Knowledge that Transforms

Abstract We examine the correlation between the expected rate of return on pension assets (ERR), as reported in the financial statements, and the com- position of the pension portfolio, measured as the percent invested in equities (% Equity). Our evidence indicates that ERR and %Equity are related, but the relation is rather weak. We also examine whether ERR and %Equity are correlated with future returns on pension assets. Only %Equity is correlated with future pension returns. Our results suggest that the FASB should consider the enforcement rather than elimination of current disclosure requirements regarding pension asset composition.

Abstract This study investigates whether the net deferred tax liabilities disclosed under Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (SFAS No. 109) provides additional value-relevant information over the disclosure required by Accounting Principles Board Opinion No. 11, Accounting for Income Taxes (APS No. 11). Evidence suggests that SEAS No. 109 data represent value-relevant information above and beyond APB No. 11. Additionally, evidence indicates that the changes made by SFAS No. 109-the separate recognition of deferred tax assets, the creation of valuation allowances for deferred tax assets and the adjustment of deferred tax accounts for enacted tax rate changes-each provide value-relevant firm data. These results suggest that SFAS No. 109 increased the value-relevance of deferred tax amounts in financial statements.

Abstract This paper explores the determinants of the valuation allowance for deferred tax assets under SFAS No.109. We find that, consistent with SFAS No. 109, the allowance is larger for firms with relatively more deferred tax assets and smaller for firms with higher levels of expected future taxable income. The most important explanatory variable for the valuation allowance is the level of firms' tax credit and tax loss carryforwards, consistent with these items being more difficult to realize. We find little evidence that managers use the valuation allowance for earnings management purposes, although these tests may not be very powerful.

Abstract This study tests the competitive equilibrium predictions of a multi-period model of audit pricing and independence in two sets of laboratory markets: a control set consisting of human subjects in the role of auditors contracting with robot clients, and a treatment set in which both auditors and clients are human subjects. The results in all the control-set markets and some of the treatment markets support the predictions of "lowball" pricing and that heterogeneous beliefs among auditors regarding the treatment of a client-reporting issue is a necessary condition for independence impairment. By contrast, several treatment-set markets exhibit cooperative behavior between auditors and clients to achieve jointly beneficial outcomes. This behavior deviates from the price-independence relationship predicted in the competitive equilibrium, exhibiting instead a price-independence relationship that is characterized by an absence of lowballing and frequent independence impairment, even when auditors have homogeneous beliefs.

Abstract This paper examines whether institutional investors create or reduce incentives for corporate managers to reduce investment in research and development (R&D) to meet short-term earnings goats. Many critics argue that the frequent trading and short-term focus of institutional investors encourages managers to engage in such myopic investment behavior Others argue that the large stockholdings and sophistication of institutions allow managers to focus on long-term value rather than on short-term earnings. I examine these competing views by testing whether institutional ownership affects R&D spending for firms that could reverse a decline in earnings with a reduction in R&D. The results indicate that managers are less likely to cut R&D to reverse an earnings decline when institutional ownership is high, implying that institutions are sophisticated investors who typically serve a monitoring role in reducing pressures for myopic behavior However, I find that a large proportion of ownership by institutions that have high portfolio turnover arid engage in momentum trading significantly increases the probability that managers reduce R&D to reverse an earnings decline. These results indicate that high turnover and momentum trading by institutional investors encourages myopic investment behavior when such institutional investors have extremely high levels of ownership in a firm; otherwise, institutional ownership serves to reduce pressures on managers for myopic investment behavior.

Abstract This study examines whether certain types of financial reporting fraud result in a higher likelihood of litigation against independent auditors. We expect that auditors are more likely to be judged responsible for failing to detect commonly occurring frauds of those that stem from fictitious transactions. We examine companies with SEC Accounting and Auditing Enforcement Releases and designate whether each fraud present in their financial statements in common and/ or arises from fictitious transactions. We then examine whether these types of fraud are related to auditor litigation in analyses that control for various client, auditor and case characteristics. Our results provide some support for our two primary hypotheses - auditors are more likely to be sued when the financial statement frauds are of a common variety or when the frauds arise from fictitious transactions.

Abstract This study investigates the rote of alternative earnings components in the CEO cash compensation function. We find that cash compensation is significantly positively related to above the line earnings, as long as results are positive. Compensation is shielded from the effects of above the line losses. Similarly, nonrecurring transactions that increase income flow through to compensation, but nonrecurring losses do not. This effect is noted for gains and losses that arise both from extraordinary transactions, discontinued operations and nonrecurring items that do not qualify for below the line presentation. Thus, the data tell a remarkably consistent story: gains flow through to compensation, but losses do not. The classification of the gain or loss on the income statement is of relatively little importance.

Abstract This study investigates whether firms that expect increases in earnings resulting from sudden product price increases use accounting accruals to reduce earnings and, thus, political sensitivity. Specifically, oil firms' accruals are analyzed in a period of rapid gasoline price increases during the 1990 Persian Gulf crisis. Our results show that oil firms that expected to profit from the crisis used accruals to reduce their reported quarterly earnings during the Gulf crisis. In contrast to previous research, we find that the tendency to release good earnings news early, documented in prior research, is reversed for oil firms during the Gulf crisis. This finding suggests that the benefit of disclosing "good news" (i.e., earnings increases) early may have been outweighed by the political costs associated with timely releases of the information.

Abstract This study investigates the relationship between insider trading and fraud. We find that in the presence of fraud, insiders reduce their holdings of company stock through high levels of selling activity as measured by either the number of transactions, the number of shares sold, or the dollar amount of shares sold. Moreover, we present evidence that a cascaded logit model, incorporating insider trading variables and firm-specific financial characteristics, differentiates companies with fraud from companies without fraud.

Abstract This paper presents a model that relates properties of the analysts' information environment of the properties of their forecasts. First, we express forecast dispersion and error in the mean forecast in terms of analyst uncertainty and consensus (that is, the degree to which analysts share a common belief). Second, were reserve the relations to show how uncertainability and consensus cab be measured by combining forecast dispersion, error in the mean forecast, and the number of forecasts. Third, we show that the quality of common and private information available to analysts can be measured using these same observable variables. The relations we present are intuitive and easily applied in empirical studies.