Knowledge that Transforms

This paper examines a real cost of awarding employee stock options. Based on the observation that managers are extremely concerned about earnings‐per‐share dilution in equity related compensation, we predict and find that firms experiencing significant employee stock option (ESO) exercises shift resources away from real investments towards the repurchase of their own stocks. We further find weak evidence of a decline in subsequent firm performance (as measured by return on assets) for several years following the cut in discretionary investments as a result of stock option exercises, though this result is sensitive to the metric used to measure performance. Collectively, our findings indicate that ESO exercises potentially impose a real cost on the firm in terms of foregone investment opportunities.

An interesting question in assessing value relevance of accounting variables is whether measures of value relevance are materially affected by market inefficiencies. We explore this question in two steps: First, we analytically examine the impact of market inefficiencies on the estimation of coefficients in value relevance regressions and derive a procedure that corrects potential biases caused by such inefficiencies. The procedure adjusts contemporaneous stock prices for future risk adjusted price changes, and yields value relevance coefficient estimates that capture both contemporaneous and delayed market reactions. Second, we apply this procedure to three types of studies that have attracted much attention in the accounting literature: 1) the value relevance of earnings and book values; 2) the value relevance of residual income value estimates; and 3) the value relevance of accruals and cash flows. We compare coefficient estimates obtained from conventional value relevance regressions with those from regressions employing our adjustment procedure, and find statistically significant differences in both level and return regression coefficient estimates. The magnitude of differences in coefficient estimates for return regressions is large enough to affect economic inferences. We find that coefficients of lagged price deflated residual income value estimates move significantly closer toward a predicted value of one implying a meaningful reduction of bias. Last, we find that cash flows now have significantly larger coefficient estimates than accruals consistent with their greater persistence.

This paper examines the impact of measuring accruals as the change in successive balance sheet accounts, as opposed to measuring accruals directly from the statement of cash flows. Our primary finding is that studies using a balance sheet approach to test for earnings management are potentially contaminated by measurement error in accruals estimates. In particular, if the partitioning variable used to indicate the presence of earnings management is correlated with the occurrence of mergers and acquisitions or discontinued operations, tests are biased and researchers are likely to erroneously conclude that earnings management exists when there is none. Additional results show that the errors in balance sheet accruals estimation can confound returns regressions where discretionary and non‐discretionary accruals are used as explanatory variables. Moreover, we demonstrate that tests of market mispricing of accruals will be understated due to erroneous classification of “extreme” accruals firms.

We study a model of financial reporting where investors infer the precision of reported earnings. Reporting a larger earnings surprise reduces the inferred earnings precision, dampening the impact on firm value of reporting higher earnings, and providing a natural demand for smoother earnings. We show that for sufficiently “bad” news, the manager under‐reports earnings by the maximum, preferring to take a “big bath” in the current period in order to report higher future earnings. If the news is “good,” the manager smoothes earnings, with the amount of smoothing depending on the level of cashflows observed. He either over‐reports or partially under‐reports for slightly good news, and gradually increases his under‐reporting as the news gets better, until he is under‐reporting the maximum amount for sufficiently good news. This result holds both when investors are “naïve” and ignore management’s ability to manipulate earnings, or “sophisticated” and correctly infer management’s disclosure strategy.

This paper examines the information voluntarily disclosed about corporate restructurings. In 1995 the FASB’s Emerging Issues Task Force reached a consensus opinion about mandatory restructuring disclosures. I use these requirements to construct a statistic that measures the amount of information voluntarily disclosed for a sample of firms from 1990–1993. Disclosure levels increased dramatically when the SEC targeted restructurings as an area for increased oversight in late 1993. Controlling for this SEC action, I document a positive association between the amount of information disclosed and increased monitoring by shareholders, suggesting that monitoring complements disclosure rather than substitutes for it. The amount disclosed is negatively related to the appointment of a new CEO prior to the restructuring, perhaps reflecting the use of the restructuring charge to manage earnings for these firms.

This study examines the association between firms’ intangible assets and properties of the information contained in analysts’ earnings forecasts. We hypothesize that analysts will supplement firms’ financial information by placing greater relative emphasis on their own private (or idiosyncratic) information when deriving their earnings forecasts for firms with significant intangible assets. Our evidence is consistent with this hypothesis. We find that the consensus in analysts’ forecasts, measured as the correlation in analysts’ forecast errors, is negatively associated with a firm’s level of intangible assets. This result is robust to controlling for analyst uncertainty about a firm’s future earnings, which we also find to be higher for firms with high levels of internally generated (and expensed) intangibles. Given that analyst uncertainty increases and analyst consensus decreases with the level of a firm’s intangible assets, we also expect and find that the degree to which the mean forecast aggregates private information and is more accurate than an individual analyst’s forecast increases with a firm’s intangible assets. Finally, additional analysis reveals that lower levels of analyst consensus are associated with high‐technology manufacturing companies, and that this association is explained by the relatively high R&D expenditures made by these firms. Overall, our results are consistent with financial analysts augmenting the financial reporting systems of firms with higher levels of intangible assets (in terms of contributing to more accurate earnings expectations), particularly R&D‐driven high‐tech manufacturers.

We investigate the relation between earnings predictability, information asymmetry and the behavior of the adverse selection cost component of the bid‐ask spread around quarterly earnings announcements for NASDAQ firms. While we find an increase in the adverse selection component of the bid‐ask spread on the day of and the day prior to quarterly earnings announcements for firms with less predictable earnings, we find no evidence of such changes for firms with more predictable earnings. During a non‐announcement period, we find that firms with relatively less predictable earnings have consistently higher total bid‐ask spreads than firms with more predictable earnings. This finding suggests that firms with relatively less predictable earnings have a higher cost of equity capital than comparable firms with more predictable earning streams, ceteris paribus. Hence, earnings predictability may be a legitimate concern of managers who wish to minimize their cost of equity capital at least as it pertains to bid‐ask spreads.

This paper examines the association between the cost of equity capital and levels of annual report and timely disclosure, and investor relations activities. We estimate the cost of equity capital using the classic dividend discount model. We find that the cost of equity capital decreases in the annual report disclosure level but increases in the level of timely disclosures. The latter result is contrary to theory but is consistent with managers’ claims that greater timely disclosures may increase the cost of equity capital, possibly through increased stock price volatility. We find no association between the cost of equity capital and the level of investor relations activities. We conclude that aggregating across different disclosure types results in a loss of information. Failing to include all disclosure types in regression analyses may lead to a correlated omitted variable bias and erroneous conclusions.

To improve audit effectiveness, public accounting firms have organized their practices to include hierarchical review by teams organized along industry lines. We examine how industry specialized auditor teams detect errors, using a sophisticated experimental design. Our analysis of nominal teams created from seniors and managers working individually shows that seniors add value to the team by detecting more mechanical errors while managers detect more conceptual errors. Working within specialization, managers and seniors both contribute in a nonredundant way to the team’s overall effectiveness. We also find that the nominal teams outperform real teams in the detection of mechanical but not conceptual errors. These results only hold when the auditors work within in their industry specialization. Out of specialization the auditors are not effective at detecting errors, and real teams perform below the nominal team benchmark in the detection of both mechanical and conceptual errors.

This study provides evidence on (a) the market’s response to revenue and revenue announcements, (b) the extent of the use of grossed‐up and barter revenue by Internet firms, and (c) whether the value relevance of revenue differs when Internet firms report grossed‐up or barter revenue. Results indicate that revenue announcements are highly associated with three‐day market returns and provide information incremental to that contained in earnings announcements. The use of grossed‐up and barter revenue is common for certain sectors of Internet firms, but not pervasive across sectors. Evidence suggests that the value relevance of revenue for firms reporting grossed‐up and barter revenue declined subsequent to the “crash” in April 2000. Additional analyses explore the effect of active individual investors on the pricing of revenue for firms reporting grossed‐up and barter revenue. Findings suggest higher pricing of revenue for firms reporting grossed‐up or barter revenue with relatively greater individual investor following.