Knowledge that Transforms

ABSTRACT: This paper identifies challenges and opportunities created by global financial reporting for the education and research activities of U.S. academics. Relating to education, after overviewing the relation between global financial reporting and U.S. GAAP, it offers suggestions for topics to be covered in global financial reporting curricula and clarifies common misunderstandings about the concepts underlying financial reporting. Relating to research, it explains how and why research can provide meaningful input into standard-setting, and identifies questions that can motivate research related to topics on the International Accounting Standards Board’s technical agenda and to the globalization of financial reporting.

ABSTRACT: This paper examines whether legal liability coverage, as measured by excess Directors’ and Officers’ (D&O) liability insurance coverage and excess cash for indemnification, is associated with the quantity and the quality of a firm’s voluntary disclosures. Using Canadian firms whose D&O insurance data are publicly available, I find that firms with higher excess coverage are less likely to report bad news forecasts for the sample firms that are cross-listed in the U.S., and that the number of bad news forecasts decreases for large cross-listed sample firms having high litigation risk. The results are consistent with the litigation cost argument for the disclosure of bad news. I also find that higher excess liability coverage leads to disclosures of more precise bad news for the cross-listed sample firms and less timely disclosures of bad news for large cross-listed sample firms. Further, excess cash for indemnification is a more significant determinant of disclosure decisions.

This paper investigates the relation between differences in accounting standards across countries and foreign analyst following and forecast accuracy. We develop two measures of differences in generally accepted accounting principles (GAAP) for 1,176 country-pairs. We then examine the impact of these measures of accounting differences on foreign analysts. In so doing, we utilize a unique database that identifies the location of financial analysts around the world, creating a sample that covers 6,888 foreign analysts making a total of 43,968 forecasts for 6,169 firms from 49 countries during 1998–2004. We find that the extent to which GAAP differs between two countries is negatively related to both foreign analyst following and forecast accuracy. Our results suggest that GAAP differences are associated with economic costs for financial analysts.

We analyze a sample of 330 firms making unaudited disclosures required by Section 302 and 383 firms making audited disclosures required by Section 404 of the Sarbanes-Oxley Act. We find that Section 302 disclosures are associated with negative announcement abnormal returns of −1.8 percent, and that firms experience an abnormal increase in equity cost of capital of 68 basis points. We conclude that Section 302 disclosures are informative and point to lower credibility of disclosing firms' financial reporting. In contrast, we find that Section 404 disclosures have no noticeable impact on stock prices or firms' cost of capital. Further, we find that auditor quality attenuates the negative response to Section 302 disclosures and that accelerated filers—larger firms required to file under Section 404—have significantly less negative returns (−1.10 percent) than non-accelerated filers (−4.22 percent). The findings have implications for the debate about whether to implement a scaled securities regulation system for smaller public companies: material weakness disclosures are more informative for smaller firms that likely have higher pre-disclosure information uncertainty.

Under the assumption that audit quality relates positively to unobservable financial reporting quality, we investigate whether audit quality is associated with the predictability of accounting earnings by focusing on analyst earnings forecast properties. The evidence shows that analysts' earnings forecast accuracy is higher and the forecast dispersion is smaller for firms audited by a Big 5 auditor. We further find that auditor industry specialization is associated with higher forecast accuracy and less forecast dispersion in the non-Big 5 auditor sample but not in the Big 5 auditor sample. Overall, our results suggest that high-quality audit provided by Big 5 auditors and industry specialist non-Big 5 auditors is associated with better forecasting performance by analysts.

ABSTRACT: We examine the design of asset revaluation policies in settings where a regulator can mandate fair value disclosure in order to mitigate a lemons problem in the asset resale market. The welfare-maximizing policy generally prescribes fair value certification for the lower asset values and (less costly) historical cost reporting for the higher asset values. The potential for voluntary certification can reduce welfare by increasing equilibrium certification costs and promoting underinvestment in socially valuable projects. Thus, a single regulated source of information (mandated disclosure) can be preferable to two sources of information (mandated and voluntary disclosure).

ABSTRACT: We examine the role of investment opportunities as a determinant of the relative importance of cash flows from operations (CFO) and accruals in firm valuation. We find that at low investment-opportunity levels, CFO value-relevance increases with investment opportunities. When investment opportunities are high, accrual value-relevance declines as investment opportunities increase. Consequently, earnings value-relevance first varies directly and then inversely with investment opportunities. We show that the increase in CFO value-relevance is consistent with cost differentials between internal and external financing causing CFO to be an increasingly important determinant of the realization of investment opportunities. The decline in accrual value-relevance at high investment-opportunity levels appears to be attributable to accounting measurement deficiencies.

We find that equity returns associated with credit risk changes are attenuated by the debt value effect of the credit risk changes, as Merton (1974) predicts. We find that the relation between credit risk changes and equity returns is significantly less negative for firms with more debt—controlling for asset value changes, credit risk increases (decreases) are associated with equity value increases (decreases). This result obtains across credit risk levels. The relation is associated with changes in both expected cash flows and systematic risk, as reflected in analyst earnings forecasts and equity cost of capital. By inverting the Merton (1974) model, we provide descriptive evidence that if unrecognized debt value changes were recognized in income, but not unrecognized asset value changes, most credit upgrade (downgrade) firms would recognize lower (higher) income. These potentially counterintuitive income effects primarily are attributable to incomplete recognition of contemporaneous asset value changes. However, for a substantial majority of downgrade firms we find that recognized asset write-downs exceed unrecognized gains from debt value decreases. This mitigates concerns that income effects from recognizing changes in debt values would be anomalous for such firms.

ABSTRACT: This essay describes implications of the subprime crisis for accounting. First, I overview the institutional and market aspects of subprime lending with the greatest accounting relevance. Second, I discuss the critical aspects of FAS No. 157’s fair value definition and measurement guidance and explain the practical difficulties that have arisen in applying this definition and guidance to subprime positions during the crisis. I also raise a potential issue regarding the application of FAS No. 159’s fair value option. Third, I discuss issues that have arisen regarding sale accounting for subprime mortgage securitizations under FAS No. 140 and consolidation of securitization entities under FIN No. 46(R) associated with mortgage foreclosures and modifications. Fourth, I indicate ways that accounting academics can address the implications of the subprime crisis in their research and teaching.

We document that accrual-based earnings management increased steadily from 1987 until the passage of the Sarbanes-Oxley Act (SOX) in 2002, followed by a significant decline after the passage of SOX. Conversely, the level of real earnings management activities declined prior to SOX and increased significantly after the passage of SOX, suggesting that firms switched from accrual-based to real earnings management methods after the passage of SOX. We also document that the accrual-based earnings management activities were particularly high in the period immediately preceding SOX. Consistent with these results, we find that firms that just achieved important earnings benchmarks used less accruals and more real earnings management after SOX when compared to similar firms before SOX. In addition, our analysis provides evidence that the increases in accrual-based earnings management in the period preceding SOX were concurrent with increases in equity-based compensation. Our results suggest that stock-option components provide a differential set of incentives with regard to accrual-based earnings management. We document that while new options granted during the current period are negatively associated with income-increasing accrual-based earnings management, unexercised options are positively associated with income-increasing accrual-based earnings management.