Private lenders’ demand for audit

Economic consequences of increasing the conformity in accounting for uncertain tax benefits

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Economic consequences of increasing the conformity in accounting for uncertain tax benefits

Frischmann, Peter J., Shevlin, Terry, Wilson, Ryan

Vol 46, Issue 2/3, 261-278 (2008)

Commentary during the development of Financial Accounting Standards Board Interpretation no. 48 suggests the interpretation could be costly for firms because new disclosure requirements could be used by the IRS to more effectively challenge uncertain tax positions. Stock returns around FIN 48 pronouncements suggest investors were not concerned about an increase in tax costs, and investors responded favorably to initial disclosures required under FIN 48. However, we document a significant negative market reaction to subsequent news of a Senate inquiry into these disclosures consistent with investors revising their beliefs over the potential for additional tax costs. [Copyright &y& Elsevier]

The timing of industry and firm earnings information in security prices: A re-evaluation

Elgers, Pieter T., Porter, Susan L., Emily Xu, Le

Vol 45, Issue 1, 78-93 (2008)

This paper re-evaluates evidence in Ayers and Freeman [Ayers, F., Freeman, R., 1997. Market assessment of industry and firm earnings information. Journal of Accounting and Economics 24, 205-218] suggesting that investors anticipate industry-wide components of earnings earlier than firm-specific components, and that post-earnings-announcement drift following annual earnings announcements is due primarily to firm-specific components of earnings. Our tests indicate that post-announcement drift is entirely attributable to coefficient bias due to measurement errors in the use of realized earnings changes as proxies for unexpected earnings. Also, coefficient differences in the market''s anticipation of subsequent-year industry and firm-specific earnings become insignificant when we introduce suitable controls for non-linearity in the return/earnings relation. [Copyright &y& Elsevier]

A positive theory of flexibility in accounting standards

Dye, Ronald A., Sridhar, Sri S.

Vol 46, Issue 2/3, 312-333 (2008)

We develop a positive theory of accounting standards when standards generate network externalities and differ in the amount of reporting discretion, or flexibility, they provide firms. We evaluate expected value-maximizing firms' preferences between two standards regimes, rigid and flexible, as the number of firms subject to each standard varies, as the organization of the securities market varies, and as the mapping from the underlying economics of the firms' transactions to the accounting reports produced under the two standards vary. We also compare firms' preferences between the two regimes to the preferences of profit-maximizing traders in the firms' securities. [Copyright &y& Elsevier]

Do firms manage earnings to meet dividend thresholds?

Daniel, Naveen D., Denis, David J., Naveen, Lalitha

Vol 45, Issue 1, 2-26 (2008)

Dividend-paying firms tend to manage earnings upward when their earnings would otherwise fall short of expected dividend levels. This behavior is evident only in firms with positive debt and is more aggressive prior to the Sarbanes-Oxley Act, subsequent to the 2003 dividend tax cut, in high-payout firms, in firms whose CEOs receive higher dollar dividends and have higher pay-performance sensitivities, and in firms that raise less outside equity. Moreover, this earnings management behavior appears to significantly impact the likelihood of a dividend cut. Our findings imply that managers treat expected dividend levels as an important earnings threshold. [Copyright &y& Elsevier]

Is accruals quality a priced risk factor?

Core, John E., Guay, Wayne R., Verdi, Rodrigo

Vol 46, Issue 1, 2-22 (2008)

Abstract: In a recent and influential empirical paper, Francis, LaFond, Olsson, and Schipper (FLOS) [2005. The market pricing of accruals quality. Journal of Accounting and Economics 39, 295-327] conclude that accruals quality (AQ) is a priced risk factor. We explain that FLOS' regressions examining a contemporaneous relation between excess returns and factor returns do not test the hypothesis that AQ is a priced risk factor. We conduct appropriate asset-pricing tests for determining whether a potential risk factor explains expected returns, and find no evidence that AQ is a priced risk factor. [Copyright &y& Elsevier]

Disclosure policy: A discussion of Leuz, Triantis and Wang (2008) on "going dark"

Coles, Jeffrey L.

Vol 45, Issue 2/3, 209-220 (2008)

Abstract: LTW (2008) examine firms withdrawing from the SEC reporting system but continuing to trade on Pink Sheets. The paper finds that Sarbanes-Oxley increased the propensity of firms to go dark but, counter to conventional wisdom, had no significant effect on the rate of going-private transactions. Agency costs, as well as poor growth opportunities, proximity to financial distress, and increased compliance costs arising from SOX increase the propensity to go dark. Suggestions to improve the empirical implementation and interpretation involve including additional control and more suitable explanatory variables, and more attention to causation issues and to the quantification of economic significance. [Copyright &y& Elsevier]

Managerial legal liability coverage and earnings conservatism

Chung, Hyeesoo H., Wynn, Jinyoung P.

Vol 46, Issue 1, 135-153 (2008)

Abstract: This paper examines the effect of managerial legal liability coverage on earnings conservatism. Using directors' and officers' (D&O) liability insurance coverage and cash for indemnification as a proxy for managerial legal liability coverage, we find that the higher the managerial liability coverage, which reduces the expected legal liability of managers, the less conservative the firm''s earnings. We also find that managerial legal liability coverage has a stronger influence on earnings conservatism in a legal regime with higher litigation risk. Our results are consistent with the threat of litigation conditioning managers to practice conservative accounting. [Copyright &y& Elsevier]

Audit effort and earnings management

Caramanis, Constantinos, Lennox, Clive

Vol 45, Issue 1, 116-138 (2008)

We test the effect of audit effort on earnings management using a unique database of hours worked by auditors on 9,738 audits in Greece between 1994 and 2002. When audit hours are lower, (1) abnormal accruals are more often positive than negative, (2) positive abnormal accruals are larger, and (3) companies are more likely to manage earnings upwards in order to meet or beat the zero earnings benchmark. These results persist after we control for endogeneity between audit hours and earnings management. We conclude that low audit effort increases the extent to which managers are able to report aggressively high earnings. [Copyright &y& Elsevier]

Discussion of "Annual report readability, current earnings, and earnings persistence"

Bloomfield, Robert

Vol 45, Issue 2/3, 248-252 (2008)

Abstract: Li [2008. Annual report readability, current earnings, and earnings persistence. Journal of Accounting and Economics, this issue, doi:10.1016/j.jacceco.2008.02.003] finds that firms with losses, or with transient income, write annual reports with long sentences and big words. I begin by discussing some explanations for Li''s primary results, using his more detailed results, along with the results of related papers, to assess the plausibility of those explanations. I then briefly discuss the 10-K''s of a single company over the course of 3 years, to provide more detailed insight into what might drive the length and readability of annual reports. Finally, I present some possible directions for future research. [Copyright &y& Elsevier]

The role of tax regulation and compensation contracts in the decision to voluntarily expense employee stock options

Blacconiere, Walter G., Johnson, Marilyn F., Lewis, Melissa F.

Vol 46, Issue 1, 101-111 (2008)

Abstract: We show that firms with executive bonuses that qualify for deduction under Internal Revenue Code Section 162(m) were less likely to expense stock option compensation (SOC) in 2002. Additionally, the more likely it is that a qualified firm will incur re-contracting costs, the less likely it is that the firm will expense SOC. CEOs of qualified firms that also expense SOC receive smaller bonuses than CEOs of expensing firms that are not qualified under 162(m), and the lower 162(m) bonuses are not offset by higher SOC. Our results suggest that 162(m) tax incentives are an important determinant of the decision to expense SOC. [Copyright &y& Elsevier]

Financial analysts' forecast revisions and managers' reporting behavior

Beyer, Anne

Vol 46, Issue 2/3, 334-348 (2008)

This paper studies an analyst's forecasting strategy and a manager's earnings management policy. When reporting earnings, the manager trades off the disutility he obtains from falling short of the analyst's forecast against the costs of manipulating earnings. The model predicts that: (i) the analyst's forecast exceeds median reported earnings; (ii) the analyst is more likely to revise his forecast downward than upward; (iii) mean and median forecast errors are larger in magnitude when the analyst has less precise information; and (iv) the stock market is, on average, more sensitive to reported earnings than to the analyst's forecasts. [Copyright &y& Elsevier]

Conservatism and Debt

Beatty, Anne, Weber, Joseph, Yu, Jeff Jiewei

Vol 45, Issue 2/3, 154-174 (2008)

Abstract: Despite the unquestionable influence of conservatism, disagreement remains about what economic demands lead to financial reporting conservatism. Research examining lenders' demands for reporting conservatism has been questioned for ignoring conservative contract modifications. We document that these modifications exist but are not ubiquitous. We find contract modifications are more likely when agency costs are higher and litigation, tax and equity demands for conservatism are lower. However, we find a positive association between unexplained reporting conservatism and contract modifications, suggesting contractual modifications alone do not fulfill lenders' demands for conservatism. [Copyright &y& Elsevier]

Earnings quality at initial public offerings

Ball, Ray, Shivakumar, Lakshmanan

Vol 45, Issue 2/3, 324-349 (2008)

Abstract: We show that, contrary to popular belief, initial public offering (IPO) firms report more conservatively. We attribute this to the higher quality reporting demanded of public firms by financial statement users and consequentially higher monitoring by auditors, boards, analysts, rating agencies, press, and litigants, and to greater regulatory scrutiny [Ball, R., Shivakumar, L., 2005. Earnings quality in UK private firms: comparative loss recognition timeliness. Journal of Accounting and Economics 39, 83-128]. We also question the evidence of Teoh et al. [1998b. Earnings management and the subsequent market performance of initial public offerings. Journal of Finance 53, 1935-1974] supporting the alternative hypothesis that managers opportunistically inflate earnings to influence IPO pricing. We conjecture that upward-biased estimates of "discretionary" accruals occur in a broad genre of studies on earnings management around similar large transactions and events. [Copyright &y& Elsevier]

Mark-to-market accounting and liquidity pricing

Allen, Franklin, Carletti, Elena

Vol 45, Issue 2/3, 358-378 (2008)

Abstract: When liquidity plays an important role as in financial crises, asset prices may reflect the amount of liquidity available rather than the asset''s future earning power. Using market prices to assess financial institutions' solvency in such circumstances is not desirable. We show that a shock in the insurance sector can cause the current market value of banks' assets to fall below their liabilities so they are insolvent. In contrast, if values based on historic cost are used, banks can continue and meet all their future liabilities. We discuss the implications for the debate on mark-to-market versus historic cost accounting. [Copyright &y& Elsevier]

Institutional stakeholdings and better-informed traders at earnings announcements

Ali, Ashiq, Klasa, Sandy, Zhen Li, Oliver

Vol 46, Issue 1, 47-61 (2008)

Abstract: Utama and Cready [Utama, S., Cready, W.M., 1997. Institutional ownership, differential predisclosure precision and trading volume at announcement dates. Journal of Accounting and Economics 24, 129-150] use total institutional ownership to proxy for the proportion of better-informed traders, an important determinant of trading around earnings announcements. We argue that institutions holding small stakes cannot justify the fixed cost of developing private predisclosure information. Also, institutions with large stakes generally do not trade around earnings announcements since they are dedicated investors or face regulations that make informed trading difficult. However, institutions holding medium stakes have incentives to develop private predisclosure information and trade on it; we show that their ownership is a finer proxy for the proportion of better-informed traders at earnings announcements. [Copyright &y& Elsevier]

Do directors perform for pay?

Adams, Renee B., Ferreira, Daniel

Vol 46, Issue 1, 154-171 (2008)

Abstract: Many corporations reward their outside directors with a modest fee for each board meeting they attend. Using a large panel data set on director attendance behavior in publicly-listed firms for the period 1996-2003, we provide robust evidence that directors are less likely to have attendance problems at board meetings when board meeting fees are higher. This is surprising since meeting fees, on average roughly

Economic consequences of the Sarbanes-Oxley Act of 2002

Zhang, Ivy Xiying

Vol 44, Issue 1/2, 74-115 (2007)

This paper investigates the economic consequences of the Sarbanes-Oxley Act (SOX) by examining market reactions to related legislative events. Using concurrent stock returns of non-U.S.-traded foreign firms to estimate normal U.S. returns, I find that U.S. firms experienced a statistically significant negative cumulative abnormal return around key SOX events. I then examine the cross-sectional variation of U.S. firms' returns around these events. Regression results are consistent with the non-audit services and governance provisions imposing net costs. Additional tests show that deferring the compliance of Section 404, which mandates an internal control test, resulted in significant cost savings for non-accelerated filers. [Copyright &y& Elsevier]

Voluntary disclosure of information when firms are uncertain of investor response

Suijs, Jeroen

Vol 43, Issue 2/3, 391-410 (2007)

Abstract: A firm may prefer not to disclose its private information if it is uncertain of investor response. In the setting under consideration, a firm needs to acquire capital from an investor. The investor can choose to invest in the firm, the risk free asset or in some alternative risky investment opportunity. It is shown that in a partial disclosure equilibrium, the firm discloses average information and withholds bad and good information. Disclosure of average information arises to attract the investor''s capital away from the risk free asset. [Copyright &y& Elsevier]

Aggregate earnings, stock market returns and macroeconomic activity: A discussion of 'does earnings guidance affect market returns? The nature and information content of aggregate earnings guidance'

Shivakumar, Lakshmanan

Vol 44, Issue 1/2, 64-73 (2007)

Anilowski, Feng and Skinner (Journal of Accounting and Economics, 2006, this issue) examine the relationship between aggregate earnings guidance, aggregate earnings news and market returns. They provide evidence that changes in aggregate proportions of downward or upward earnings guidance are associated with aggregate earnings news and weakly associated with market returns. However, the study is unable to establish causality or the precise nature of the relationship between aggregate earnings guidance and market returns. To better understand the relationship, this paper analyzes the relation between aggregate earnings, stock market returns and the macroeconomy. The paper concludes with suggestions for future research. [Copyright &y& Elsevier]

Asymmetric timeliness of earnings, market-to-book and conservatism in financial reporting

Roychowdhury, Sugata, Watts, Ross L.

Vol 44, Issue 1/2, 2-31 (2007)

Using an accounting conservatism theory that reflects accounting's role in practice, we investigate the relation between two extensively used measures of conservatism: asymmetric timeliness of earnings and the market-to-book ratio (MTB). We predict and observe that when asymmetric timeliness is measured cumulatively over long periods, its relation with end-of-period MTB is positive. When asymmetric timeliness is measured over short periods, its dependence on beginning-of-period composition of equity value (EV) is responsible for its negative association with MTB. Further, asymmetric timeliness appears to measure conservatism more efficiently when it is estimated cumulatively over multiple periods. [Copyright &y& Elsevier]

Executive compensation and capital structure: The effects of convertible debt and straight debt on CEO pay

Ortiz-Molina, Hernan

Vol 43, Issue 1, 69-93 (2007)

I examine how CEO compensation is related to firms' capital structures. My tests address the simultaneity of these decisions and distinguish between debt types with different theoretical implications for managerial incentives. Pay-performance sensitivity decreases in straight-debt leverage, but is higher in firms with convertible debt. Furthermore, stock option policy is the component of CEO pay that is most sensitive to differences in capital structure. The results strongly support the hypothesis that firms trade-off shareholder-manager incentive alignment in order to mitigate shareholder-bondholder conflicts of interest. The hypothesis that debt reduces manager-shareholder conflicts can explain some but not all of the results. [Copyright &y& Elsevier]

Does the stock market underreact to going concern opinions? Evidence from the U.S. and Australia

Ogneva, Maria, Subramanyam, K. R.

Vol 43, Issue 2/3, 439-452 (2007)

Abstract: We examine 12-month returns following disclosure of first-time going concern (GC) opinions in the U.S. and Australia. We find no evidence of significant negative abnormal returns associated with GC opinions in Australia. In the U.S., negative abnormal returns subsequent to GC opinions are sensitive to choice of expected returns--notably, there are no significant negative abnormal returns when using factor models or after controlling for momentum. Overall, contrary to Taffler, Lu, Kausar''s [2004. In denial? Stock market underreaction to going-concern audit report disclosures. Journal of Accounting and Economics 38, 263-285.] U.K. results, we are unable to document a market anomaly in the U.S. or Australia associated with GC opinions. [Copyright &y& Elsevier]

Was the Sarbanes-Oxley Act of 2002 really this costly? A discussion of evidence from event returns and going-private decisions

Leuz, Christian

Vol 44, Issue 1/2, 146-165 (2007)

This paper discusses evidence on the costs of the Sarbanes-Oxley Act (SOX) from stock returns and going-private decisions. Zhang, [2007. Economic consequences of the Sarbanes-Oxley Act of 2002. Journal of Accounting and Economics, doi:10.1016/j.jacceco.2006.07.002] analyzes returns around legislative events and concludes that SOX imposes significant costs on firms. Engel, et al. [2007. The Sarbanes-Oxley Act and firms' going-private decisions. Journal of Accounting and Economics, doi:10.1016/j.jacceco.2007.02.002] examine going-private decisions and point to unintended consequences. Both studies are carefully conducted and deserve praise for tackling an important issue. However, as my discussion highlights, several key findings may not be attributable to SOX and we should exercise caution in interpreting the evidence. While it is not implausible that one-size-fits-all regulation imposes substantial costs on firms, we presently do not have much SOX-related evidence to support this conclusion. [Copyright &y& Elsevier]

Factors related to internal control disclosure: A discussion of Ashbaugh, Collins, and Kinney (2007) and Doyle, Ge, and McVay (2007)

Leone, Andrew J.

Vol 44, Issue 1/2, 224-237 (2007)

Ashbaugh, Collins, and Kinney, henceforth ACK, and Doyle, Ge, and McVay, henceforth DGM, provide the first evidence relating firm characteristics to internal control deficiencies (ICDs) reported under new disclosure requirements. Both studies document that control risk factors associated with organizational complexity and significant organizational change, as well as relative investment in internal control systems, are related to disclosure of internal control. ACK also test whether factors associated with incentives to discover and report ICDs affect disclosure of ICDs but this evidence is less compelling. I present alternative explanations and provide some descriptive evidence that is consistent with these alternative explanations. [Copyright &y& Elsevier]

Intra-year shifts in the earnings distribution and their implications for earnings management

Kerstein, Joseph, Rai, Atul

Vol 44, Issue 3, 399-419 (2007)

Abstract: Previous findings that upward earnings management causes a kink in the distribution of annual earnings cannot be verified without a well-specified benchmark for pre-managed annual earnings. We model shifts in the cumulative earnings distribution during the fourth quarter to explain the kink''s formation. Logistic regression results show that compared to a control group, a high proportion of firms with small cumulative profits or losses at the beginning of the fourth-quarter report small annual profits rather than small annual losses. This suggests that upward earnings management causes the kink and indicates which firms are likely to manage earnings upward. [Copyright &y& Elsevier]

Industry product market competition and managerial incentives

Karuna, Christo

Vol 43, Issue 2/3, 275-297 (2007)

Abstract: While some studies suggest that industry product market competition can substitute for managerial incentives, other studies suggest a complementary relation. The underlying assumption behind these studies is that competition can be uni-dimensionally proxied for by industry concentration. However, recent studies suggest that competition can reflect several dimensions: product substitutability, market size, and entry costs, given the level of industry concentration. Using these determinants of competition, this study contributes to the literature by showing that (a) firms provide stronger incentives when industry competition is greater, (b) competition is multi-dimensional in its relation to incentives; and (c) industry characteristics play a major role in influencing incentives. [Copyright &y& Elsevier]

Earnings management and accounting income aggregation

Jacob, John, Jorgensen, Bjorn N.

Vol 43, Issue 2/3, 369-390 (2007)

Abstract: Quarterly earnings allow aggregation into annual earnings in four different ways. Fiscal year earnings is one measure of annual earnings, the others being earnings for annual periods ending at interim quarter-ends. We investigate earnings management in fiscal year earnings relative to these alternative measures of firms' annual earnings. We confirm prior findings in Burgstahler and Dichev (1997. Earnings management to avoid earnings decreases and losses. Journal of Accounting and Economics 24, 99-126) of discontinuities around zero and prior year earnings in histograms of earnings. Subsequent research questions whether these discontinuities are evidence of earnings management. Using histograms of our alternative annual earnings measures, we offer evidence suggesting earnings management is responsible for the discontinuities. [Copyright &y& Elsevier]

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