Abstract: This paper formalizes a two-step representation of accounting measurement and uses it to formalize a general rationale for conservatism as a measurement principle. A transaction''s economic substance manifests itself in characteristics of the transaction, and an accounting rule is a mapping from transaction characteristics to an accounting report. Managers who have stakes in the accounting report are able to influence transaction characteristics. Such earnings management is ex post rational for managers but ex ante inefficient. To safeguard against such ex post opportunism, the optimal ex ante accounting rule is conservative in the sense that it requires more verification of the transaction characteristics favorable to managers. Thus, this rationale for conservatism is as general as the managers'' ability and incentive to inflate transaction characteristics. By opening the black box of accounting measurement, the two-step representation also formalizes some classic accounting concepts, such as relevance, reliability, verifiability, verification, and accounting-motivated transactions. [Copyright &y& Elsevier]
Estimation sample selection for discretionary accruals models
Abstract: We examine how the criteria for choosing estimation samples affect the ability to detect discretionary accruals, using several variants of the Jones (1991) model. Researchers commonly estimate accruals models in cross-section, and define the estimation sample as all firms in the same industry. We examine whether firm size performs at least as well as industry membership as the criterion for selecting estimation samples. For U.S. data, we find estimation samples based on similarity in lagged assets perform at least as well as estimation samples based on industry membership at detecting discretionary accruals, both in simulations with seeded accruals between 2% and 100% of total assets and in tests examining restatement data and AAER data. For non-U.S. data, we find industry-based estimation samples result in significant sample attrition and estimation samples based on lagged assets perform at least as well as estimation samples based on industry membership, both in simulations and in tests examining German restatement data, with substantially less sample attrition. [Copyright &y& Elsevier]
Do managers define non-GAAP earnings to meet or beat analyst forecasts?
Doyle, Jeffrey T., Jennings, Jared N., Soliman, Mark T.
Vol 56, Issue 1, 40-56 (2013)
Abstract: We provide evidence consistent with firm managers opportunistically defining non-GAAP earnings in order to meet or beat analyst expectations. This result is robust to controlling for other tools of benchmark beating (e.g., discretionary accruals, real earnings management, and expectation management). We also find that managers tend to exclude more expenses from non-GAAP earnings when it is costlier to use accrual earnings management due to balance sheet constraints, indicating that these tools are substitutes. Lastly, we find that investors discount positive earnings surprises when accompanied by exclusions from GAAP earnings, suggesting that the market partially understands the opportunistic nature of these exclusions. Our evidence is consistent with managers opportunistically defining non-GAAP earnings in a way that analysts fail to fully anticipate, resulting in an increased likelihood of exceeding analyst forecasts. [Copyright &y& Elsevier]
Insider trading restrictions and top executive compensation
Denis, David J., Xu, Jin
Vol 56, Issue 1, 91-112 (2013)
Abstract: The use of equity incentives is significantly greater in countries with stronger insider trading restrictions, and these higher incentives are associated with higher total pay. These findings are robust to alternative definitions of insider trading restrictions and enforcement, and to panel regressions with country fixed effects. We also find significant increases in top executive pay and the use of equity-based incentives in the period immediately following the initial enforcement of insider trading laws. We conclude that insider trading laws are one channel through which cross-country differences in pay practices can be explained. [Copyright &y& Elsevier]
Mitigating incentive conflicts in inter-firm relationships: Evidence from long-term supply contracts
Costello, Anna M.
Vol 56, Issue 1, 19-39 (2013)
Abstract: Using a sample of long-term supply contracts collected from SEC filings, I show that hold-up concerns and information asymmetry are important determinants of contract design. Asymmetric information between buyers and suppliers leads to shorter term contracts. However, when longer duration contracts facilitate the exchange of relationship specific assets, the parties substitute short-term contracts with financial covenants in order to reduce moral hazard. Covenant restrictions are more prevalent when direct monitoring is costly and the products exchanged are highly specific. Finally, I find that buyers and suppliers are less likely to rely on financial covenants when financial statement reliability is low. [Copyright &y& Elsevier]
Preannouncing competitive decisions in oligopoly markets
Corona, Carlos, Nan, Lin
Vol 56, Issue 1, 73-90 (2013)
Abstract: We examine a duopolistic setting in which firms can preannounce their future competitive decisions before they actually implement them. We show that there is a unique equilibrium in which both firms preannounce and overstate their future actions when uncertainty of demand is low. We find that firms choose higher real actions than the ones they would choose in the absence of preannouncements. Moreover, the real actions of both firms are single-peaked functions of their credibility. In a Cournot market, firms face a prisoner's dilemma in which preannouncing lowers firms' profits. If firms could commit not to preannounce, they would remain silent. In a Bertrand market, firms overstate their future actions to foster collusion. [Copyright &y& Elsevier]
Personally tax aggressive executives and corporate tax sheltering
Chyz, James A.
Vol 56, Issue 2/3, 311-328 (2013)
Abstract: This paper investigates whether executives who evidence a propensity for personal tax evasion (suspect executives) are associated with tax sheltering at the firm level. I adapt recent research to identify the presence of these executives and examine associations between suspect executive presence and firm-level measures of tax sheltering. The results indicate that the presence of suspect executives is positively associated with proxies for corporate tax sheltering. In addition, firm-years with suspect executive presence have significantly higher cash tax savings relative to firm-years without suspect executive presence. I also investigate the firm value implications of suspect executive presence and find that increases in tax sheltering are incrementally more valuable for firms that have suspect executives than similar increments made by firms that do not have suspect executives. [Copyright &y& Elsevier]
Assessing methods of identifying management forecasts: CIG vs. researcher collected
Chuk, Elizabeth, Matsumoto, Dawn, Miller, Gregory S.
Vol 55, Issue 1, 23-42 (2013)
Abstract: This paper examines the characteristics of management forecasts available on Thomson First Call's Company Issued Guidance (CIG) database relative to a sample of forecasts hand-collected through a search of company press releases. Due to the significantly lower cost of using CIG (relative to hand-collecting data), academics have increasingly relied on this database as a source of management forecasts. However, it is important for researchers to consider the properties of this database (such as coverage, accuracy, and breadth) when evaluating whether it is an appropriate data source for their study. Overall, our results suggest systematic differences between forecasts reported on CIG and forecasts gathered from company press releases. We suggest several sample criteria that will remove or mitigate these biases. [Copyright &y& Elsevier]
Does investment efficiency improve after the disclosure of material weaknesses in internal control over financial reporting?
Cheng, Mei, Dhaliwal, Dan, Zhang, Yuan
Vol 56, Issue 1, 1-18 (2013)
Abstract: We provide more direct evidence on the causal relation between the quality of financial reporting and investment efficiency. We examine the investment behavior of a sample of firms that disclosed internal control weaknesses under the Sarbanes-Oxley Act. We find that prior to the disclosure, these firms under-invest (over-invest) when they are financially constrained (unconstrained). More importantly, we find that after the disclosure, these firms' investment efficiency improves significantly. [Copyright &y& Elsevier]
The spillover effect of fraudulent financial reporting on peer firms' investments
Beatty, Anne, Liao, Scott, Yu, Jeff Jiewei
Vol 55, Issue 2/3, 183-205 (2013)
Abstract: We investigate how high-profile accounting frauds affect peer firms'' investment. We document that peers react to the fraudulent reports by increasing investment during fraud periods. We show that this finding is not driven by frauds that have a higher ex ante likelihood of detection or by an association between fraud and investment booms. In addition, we find that peers' investments increase in fraudulent earnings overstatements, and in industries with higher investor sentiment, lower cost of capital and higher private benefits of control. We also find evidence consistent with equity analysts potentially facilitating the spillover effect. [Copyright &y& Elsevier]
Barth, Mary E., Konchitchki, Yaniv, Landsman, Wayne R.
Vol 55, Issue 2/3, 206-224 (2013)
Abstract: We provide evidence that firms with more transparent earnings enjoy a lower cost of capital. We base our earnings transparency measure on the extent to which earnings and change in earnings covary contemporaneously with returns. We find a significant negative relation between our transparency measure and subsequent excess and portfolio mean returns, and expected cost of capital, even after controlling for previously documented determinants of cost of capital. [Copyright &y& Elsevier]
Employment protection legislation, adjustment costs and cross-country differences in cost behavior
Banker, Rajiv D., Byzalov, Dmitri, Chen, Lei
Vol 55, Issue 1, 111-127 (2013)
Abstract: Central to the economic theory of sticky costs is the proposition that managers consider adjustment costs when changing resource levels. We test this proposition using employment protection legislation (EPL) provisions in different countries as a proxy for labor adjustment costs. Using a large sample of firms in 19 OECD countries during 1990-2008, we find that the degree of cost stickiness at the firm level varies with the strictness of the country-level EPL provisions. This finding supports the theory that cost stickiness reflects the deliberate resource commitment decisions of managers in the presence of adjustment costs. [Copyright &y& Elsevier]
The separation of ownership and control and corporate tax avoidance
Badertscher, Brad A., Katz, Sharon P., Rego, Sonja O.
Vol 56, Issue 2/3, 228-250 (2013)
Abstract: We examine whether variation in the separation of ownership and control influences the tax practices of private firms with different ownership structures. Fama and Jensen (1983) assert that when equity ownership and corporate decision-making are concentrated in just a small number of decision-makers, these owner-managers will likely be more risk averse and thus less willing to invest in risky projects. Because tax avoidance is a risky activity that can impose significant costs on a firm, we predict that firms with greater concentrations of ownership and control, and thus more risk averse managers, avoid less income tax than firms with less concentrated ownership and control. Our results are consistent with these expectations. However, we also consider a competing explanation for these findings. In particular, we examine whether certain private firms enjoy lower marginal costs of tax planning, which facilitate greater income tax avoidance. Our results are consistent with the marginal costs of tax avoidance and the separation of ownership and control both influencing corporate tax practices. [Copyright &y& Elsevier]
Accounting restatements, governance and municipal debt financing
Baber, William R., Gore, Angela K., Rich, Kevin T., Zhang, Jean X.
Vol 56, Issue 2/3, 212-227 (2013)
Abstract: We find that mean municipal debt costs are greater following financial restatement disclosures. Comparisons of the relative use of municipal debt, and of the use of unsecured versus secured debt, corroborate that financial restatements increase the cost of municipal debt financing. Additional analyses indicate that adverse consequences of restatements are mitigated by strong audit oversight and by provisions that encourage direct voter participation in the governance process. The evidence supports the use of restatements as a summary measure of financial reporting quality in the municipal context and informs thinking about auditor and voter oversight in the municipal financial reporting process. [Copyright &y& Elsevier]
Discretionary disclosure in the presence of dual distribution channels
Arya, Anil, Mittendorf, Brian
Vol 55, Issue 2/3, 168-182 (2013)
Abstract: A prevailing view in the disclosure literature is that firms who learn favorable market information are reluctant to disclose it, fearing it will attract new rivals. In this paper, we demonstrate that the presence of dual distribution arrangements, wherein consumers can purchase products either from traditional retail firms or directly from suppliers, can notably alter disclosure incentives. As under prevailing views, a retailer disclosing positive news risks entry by competitors. However, entry shifts the incumbent supplier-retailer relationship: the presence of new competitors leads the supplier to treat its retailer more as a strategic partner, translating into lower wholesale prices. This, in turn, can lead the retailer to willingly share favorable news, since such disclosure invites entry precisely when the retailer stands to benefit most from price concessions. Our results suggest that as dual distribution continues to increase in prominence, firms may be more willing to voluntarily disclose sensitive financial information particularly that which points to high demand for its products. [Copyright &y& Elsevier]
Accrual reversals, earnings and stock returns
Allen, Eric J., Larson, Chad R., Sloan, Richard G.
Vol 56, Issue 1, 113-129 (2013)
Abstract: We show that accruals consist of at least two distinct underlying processes, one with positive serial correlation and the other with negative serial correlation. We also find that the accrual reversals characterizing the negatively serially correlated process are predominantly good accruals that correctly anticipate fluctuations in working capital. Accrual estimation error is the least persistent component of earnings, while accruals relating to firm growth are less persistent than cash flows. Finally, the mispricing of accruals appears to be driven by a combination of accrual estimation error and firm growth. [Copyright &y& Elsevier]
Towards an understanding of the role of standard setters in standard setting
Allen, Abigail, Ramanna, Karthik
Vol 55, Issue 1, 66-90 (2013)
Abstract: We investigate the effect of standard setters in standard setting. We examine how certain professional and political characteristics of FASB members and SEC commissioners predict the accounting "reliability" and "relevance" of proposed standards. Notably, we find FASB members with backgrounds in financial services are more likely to propose standards that decrease "reliability" and increase "relevance," partly due to their tendency to propose fair-value methods. We find opposite results for FASB members affiliated with the Democratic Party, although only when excluding financial-services background as an independent variable. Jackknife procedures show that results are robust to omitting any individual standard setter. [Copyright &y& Elsevier]
Firms' use of accounting discretion to influence their credit ratings
Alissa, Walid, Bonsall, Samuel B., Koharki, Kevin, Penn, Michael W.
Vol 55, Issue 2/3, 129-147 (2013)
Abstract: This paper examines whether firms that deviate from an empirically modeled ("expected") credit rating engage in earnings management activities, as measured by abnormal accruals and real activities earnings management. We find evidence that firms use income-increasing (-decreasing) earnings management activities when they are below (above) their expected ratings. We then test whether such actions are successful in helping these firms move toward their expected credit ratings. The results suggest that firms below or above their expected credit ratings may be able to move toward expected ratings through the use of directional earnings management. [Copyright &y& Elsevier]
Economic effects of SOX Section 404 compliance: A corporate insider perspective
Alexander, Cindy R., Bauguess, Scott W., Bernile, Gennaro, Lee, Yoon-Ho Alex, Marietta-Westberg, Jennifer
Vol 56, Issue 2/3, 267-290 (2013)
Abstract: We use survey responses from 2,901 corporate insiders to assess the costs and benefits of compliance with Section 404 of the Sarbanes-Oxley Act. The majority of respondents recognize compliance benefits, but they do not perceive these benefits to outweigh the costs, on average. This is particularly true among smaller companies where the start-up costs are proportionately larger. However, the perceived efficiency of compliance increases with auditor attestations, years of compliance experience, and after the remediation of a material weakness. Notably, the perceived effects of compliance depend largely on firm complexity, but are mostly unrelated to firm governance structure. [Copyright &y& Elsevier]
Capital market consequences of managers' voluntary disclosure styles
Yang, Holly I.
Vol 53, Issue 1/2, 167-184 (2012)
Abstract: This paper studies the capital market consequences of managers establishing an individual forecasting style. Using a manager-firm matched panel dataset, I examine whether and when manager-specific credibility matters. If managers'' forecasting styles affect their perceived credibility, then the stock price reaction to forecast news should increase with managers'' prior forecasting accuracy. Consistent with this prediction, I find that the stock price reaction to management forecast news is stronger when information uncertainty is high and when the manager has a history of issuing more accurate forecasts, indicating that individual managers benefit from establishing a personal disclosure reputation. [Copyright &y& Elsevier]
Abstract: Fu, Kraft and Zhang (2012) use a hand-collected sample of firms with different interim reporting frequencies from 1951 to 1973 to test whether higher reporting frequency is associated with lower information asymmetry and a lower cost of equity capital. Their results suggest that firms with higher reporting frequency (e.g., firms reporting quarterly as opposed to annually) have lower information asymmetry and a lower cost of equity capital. In this discussion, I expand on FKZ by elaborating on their hypothesis development and research design, and providing suggestions for future research. [Copyright &y& Elsevier]
The factors affecting illegal insider trading in firms with violations of GAAP
Vol 53, Issue 1/2, 375-390 (2012)
Abstract: Consistent with the economics of crime approach, this paper finds that insider selling is decreasing in the perceived costs of potential private and public enforcement upon discovery of GAAP misstatements, and increasing in managerial private benefits as measured by the market reaction to the misstatement announcement. Additionally, insiders at fraud firms sell more on average, although the intensity of their trades is less likely to be associated with the magnitude of their private information. Further analysis suggests that managers perceive a higher cost of public enforcement in the post-Enron period. [Copyright &y& Elsevier]
A new measure of earnings forecast uncertainty
Sheng, Xuguang, Thevenot, Maya
Vol 53, Issue 1/2, 21-33 (2012)
Abstract: Relying on the well-established theoretical result that uncertainty has a common and an idiosyncratic component, we propose a new measure of earnings forecast uncertainty as the sum of dispersion among analysts and the variance of mean forecast errors estimated by a GARCH model. The new measure is based on both common and private information available to analysts at the time they make their forecasts. Hence, it alleviates some of the limitations of other commonly used proxies for forecast uncertainty in the literature. Using analysts'' earnings forecasts, we find direct evidence of the new measure''s superior performance. [Copyright &y& Elsevier]
Executive overconfidence and the slippery slope to financial misreporting
Schrand, Catherine M., Zechman, Sarah L. C.
Vol 53, Issue 1/2, 311-329 (2012)
Abstract: A detailed analysis of 49 firms subject to AAERs suggests that approximately one-quarter of the misstatements meet the legal standards of intent. In the remaining three quarters, the initial misstatement reflects an optimistic bias that is not necessarily intentional. Because of the bias, however, in subsequent periods these firms are more likely to be in a position in which they are compelled to intentionally misstate earnings. Overconfident executives are more likely to exhibit an optimistic bias and thus are more likely to start down a slippery slope of growing intentional misstatements. Evidence from a high-tech sample and a larger and more general sample support the overconfidence explanation for this path to misstatements and AAERs. [Copyright &y& Elsevier]
Institutional ownership and conservatism
Ramalingegowda, Santhosh, Yu, Yong
Vol 53, Issue 1/2, 98-114 (2012)
Abstract: Recent research suggesting that shareholders demand conservative financial reporting raises the question: Which shareholders demand conservatism? We find that higher ownership by institutions that are likely to monitor managers is associated with more conservative financial reporting. This positive association is more pronounced among firms with more growth options and higher information asymmetry, where direct monitoring is more difficult and the potential governance benefits of conservatism are greater. Further, lead-lag tests of the direction of causality suggest that ownership by monitoring institutions leads to more conservative reporting, rather than the reverse. Collectively, these results are consistent with monitoring institutions demanding conservatism. [Copyright &y& Elsevier]