Knowledge that Transforms

This paper examines the information content of alternative summary performance measures, using stock returns as the benchmark, for 138 REITs during 1994–1996. This paper tests for both incremental and relative information content of FFO (a voluntarily disclosed, accounting-based performance measure that is the industry standard for REITs) compared to GAAP net income (EPS), cash from operations, and earnings before interest, taxes, depreciation and amortization. Results indicate that both FFO and EPS consistently provide incremental information content with only weak evidence that EPS has greater relative information content and no evidence for the other summary performance measures.

This paper demonstrates that the evidence supporting the hypothesis that post-earnings announcement drift (PEAD) is caused by investors’ failure to incorporate the implications of current earnings for future earnings is (also) consistent with researchers’ over-differencing an already stationary time-series. Specifically, we show the evidence is driven by a subset of firms where over-differencing of quarterly earnings in estimating earnings surprises is most likely to have occurred. Given the persistence of the PEAD over time, our alternative explanation suggests that the prior research investigating the causes for the PEAD overestimates investors’ naivete.

This paper exploits the 1990 change in capital adequacy regulations to construct more powerful tests of capital and earnings management effects on bank loan loss provisions. We find strong support for the hypothesis that loan loss provisions are used for capital management. We do not find evidence of earnings management via loan loss provisions. We also document the reasons for the conflicting results on these effects observed in prior studies. Additionally, we find that loan loss provisions are negatively related to both future earnings changes and contemporaneous stock returns contrary to the signaling results documented in prior work.

This paper estimates the magnitude of tax costs and their impact on the decision to divest assets via a taxable sale rather than a tax-free spin-off. We find that the tax costs are substantial, averaging 8% of market value of the divested assets, and that cross-sectional variation in tax costs has a large impact on managers’ choice of divestiture method. Our results are consistent with two explanations. First, managers are willing to incur avoidable tax costs to gain earnings and cash flow benefits. Second, managers choose taxable sales because the acquisition premia on the sales exceed the avoidable tax costs.

In dynamic principal–agent relationships, unless a principal can commit to a multiperiod contract, incentives are affected by a problem known as the ratchet effect. We present a two-period agency model to show that the use of more aggregate performance measures and greater consolidation of responsibility helps mitigate the ratchet effect. For example, an aggregate measure may be preferred to a set of disaggregate measures to avoid aggravating the ratchet effect. Similarly, it may be preferable to consolidate responsibility for two activities in the hands of one agent despite the potential loss of performance evaluation information implied by consolidation.

When a franchisor offers to sell new franchises, disclosures relevant to the earnings of franchise units are optional. I find that the 26% percent of franchisors who volunteer earnings-related information tend to impose greater investment risk on new franchisees in the form of (1) higher contractual payments and (2) greater product demand uncertainty. I also observe that larger franchise systems, which collect data from more locations and therefore have more precise proprietary information, are less likely to disclose. This finding is contrary to what has been observed in the securities market, where large firms are associated with more voluntary disclosure.

Firms with more intangible assets are more likely to repurchase shares and have more positive repurchase announcement returns, as predicted. Because intangibles generally are unrecognized, share repurchases represent a potential cost to an incomprehensive accounting model. Idle cash is positively related to repurchase likelihood and negatively related to announcement returns, as predicted. Contrary to predictions, general information asymmetry is negatively related to repurchase likelihood, but announcement returns are positively related, as predicted. Tests include controls for stock option plans, dividends, and book-to-market ratios, which generally are significant as predicted. Using change variables in the repurchase likelihood tests yields consistent inferences.

This paper investigates the association between voluntary disclosures and insider transactions (i.e., transactions by managers in their own firms’ shares). The findings suggest that managers do not make insider transactions to profit from news about their own firms just before it becomes publicly available. However, managers appear to employ other strategies for exploiting private information when making insider transactions. Managers cluster insider transactions after voluntary disclosures when doing so results in more favorable stock prices for them. Also, managers take advantage of knowledge about their own firms’ long-term prospects while utilizing voluntary disclosures to shield themselves against profiteering allegations.

In an attempt to increase credibility in its capital markets, China recently adopted new auditing standards. Consistent with increased auditor independence, we find that the frequency of modified opinions increases nine-fold subsequent to the adoption of the new standards. However, the increase in modified reports is followed by a decline in audit market share among large auditors – those with the greatest propensity to issue modified reports. We conjecture that this `flight from audit quality’ results from lack of incentives to demand independent auditors. Our findings suggest that government regulation alone is insufficient to create financial markets that foster auditor independence.

In this discussion I comment on the contribution of two papers toward our understanding of how disclosure affects the cost of capital. Specifically, in the context of these papers, I comment on whether disclosure ameliorates or exacerbates the cost of capital that arises from the existence of information asymmetries in capital markets. This is a notion that should be of fundamental interest in that it provides an economic basis for evaluating the costs and benefits of accounting information.