Knowledge that Transforms

Many firms that take restructuring charges reverse a portion of those restructuring charge accruals in a later quarter. These reversals increase net income, often substantially. In this study, I investigate whether restructuring charge reversals are associated with incentives to meet or exceed analysts' forecasts, avoid earnings declines relative to prior‐year levels, and avoid losses. I examine both the decision to record a reversal and the amount of the reversal, using a sample of 121 reversals recorded between 1990 and 1999. The results suggest that some firms record reversals to beat analysts' forecasts and to avoid reporting net losses. There is also some evidence that firms record reversals to avoid earnings declines. Overall, the results are consistent with firms using restructuring accrual reversals to manage earnings.

This study provides evidence on how auditors' use of decision aids affects jurors' evaluation of auditor legal liability, based on an experiment in which actual jurors responded to a hypothetical audit lawsuit. The results suggest that decision aids can have positive, negative, or neutral effects on auditors' legal liability, depending on how auditors use the decision aid and the reliability of the decision aid. For high-reliability aids, jurors attributed more responsibility for an audit failure to the auditor when the auditor overrode the recommendation of a decision aid than when the auditor did not use the decision aid. However, jurors attributed lower responsibility to an auditor who relied on the recommendation of a highly reliable decision aid, even though the aid turned out to be incorrect. In contrast to the high-reliability conditions, auditors' use of the decision aid had virtually no impact on jurors' liability judgments when the reliability of the decision aid was low.

Value at Risk (VAR), a measure of the dollar amount of potential loss from adverse market moves, has become a standard benchmark for measuring financial risk. Spurred by regulators and competitive pressures, more institutions are reporting VAR numbers in annual and quarterly financial reports. To provide preliminary evidence on the informativeness of these new disclosures, I investigate the relation between the trading VAR disclosed by a small sample of U.S. commercial banks and the subsequent variability of their trading revenues. The empirical results suggest that VAR disclosures are informative in that they predict the variability of trading revenues. Thus, analysts and investors can use VAR disclosures to compare the risk profiles of banks' trading portfolios.

We investigate factors that explain firms' decisions to disclose and record contingent tax liabilities. Our findings are based on confidential Internal Revenue Service audit data and financial statement footnotes for 100 large industrial firms from 1987 to 1995. Descriptive statistics indicate that these firms often fail to disclose IRS claims for tax deficiencies that exceed a 5-percent-of-income rule of thumb. We find that the probability of disclosure increases in the relative amount of the claim or the expected loss, although the largest claims drive this result. Our evidence is consistent with firms using a stable measure of size, such as assets or normal income, to gauge materiality, rather than relying only on current period reported income. We also find that the amount accrued for the contingent liability increases in the amount of the expected loss. However, our inferences may not generalize beyond a population of large, frequently audited firms.

The balance sheet accumulates the effects of previous accounting choices, so the level of net assets partly reflects the extent of previous earnings management. We predict that managers' ability to optimistically bias earnings decreases with the extent to which the balance sheet overstates net assets relative to a neutral application of GAAP. To test this prediction, we examine the likelihood of reporting various earnings surprises for 3,649 firms during 1993–1999. Consistent with our prediction, we find that the likelihood of reporting larger positive or smaller negative earnings surprises decreases with our proxy for overstated net asset values.

Audit committees evaluate financial reporting quality as part of their corporate oversight responsibilities. Given this responsibility, the national stock exchanges now require all audit committee members to be financially literate and at least one member to have financial expertise. In light of recent debates over this requirement, we provide evidence on how experts and literates differ in their evaluations of financial reporting quality. Results suggest that experts' evaluations of financial reporting quality are more strongly associated with their assessments of characteristics underlying reporting quality (e.g., relevance) espoused in Statement of Financial Accounting Concepts No. 2's framework than literates' evaluations. Additionally, literates are more likely than experts to identify concerns about reporting treatments for business activities that are prominent in the business press or are distinguished by their nonrecurring nature, while experts are more likely to raise concerns about reporting treatments for less prominent, recurring activities. This same pattern occurs in the ratings of the quality of the reporting treatments for specific financial statement items with respect to elements underlying reporting quality (e.g., neutrality); literates (experts) assess the quality elements for the reporting treatments of prominent and nonrecurring items (less prominent and recurring items) comparatively lower than experts (literates). These results suggest that including financial experts on audit committees is likely to change the structure and focus of audit committee discussions about financial reporting quality, and may affect the committee's overall assessment of the quality of a company's financial reports.

This paper demonstrates that a firm's trade-offs between reporting good news to reduce the cost of capital and bad news to minimize proprietary costs can induce the firm's manager to provide truthful disclosures when the opposing effects balance each other. We also show that greater proprietary costs can make a firm's disclosures more credible, increase the frequency of voluntary adverse disclosures, and improve the disclosing firm's welfare. Further, we find that potential shareholder litigation can interact with capital and product markets' influences to make voluntary disclosures more credible, but only under certain circumstances. For example, although product market competition can complement the capital market effects in inducing the manager to provide truthful disclosures, shareholder litigation cannot complement the capital market in the same way. Nevertheless, while shareholder litigation can never induce misreporting, a very strong product market influence can prompt a firm to underreport its true economic condition.

Many firms that take restructuring charges reverse a portion of those restructuring charge accruals in a later quarter. These reversals increase net income, often substantially. In this study, I investigate whether restructuring charge reversals are associated with incentives to meet or exceed analysts' forecasts, avoid earnings declines relative to prior-year levels, and avoid losses. I examine both the decision to record a reversal and the amount of the reversal, using a sample of 121 reversals recorded between 1990 and 1999. The results suggest that some firms record reversals to beat analysts' forecasts and to avoid reporting net losses. There is also some evidence that firms record reversals to avoid earnings declines. Overall, the results are consistent with firms using restructuring accrual reversals to manage earnings.

In 1998, the SEC expressed concern that conference calls encourage selective disclosure by revealing new information to financial analysts privy to the call. This study investigates whether the regular use of earnings-related conference calls increases the amount of information available to financial analysts by examining the effect of conference calls on analysts' forecast error and dispersion. Results indicate that conference calls increase analysts' ability to forecast earnings accurately, suggesting that these calls increase the total information available about a firm. We also find some evidence that conference calls decrease dispersion among analysts. Given conference calls were generally restricted during our sample period, our evidence suggests that conference calls may have contributed to an information gap between analysts privy to the call and the remainder of the investment community. We also investigate whether conference calls differentially affect analysts' forecast errors depending on analysts' prior forecasting ability or brokerage-house affiliation. We find evidence suggesting that analysts with relatively weak prior forecasting performance benefit more from conference calls, suggesting that conference calls help “level the playing field” across analysts.

We consider a setting in which a firm uses residual income to motivate a manager's investment decision. Textbooks often recommend adjusting the residual income capital charge for market risk, but not for firmspecific risk. We demonstrate two basic flaws in this recommendation. First, the capital charge should not be adjusted for market risk. Charging a market risk premium results in “double” counting because a risk-averse manager will personally consider this risk. Second, while investors can avoid firm-specific risk through diversification, a manager cannot. If the manager faces significant firm-specific risk at the time he makes his investment decision, then it is optimal to charge him less than the riskless return so as to partially offset his reluctance to undertake risky investments. On the other hand, the manager will vary his investment decisions with the pre-decision information he receives, which accentuates his compensation risk, and the firm must compensate him for bearing this additional risk. Hence, if the manager will receive relatively precise pre-decision information, then it is optimal to charge him more than the riskless return to reduce the variability of his investment decisions.