Private lenders’ demand for audit

Discussion of "The impact of the options backdating scandal on shareholders" and "Taxes and the backdating of stock option exercise dates"

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Discussion of "The impact of the options backdating scandal on shareholders" and "Taxes and the backdating of stock option exercise dates"

Armstrong, Christopher S., Larcker, David F.

Vol 47, Issue 1/2, 50-58 (2009)

Abstract: Bernile and Jarrell provide extensive analysis regarding the impact of backdating the stock option exercise price on stock returns for a sample of firms identified by the Wall Street Journal. Dhaliwal, Erickson, and Heitzman investigate whether executives backdate the exercise date to obtain favorable tax consequences. This discussion comment focuses on several fundamental issues that confront researchers examining the backdating scandal and other related decisions. Specifically, we discuss the decision models for executives engaged in backdating and the potential role of social networks among directors, selection considerations, institutional voting behavior, and how backdated options can be replicated with existing equity instruments. [Copyright &y& Elsevier]

On the information role of stock recommendation revisions

Altinkilic, Oya, Hansen, Robert S.

Vol 48, Issue 1, 17-36 (2009)

Abstract: We examine the information transmission role of stock recommendation revisions by sell-side security analysts. Revisions are associated with economically insignificant mean price reactions and often piggyback on recent news, events, long-term momentum, and short-run contrarian return predictors, typically downgrading after bad news and upgrading after good news. However, the revisions are usually information-free for investors. The findings go against the long-standing view that recommendations are an important means by which analysts assimilate information into stock prices. They disagree with the view of policymakers that analysts' stock picks materially impact stock prices. [Copyright &y& Elsevier]

Peer firms in relative performance evaluation

Albuquerque, Ana

Vol 48, Issue 1, 69-89 (2009)

Abstract: Relative performance evaluation (RPE) in chief executive officer (CEO) compensation provides insurance against external shocks and yields a more informative measure of CEO actions. I argue that empirical evidence on the use of RPE is mixed because previous studies rely on a misspecified peer group. External shocks and flexibility in responding to the shocks are functions of, for example, the firm''s technology, the complexity of the organization, and the ability to access external credit, which depend on firm size. When peers are composed of similar industry-size firms, evidence is consistent with the use of RPE in CEO compensation. [Copyright &y& Elsevier]

Analyst responsiveness and the post-earnings-announcement drift

Zhang, Yuan

Vol 46, Issue 1, 201-215 (2008)

Abstract: This study examines the responsiveness of analyst forecasts to current earnings announcements. The results show considerable cross-sectional variation in analyst responsiveness and suggest that this variation is related to the costs and benefits associated with prompt forecast revisions. More importantly, this study finds that with responsive forecast revisions, more of the market reaction takes place in the event window and less in the drift window, suggesting that analyst responsiveness mitigates the post-earnings-announcement drift and facilitates market efficiency. [Copyright &y& Elsevier]

The contracting benefits of accounting conservatism to lenders and borrowers

Zhang, Jieying

Vol 45, Issue 1, 27-54 (2008)

This paper examines the ex post and ex ante benefits of accounting conservatism to lenders and borrowers in the debt contracting process. I expect conservatism to benefit lenders ex post through the timely signaling of default risk, as manifested by accelerated covenant violations, and to benefit borrowers ex ante through lower initial interest rates. Consistent with these predictions, I find that more conservative borrowers are more likely to violate debt covenants following a negative price shock, and that lenders offer lower interest rates to more conservative borrowers. [Copyright &y& Elsevier]

The role of information asymmetry and financial reporting quality in debt trading: Evidence from the secondary loan market

Wittenberg-Moerman, Regina

Vol 46, Issue 2/3, 240-260 (2008)

I explore which firm and loan characteristics decrease or exacerbate information asymmetry in the trading of private debt. I find that loans of public firms, loans with an available credit rating, loans of profit firms and loans syndicated by more reputable arrangers are traded at lower bid-ask spreads, while revolvers, distressed loans and loans issued by institutional investors are associated with higher information costs. I also find that timely loss recognition reduces the bid-ask spread. This finding suggests that conservative reporting decreases information asymmetry regarding a borrower and increases the efficiency of the secondary trading of debt securities. [Copyright &y& Elsevier]

State ownership, the institutional environment, and auditor choice: Evidence from China

Wang, Qian, Wong, T. J., Xia, Lijun

Vol 46, Issue 1, 112-134 (2008)

Abstract: This paper finds that compared with non-state-owned firms, Chinese state-owned enterprises controlled by province, city, and county governments (local SOEs) are more likely to hire small auditors within the same region (small local auditors). In regions with less developed institutions, SOEs controlled by central government (central SOEs) also have such a tendency. However, the tendency of local and central SOEs to hire small local auditors is attenuated as the institutions develop. This auditor choice pattern is likely to be explained by SOEs' lack of demand for large or non-local auditors, small local auditors' superior local knowledge, and SOEs' collusion incentives. [Copyright &y& Elsevier]

What's in a vote? The short- and long-run impact of dual-class equity on IPO firm values

Smart, Scott B., Thirumalai, Ramabhadran S., Zutter, Chad J.

Vol 45, Issue 1, 94-115 (2008)

We find that relative to fundamentals, dual-class firms trade at lower prices than do single-class firms, both at the IPO and for at least the subsequent 5 years. The lower prices attached to duals do not foreshadow abnormally low stock or accounting returns. Moreover, some types of CEO turnover are less frequent among duals, and in general CEO turnover is sensitive to firm performance for singles but not for duals. Finally, when duals unify their share classes, statistically and economically significant value gains occur. Collectively, our results suggest that the governance associated with dual-class equity influences the pricing of duals. [Copyright &y& Elsevier]

Discussion of "The implications of unverifiable fair-value accounting: Evidence from the political economy of goodwill accounting"

Skinner, Douglas J.

Vol 45, Issue 2/3, 282-288 (2008)

Abstract: Ramanna [2007. The implications of unverifiable fair-value accounting: evidence from the political economy of goodwill accounting, Journal of Accounting and Economics] provides interesting and novel evidence on how firms use contributions from their political action committees (PACs) to members of Congress as a means of lobbying for preferred positions on the two exposure drafts that led to SFAS-141 and SFAS-142. My discussion raises some concerns about his main conclusion: that pooling firms lobbied the FASB to obtain a "fair-value"-based impairment rule to facilitate their ability to manipulate financial statements. I offer a more benign explanation and make some other observations about how this line of research could proceed in the future. [Copyright &y& Elsevier]

The rise of deferred tax assets in Japan: The role of deferred tax accounting in the Japanese banking crisis

Skinner, Douglas J.

Vol 46, Issue 2/3, 218-239 (2008)

This paper provides evidence on the role of deferred taxes in the recent financial crisis among Japanese banks. Upon adoption of deferred tax accounting in the fiscal year 1998, the major Japanese banks recognized net deferred tax assets of Yen 6.6 trillion (AD -

Do accounting measurement regimes matter? A discussion of mark-to-market accounting and liquidity pricing

Sapra, Haresh

Vol 45, Issue 2/3, 379-387 (2008)

Abstract: Using a model with banking and insurance sectors, Allen and Carletti show that marking-to-market interacts with liquidity pricing to exacerbate the likelihood of financial contagion between the two sectors. In this discussion, I lay out the main ingredients of their model and explain how they interact with liquidity pricing to generate financial contagion. I then discuss some limitations of their model and propose an interesting extension. [Copyright &y& Elsevier]

Dynamic incentives and retirement

Sabac, Florin

Vol 46, Issue 1, 172-200 (2008)

Abstract: This paper examines multi-period compensation contracts when retirement is anticipated. Short-term contracts in long-term employment relationships are equivalent to a long-term renegotiation-proof contract. The dynamic of incentive rates is determined by (i) how and in which periods managerial effort affects the contractible performance measures; and by (ii) the time-series correlation of error terms in performance reports. The model explains why long-term investments can decrease while incentive rates increase as managers approach retirement. Earnings persistence is negatively associated to earnings-based incentive rates but, towards retirement, high earnings persistence implies increasing earnings-based incentive rates. [Copyright &y& Elsevier]

The effect of "invisible" tax preferences on investment and tax preference measures

Robinson, Leslie A., Sansing, Richard

Vol 46, Issue 2/3, 389-404 (2008)

This paper develops and analyzes a model in which tax considerations and financial reporting considerations have countervailing effects on a firm's investments in internally developed intangible assets. It also proposes and estimates a new measure of tax preferences, which we call the economic effective tax rate. This measure reflects both investments in intangible assets and the use of debt financing, neither of which generates a book-tax difference. Our measure indicates that the economic effective tax rate was about 18 percent between 1988 and 2005, when the statutory tax rate was either 34 or 35 percent. [Copyright &y& Elsevier]

The implications of unverifiable fair-value accounting: Evidence from the political economy of goodwill accounting

Ramanna, Karthik

Vol 45, Issue 2/3, 253-281 (2008)

Abstract: I study the evolution of SFAS 142, which uses unverifiable fair-value estimates to account for acquired goodwill. I find evidence consistent with the FASB issuing SFAS 142 in response to political pressure over its proposal to abolish pooling accounting. The result is interesting given this proposal was due in part to SEC concerns over pooling misuse. I also find evidence consistent with lobbying support for SFAS 142 increasing in firms' discretion under the standard. Agency theory predicts such unverifiable discretion can be used opportunistically. [Copyright &y& Elsevier]

The market reaction to Arthur Andersen's role in the Enron scandal: Loss of reputation or confounding effects?

Nelson, Karen K., Price, Richard A., Rountree, Brian R.

Vol 46, Issue 2/3, 279-293 (2008)

This paper tests the hypothesis that negative client stock returns following the revelation that Enron documents had been shredded are attributable to confounding effects as opposed to a loss of Andersen's reputation. We find that a sharp decline in oil prices along with differences in the industry composition of the Andersen and Big 4 client portfolios combine to produce significantly more negative returns for Andersen clients relative to Big 4 clients, and for Andersen's Houston office clients relative to its clients in other locations. The market reaction to two other Enron-related events also offers little support for a reputation effect. [Copyright &y& Elsevier]

Endogenous entry/exit as an alternative explanation for the disciplining role of independent analysts

Lys, Thomas Z., Sunder, Jayanthi

Vol 45, Issue 2/3, 317-323 (2008)

Abstract: Gu and Xue [2008. The superiority and disciplining role of independent analysts. Journal of Accounting and Economics, this issue, doi:10.1016/j.jacceco.2008.02.002] study the disciplining effect of independent analysts on the accuracy and forecast relevance of the forecasts of non-independent analysts. One of the intriguing results is that while independent analysts issue inferior forecasts, their presence appears to reduce the forecast bias, improve the forecast accuracy and increase the forecast relevance of forecasts issued by non-independent analysts. We explore alternative explanations for the Gu-Xue results. Our evidence of endogenous entry and exit of independent analysts provides a more compelling explanation for the reported results. [Copyright &y& Elsevier]

Earnings management and earnings quality

Lo, Kin

Vol 45, Issue 2/3, 350-357 (2008)

Abstract: Viewing the detection of earnings management from the perspective of a crime scene investigator sheds new light on prior research on earnings management and its close relative, earnings quality. The works of Ball and Shivakumar [2008. Earnings quality at initial public offerings. Journal of Accounting and Economics, in press.] and Teoh et al. [1998. Earnings management and the subsequent market performance of initial public offerings. Journal of Finance 53, 1935-1974.] are used to illustrate the application of seven components of a crime scene investigation to earnings management research. [Copyright &y& Elsevier]

Annual report readability, current earnings, and earnings persistence

Li, Feng

Vol 45, Issue 2/3, 221-247 (2008)

Abstract: This paper examines the relation between annual report readability and firm performance and earnings persistence. I measure the readability of public company annual reports using the Fog index from the computational linguistics literature and the length of the document. I find that: (1) the annual reports of firms with lower earnings are harder to read (i.e., they have a higher Fog index and are longer); and (2) firms with annual reports that are easier to read have more persistent positive earnings. [Copyright &y& Elsevier]

Why do firms go dark? Causes and economic consequences of voluntary SEC deregistrations

Leuz, Christian, Triantis, Alexander, Yue Wang, Tracy

Vol 45, Issue 2/3, 181-208 (2008)

Abstract: We examine a comprehensive sample of going-dark deregistrations where companies cease SEC reporting, but continue to trade publicly. We document a spike in going dark that is largely attributable to the Sarbanes-Oxley Act. Firms experience large negative abnormal returns when going dark. We find that many firms go dark due to poor future prospects, distress and increased compliance costs after SOX. But we also find evidence suggesting that controlling insiders take their firms dark to protect private control benefits and decrease outside scrutiny, particularly when governance and investor protection are weak. Finally, we show that going dark and going private are distinct economic events. [Copyright &y& Elsevier]

Voluntary disclosures and information production by analysts

Langberg, Nisan, Sivaramakrishnan, K.

Vol 46, Issue 1, 78-100 (2008)

Abstract: We analyze the voluntary disclosure decision of a manager when analysts scrutinize the quality of disclosure. We derive an equilibrium in which managers voluntarily disclose unfavorable information only if sufficiently precise, but disclose favorable news with lower levels of accuracy. We show that analysts cover good news disclosures with higher scrutiny. To the extent analysts rely on mandatory financial reports to interpret voluntary disclosures, we show that more precise financial reports may lead to more precise but less frequent voluntary disclosures. Moreover, a slant toward conservatism in financial reports can lead to less precise yet more frequent voluntary disclosures. [Copyright &y& Elsevier]

Are accruals mispriced? Evidence from tests of an Intertemporal Capital Asset Pricing Model

Khan, Mozaffar

Vol 45, Issue 1, 55-77 (2008)

This paper proposes a risk-based explanation for the accrual anomaly. Risk is measured using a four-factor model motivated by the Intertemporal Capital Asset Pricing Model. Tests of the model suggest that a considerable portion of the cross-sectional variation in average returns to high and low accrual firms is explained by risk. The four-factor model also performs better than some other widely used models in pricing a number of different hedge portfolios. [Copyright &y& Elsevier]

Effect of personal taxes on managers' decisions to sell their stock

Jin, Li, Kothari, S. P.

Vol 46, Issue 1, 23-46 (2008)

Abstract: We examine the effect of personal taxes on CEOs' decisions to sell their equity, controlling for diversification, managerial overconfidence, and other determinants. While CEOs frequently sell large amounts of their unrestricted firm equity, the tax burden associated with the sale significantly deters them from selling equity even after controlling for other determinants like diversification. We also find that both taxable institutional investors and CEOs respond to taxes in their selling of equity, although CEOs appear to be less tax-sensitive. Our findings underscore the importance of taxes in corporate and managerial decisions and they have implications for executive compensation policies. [Copyright &y& Elsevier]

The impact of the SEC's regulation of non-GAAP disclosures

Heflin, Frank, Hsu, Charles

Vol 46, Issue 2/3, 349-365 (2008)

Rules implemented by the U.S. Securities and Exchange Commission in 2003 impose additional disclosure and filing requirements on firms publicly disclosing non-generally accepted accounting principles (GAAP) earnings. We find the regulations produced (1) modest declines in the frequency of special- and other-item exclusions, (2) a decline in exclusion magnitude, (3) a modest decline in the probability disclosed earnings meet or beat forecasts, and (4) a decline in the association between returns and forecast errors. Our results suggest that, while the regulations reduced firms' use of non-GAAP disclosures to improve performance perceptions, they also reduced firms' willingness to use non-GAAP earnings to convey permanent earnings. [Copyright &y& Elsevier]

An unintended consequence of book-tax conformity: A loss of earnings informativeness

Hanlon, Michelle, Maydew, Edward L., Shevlin, Terry

Vol 46, Issue 2/3, 294-311 (2008)

Increasing the conformity between accounting earnings and taxable income has been proposed to improve financial reporting and curtail aggressive tax planning. We find, however, that increasing conformity results in earnings that are less informative. Our inquiry exploits a unique sample of firms forced to change from the cash method to the accrual method for tax purposes, thereby increasing their book-tax conformity. We find that these firms experienced a decrease in earnings informativeness compared to control firms unaffected by the change. To our knowledge, this is the first evidence of tax law changes affecting the informativeness of accounting earnings. [Copyright &y& Elsevier]

Performance standards and optimal incentives

Gutierrez Arnaiz, Oscar, Salas-Fumas, Vicente

Vol 45, Issue 1, 139-152 (2008)

This paper analyzes incentive design when agents' effort influences an uncertain output governed by a random process with semi-heavy tails. We find that the second-best incentive contract pays an output-increasing but bounded fee with a shape resembling performance-standard contracts that pay a fixed salary plus a capped bonus. In this contract, the pay-performance sensitivity around the standard increases (decreases) with the frequency with which performance is measured and with the kurtosis (volatility) parameter of the performance probability distribution. We also find that the optimal maximum bonus increases with volatility but decreases with the kurtosis parameter of the performance distribution. [Copyright &y& Elsevier]

Conservative financial reporting, debt covenants, and the agency costs of debt

Guay, Wayne R.

Vol 45, Issue 2/3, 175-180 (2008)

Abstract: Considerable research has documented the role of debt covenants and conservative financial accounting in addressing agency conflicts between lenders and borrowers. Beatty, A., Weber, J., and Yu, J. [2008. Conservatism and debt. Journal of Accounting and Economics, forthcoming] document interesting, but mixed, findings on the relation between debt covenants and conservative accounting, and the extent to which the two contracting mechanisms act as substitutes or complements. In this paper, I discuss the economic roles of financial reporting, debt covenants, and conservatism within the debt contracting environment, and attempt to fit BWY''s findings within this context. [Copyright &y& Elsevier]

The superiority and disciplining role of independent analysts

Gu, Zhaoyang, Xue, Jian

Vol 45, Issue 2/3, 289-316 (2008)

Abstract: We show that although forecasts of independent analysts are less accurate ex post, they yield forecast errors that are more strongly associated with abnormal stock returns. This suggests that forecasts of independent analysts are superior to those of nonindependent analysts in representing ex ante market expectations. We also show that forecasts of nonindependent analysts become more accurate and less biased, and produce forecast errors more strongly associated with abnormal stock returns when independent analysts are following the same firms than when they are not. This suggests that the presence of independent analysts disciplines the behavior of nonindependent analysts. [Copyright &y& Elsevier]

Using tax return data to simulate corporate marginal tax rates

Graham, John R., Mills, Lillian F.

Vol 46, Issue 2/3, 366-388 (2008)

We document that simulated corporate marginal tax rates based on financial statement data [Shevlin, T., 1990. Estimating corporate marginal tax rates with asymmetric tax treatment of gains and losses. The Journal of the American Taxation Association 11, 51-67; Graham, J., 1996a. Debt and the marginal tax rate. Journal of Financial Economics 41, 41-73] are highly correlated with simulated rates based on corporate tax return data. We provide algorithms that can be used to estimate the book or tax simulated rates when they are not available. We find that the simulated book marginal tax rate does a better job of explaining financial statement debt ratios than does the analogous tax return variable and discuss how the book-simulated rate is likely to be an appropriate measure in settings with global, long-term considerations. [Copyright &y& Elsevier]

Earnings management, lawsuits, and stock-for-stock acquirers' market performance

Gong, Guojin, Louis, Henock, Sun, Amy X.

Vol 46, Issue 1, 62-77 (2008)

Abstract: There is a positive association between stock-for-stock acquirers' pre-merger abnormal accruals and post-merger announcement lawsuits. The market only partially anticipates the effects of post-merger announcement lawsuits at the merger announcement and the post-merger announcement long-term market underperformance is largely limited to litigated acquisitions. Overall, the evidence suggests that it is important that investors not only undo the direct stock price effects of earnings management but also factor the contingent legal costs associated with earnings management. [Copyright &y& Elsevier]

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