure, and organizational form, and (4) taxes and asset pricing. We summarize the research areas and questions examined to date and what we have learned or not learned from the work completed thus far. In addition, we provide our opinion as to the interesting and important issues for future research. [ABSTRACT FROM AUTHOR]

Acquisition profitability and timely loss recognition

Francis, Jere R., Martin, Xiumin

Vol 49, Issue 1/2, 161-178 (2010)

Abstract: We investigate if timely loss recognition is associated with acquisition-investment decisions. Using a piece-wise linear regression model, we find that firms with more timely incorporation of economic losses into earnings make more profitable acquisitions, measured by the bidder''s announcement returns and by changes in post-acquisition operating performance. These firms are also less likely to make post-acquisition divestitures (consistent with better ex ante investment decisions), but act more quickly to divest. We also find that the positive association between timely loss recognition and acquisition profitability is more pronounced for firms with higher ex ante agency costs. [Copyright &y& Elsevier]

Audit committee compensation and the demand for monitoring of the financial reporting process

Engel, Ellen, Hayes, Rachel M., Wang, Xue

Vol 49, Issue 1/2, 136-154 (2010)

Abstract: We examine the relation between audit committee compensation and the demand for monitoring of the financial reporting process. We find that total compensation and cash retainers paid to audit committees are positively correlated with audit fees and the impact of the Sarbanes-Oxley Act, our proxies for the demand for monitoring. Our results are robust to the inclusion of audit committee quality, measured as the committee chair financial expertise. Our results suggest a recent willingness by firms to deviate from the historically prevalent one-size-fits-all approach to director pay in response to increased demands on audit committees and differential director expertise. [Copyright &y& Elsevier]

The chilling effect of Sarbanes-Oxley: A discussion of Sarbanes-Oxley and corporate risk-taking

Dey, Aiyesha

Vol 49, Issue 1/2, 53-57 (2010)

Abstract: Bargeron, Lehn, and Zutter [2009. Sarbanes-Oxley and corporate risk-taking. Journal of Accounting and Economics, forthcoming] document that as compared with non-US firms, risk-taking by publicly traded companies in the US declined after the passage of the Sarbanes-Oxley Act in 2002 (SOX). They conclude that this decline is related to board structure, firm size, and research and development expenditures. In my view, Bargeron, Lehn, and Zutter tackle an important question and provide carefully conducted analyses. However, as my discussion highlights, the question is difficult to answer, and as in similar studies on SOX, the evidence needs to be interpreted with caution. [Copyright &y& Elsevier]

How should the auditors be audited? Comparing the PCAOB Inspections with the AICPA Peer Reviews

DeFond, Mark L.

Vol 49, Issue 1/2, 104-108 (2010)

Abstract: In their investigation of the new PCAOB Inspections, Lennox and Pittman [Lennox, C., Pittman, J., 2009. Auditing the auditors: evidence on the recent reforms to the external monitoring of the audit firms. Journal of Accounting and Economics, forthcoming] address one of the most important and controversial features of the recent shift from self-regulation to government regulation in the US audit markets. In this paper I attempt to place their investigations into the broader auditing and regulatory literature, critique what we learn and do not learn from their analysis, and make suggestions for future related research. [Copyright &y& Elsevier]

Earnings quality research: Advances, challenges and future research

DeFond, Mark L.

Vol 50, Issue 2/3, 402-409 (2010)

Abstract: This discussion makes several observations regarding the earnings quality research reviewed in (DGS). I discuss some of the factors that led to the large growth in the earnings quality literature over the past two decades, and note a few of the important contributions from this literature. I also present what I view as several major challenges the literature faces as well as some avenues for future research. In addition, I discuss the difficulties in evaluating such a diverse body of literature, and comment on DGS's major conclusions. [ABSTRACT FROM AUTHOR]

Fair value accounting and gains from asset securitizations: A convenient earnings management tool with compensation side-benefits

Dechow, Patricia M., Myers, Linda A., Shakespeare, Catherine

Vol 49, Issue 1/2, 2-25 (2010)

Abstract: Accounting rules for valuing retained interest from securitizations require management to make assumptions concerning discount rates, default rates, and prepayment rates. These assumptions provide management with discretion to determine the "gain on sale" of the receivables. We investigate whether CEO compensation is less sensitive to securitization gains than to other earnings components in the presence of proxies for how independent (outsiders, females, fewer CEO-selected directors) and informed (financial expertise) directors are. Overall, our results do not suggest that better "monitoring" reduces earnings management or CEO pay-sensitivity to reported securitization gains. Our results suggest that CEOs are rewarded for the gains they report and boards do not intervene. [Copyright &y& Elsevier]

Understanding earnings quality: A review of the proxies, their determinants and their consequences

Dechow, Patricia, Ge, Weili, Schrand, Catherine

Vol 50, Issue 2/3, 344-401 (2010)

Abstract: Researchers have used various measures as indications of "earnings quality" including persistence, accruals, smoothness, timeliness, loss avoidance, investor responsiveness, and external indicators such as restatements and SEC enforcement releases. For each measure, we discuss causes of variation in the measure as well as consequences. We reach no single conclusion on what earnings quality is because "quality" is contingent on the decision context. We also point out that the "quality" of earnings is a function of the firm's fundamental performance. The contribution of a firm's fundamental performance to its earnings quality is suggested as one area for future work. [ABSTRACT FROM AUTHOR]

Accrual-based and real earnings management activities around seasoned equity offerings

Cohen, Daniel A., Zarowin, Paul

Vol 50, Issue 1, 2-19 (2010)

Abstract: We show that SEO firms engage in real activities manipulation, and the decline in post-SEO performance due to the real activities management is more severe than that due to accrual management. Our evidence is important, because it shows that post-SEO operating underperformance is driven not just by accrual reversals, but also reflects the real consequences of operational decisions made to manage earnings. We also show how firms' choices of real versus accrual-based earnings management activities around SEOs vary predictably as a function of the firm''s ability to use accrual management and the costs of doing so. [Copyright &y& Elsevier]

On the relationship between analyst reports and corporate disclosures: Exploring the roles of information discovery and interpretation

Chen, Xia, Cheng, Qiang, Lo, Kin

Vol 49, Issue 3, 206-226 (2010)

Abstract: We examine the relationship between analyst research and corporate earnings announcements to explore the relative importance of information discovery versus interpretation of previously released information. Using equity market reaction to capture information content, we find that information discovery (interpretation) dominates in the week before (after) firms announce their earnings. In addition, we find that the interpretation role increases in importance with the difficulty of financial accounting information. Analysis of all weeks surrounding earnings announcements shows that the information discovery role is overall more important. We are able to reconcile this result with the opposite finding in . [Copyright &y& Elsevier]

Will a departure from tax-based accounting encourage tax noncompliance? Archival evidence from a transition economy

Chan, K. Hung, Lin, Kenny Z., Mo, Phyllis L. L.

Vol 50, Issue 1, 58-73 (2010)

Abstract: We investigate whether a departure from a tax-based accounting system toward the adoption of International Financial Reporting Standards encourages tax noncompliance. We also examine whether such a departure, which weakens book-tax conformity, affects the informativeness of book-tax differences for tax noncompliance. Our evidence suggests that as book-tax conformity decreases, tax noncompliance increases. Although book-tax differences remain informative of tax noncompliance, the informativeness attenuates as book-tax conformity weakens. Additionally, firms with high incentives to inflate book income are more tax compliant than their counterparts after the departure from a tax-based accounting system. [Copyright &y& Elsevier]

The incentives of compensation consultants and CEO pay

Cadman, Brian, Carter, Mary Ellen, Hillegeist, Stephen

Vol 49, Issue 3, 263-280 (2010)

Abstract: We examine whether compensation consultants' potential cross-selling incentives explain more lucrative CEO pay packages using 755 firms from the S&P 1500 for 2006. Critics allege that these incentives lead consultants to bias their advice to secure greater revenues from their clients [Waxman, H., 2007. Executive pay: conflicts of interest among compensation consultants. United States House of Representatives Committee on Oversight and Government Reform Majority Staff, December]. Among firms that retain consultants, we are unable to find widespread evidence of higher levels of pay or lower pay-performance sensitivities for clients of consultants with potentially greater conflicts of interest. Overall, we do not find evidence suggesting that potential conflicts of interest between the firm and its consultant are a primary driver of excessive CEO pay. [Copyright &y& Elsevier]

Corporate governance myths: Comments on Armstrong, Guay, and Weber

Brickley, James A., Zimmerman, Jerold L.

Vol 50, Issue 2/3, 235-245 (2010)

Abstract: This paper argues that academics, politicians, and the media have six commonly held but misguided beliefs about corporate governance. While discuss some of these misconceptions, a wider recognition that these beliefs are actually "myths" is important. They include: (1) a common definition of "corporate governance" exists; (2) a useful distinction is "internal" versus "external" governance mechanisms; (3) outside directors perform two separable roles: to advise and monitor managers; (4) research has identified "good" and "bad" governance practices; (5) a "good" governance index can be constructed; and (6) corporate governance "best practices" can be deduced from peer data. [ABSTRACT FROM AUTHOR]

The financial reporting environment: Review of the recent literature

Beyer, Anne, Cohen, Daniel A., Lys, Thomas Z., Walther, Beverly R.

Vol 50, Issue 2/3, 296-343 (2010)

Abstract: The corporate information environment develops endogenously as a consequence of information asymmetries and agency problems between investors, entrepreneurs, and managers. We review current research on the three main decisions that shape the corporate information environment in capital market settings: (1) managers' voluntary disclosure decisions, (2) disclosures mandated by regulators, and (3) reporting decisions by analysts. We conclude that, in the last ten years, research has generated several useful insights. Despite this progress, we call for researchers to consider interdependencies between the various decisions that shape the corporate information environment and suggest new and interesting issues for researchers to address. [ABSTRACT FROM AUTHOR]

In defense of fair value: Weighing the evidence on earnings management and asset securitizations

Barth, Mary, Taylor, Daniel

Vol 49, Issue 1/2, 26-33 (2010)

Abstract: Dechow, Myers, and Shakespeare (DMS, 2009) find a negative relation between income from securitization activities and income from non-securitization activities. DMS interprets this finding as indicating that managers use the flexibility available in fair value accounting rules to smooth earnings. We clarify the role of fair value in accounting for asset securitizations, discuss alternative explanations for the evidence presented in DMS, and offer suggestions for future research. We caution against inferring the desirability of any particular accounting method from earnings management research. [Copyright &y& Elsevier]

Sarbanes-Oxley and corporate risk-taking

Bargeron, Leonce L., Lehn, Kenneth M., Zutter, Chad J.

Vol 49, Issue 1/2, 34-52 (2010)

Abstract: We empirically examine whether risk-taking by publicly traded US companies declined significantly after adoption of the Sarbanes-Oxley Act of 2002 (SOX). Several provisions of SOX are likely to discourage risk-taking, including an expanded role for independent directors, an increase in director and officer liability, and rules related to internal controls. We find several measures of risk-taking decline significantly for US versus non-US firms after SOX. The magnitudes of the declines are related to several firm characteristics, including pre-SOX board structure, firm size, and R&D expenditures. The evidence is consistent with the proposition that SOX discourages risk-taking by public US companies. [Copyright &y& Elsevier]

Post loss/profit announcement drift

Balakrishnan, Karthik, Bartov, Eli, Faurel, Lucile

Vol 50, Issue 1, 20-41 (2010)

Abstract: We document a market failure to fully respond to loss/profit quarterly announcements. The annualized post portfolio formation return spread between two portfolios formed on extreme losses and extreme profits is approximately 21 percent. This loss/profit anomaly is incremental to previously documented accounting-related anomalies, and is robust to alternative risk adjustments, distress risk, firm size, short sales constraints, transaction costs, and sample periods. In an effort to explain this finding, we show that this mispricing is related to differences between conditional and unconditional probabilities of losses/profits, as if stock prices do not fully reflect conditional probabilities in a timely fashion. [Copyright &y& Elsevier]

Book-tax conformity, earnings persistence and the association between earnings and future cash flows

Atwood, T. J., Drake, Michael S., Myers, Linda A.

Vol 50, Issue 1, 111-125 (2010)

Abstract: Calls for eliminating differences between accounting earnings and taxable income in the US have been debated extensively. Proponents of increased book-tax conformity argue that tax compliance will increase and earnings quality will improve. Opponents argue that earnings quality will decline. We examine whether the level of required book-tax conformity affects earnings persistence and the association between earnings and future cash flows. We develop a comprehensive book-tax conformity measure and find that earnings have lower persistence and a lower association with future cash flows when conformity is higher. Our evidence suggests that increased book-tax conformity may reduce earnings quality. [Copyright &y& Elsevier]

The role of information and financial reporting in corporate governance and debt contracting

Armstrong, Christopher S., Guay, Wayne R., Weber, Joseph P.

Vol 50, Issue 2/3, 179-234 (2010)

Abstract: We review recent literature on the role of financial reporting transparency in reducing governance-related agency conflicts among managers, directors, and shareholders, as well as in reducing agency conflicts between shareholders and creditors, and offer researchers some suggested avenues for future research. Key themes include the endogenous nature of debt contracts and governance mechanisms with respect to information asymmetry between contracting parties, the heterogeneous nature of the informational demands of contracting parties, and the heterogeneous nature of the resulting governance and debt contracts. We also emphasize the role of a commitment to financial reporting transparency in facilitating informal multiperiod contracts among managers, directors, shareholders, and creditors. [ABSTRACT FROM AUTHOR]

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