Knowledge that Transforms

ABSTRACT: One might expect that disclosure quality improves investor welfare by reducing cost of capital. This study shows that the argument is valid only in limited circumstances. Based on a production economy with perfect competition among investors, the analysis demonstrates three points. First, cost of capital could increase with disclosure quality when new investment is sufficiently elastic. Second, there are plausible conditions under which disclosure quality reduces the welfare of current and/or new investors. Finally, cost of capital could move in opposition to the welfare of either current or new investors as disclosure quality changes.

ABSTRACT: FIN No. 48, Accounting for Uncertainty in Income Taxes (FASB 2006), requires firms to disclose tax reserves and to record changes in tax reserves at adoption of FIN No. 48 as cumulative effect adjustments in stockholders’ equity. We predict that between the enactment and adoption of FIN No. 48, relative to historical levels, firms settle disputes more often to potentially decrease visibility to the IRS and release reserves more often to reduce scrutiny and increase earnings (as opposed to retained earnings). We analyze 2005 and 2006 10-Qs and 10-Ks for the 100 largest nonfinancial, nonutility firms followed by analysts. Between enactment and adoption of FIN No. 48, relative to historical levels, firms report more settlements with tax authorities and release reserves more frequently. In addition, firms with higher IRS deficiencies are more likely to settle disputes. Between enactment and adoption of FIN No. 48, firms increased earnings by releasing $4.4 billion of tax reserves, nearly equaling the $4.5 billion released at adoption.

ABSTRACT: This study examines whether and how earnings quality, measured as accruals quality (AQ), affects the cost of equity capital. Using two-stage cross-sectional regression tests, we find that the AQ risk factor is significantly priced, after controlling for low-priced stocks. This result is robust in tests using individual stocks, various portfolio formations, and different beta estimations. Furthermore, we show that AQ and its pricing effect systematically vary with business cycles and macroeconomic variables. In particular, this pricing effect is prominent in total AQ and innate AQ but not in discretionary AQ. The risk premium associated with AQ exists only in economic expansion but not in recession periods. Poorer AQ firms are more vulnerable to macroeconomic shocks. The risk premium and the dispersion of AQ are also related to future economic activity. Overall, our results suggest that AQ contributes to the cost of equity capital and that its pricing effect is associated with fundamental risk.

ABSTRACT: A flourishing stream of research suggests that liquidity-constrained firms with low accounting quality have limited access to capital for investments. We extend this research by investigating whether these firms are more likely to lease their assets. Lessors’ superior control rights allow them to provide capital to constrained firms with low-quality accounting reports. Consistent with this conjecture, we find that low accounting quality firms have a higher propensity to lease than purchase assets. To verify that leasing does not merely reflect these firms’ desire for off-balance-sheet accounting, we investigate whether banks’ access to private information and monitoring affect the relation between accounting quality and leasing. We find the association between accounting quality and leasing decreases when banks have higher monitoring incentives and when loans contain capital expenditure provisions. These results suggest that other mechanisms can substitute for the role of accounting quality in reducing information problems.

ABSTRACT: This study investigates whether MD&A disclosures have predictive ability for future firm performance in cases of disproportionate inventory increases. Using a sample of 568 manufacturing firms with disproportionate inventory increases, I find that the favorability of explanations for inventory changes in MD&A is positively associated with a firm’s profitability and sales growth in the subsequent three years. I also find that future profitability and sales growth of firms that do not explain disproportionate inventory increases in MD&A fall between those of firms with favorable explanations and firms with unfavorable explanations. These results suggest that the existence and the favorability of MD&A inventory disclosures help users interpret disproportionate inventory increases and predict future firm performance.

ABSTRACT: We examine how management quarterly guidance strategy is affected by various outcomes from previously issued guidance. We find that managers are less likely to provide quarterly earnings guidance for a given year when past management forecasts have been overly optimistic, when past forecasts were unsuccessful at influencing analysts’ expectations, when past forecasts failed to reduce information asymmetry, and when past forecasts resulted in earnings disappointments. For firms that continue to give guidance, adverse prior outcomes also affect the precision of future guidance and the number of quarters within a year for which they give guidance.

ABSTRACT: This study examines how firms’ asymmetric cost behavior influences analysts’ earnings forecasts, primarily the accuracy of analysts’ consensus earnings forecasts. Results indicate that firms with stickier cost behavior have less accurate analysts’ earnings forecasts than firms with less sticky cost behavior. Furthermore, findings show that cost stickiness influences analysts’ coverage priorities and investors appear to consider sticky cost behavior in forming their beliefs about the value of firms. This study integrates a typical management accounting research topic, cost behavior, with three standard financial accounting topics (namely, accuracy of analysts’ earnings forecasts, analysts’ coverage, and market response to earnings surprises).

ABSTRACT: We examine how biased financial reports (managed earnings) affect product market competition and how product market competition affects incentives to bias financial reports in a model with fully rational firms. We find that Cournot competitors bias their reports to create the impression that their costs are lower than they actually are. This bias leads to lower total production and a higher product price, even though each firm fully understands its rival’s incentives to bias its financial reports. The magnitude of the bias is larger when firms compete in more profitable product markets and smaller when the firm can extract more information about its rival’s costs from its own. When the costs of misreporting are asymmetric, the lower-cost firm engages in more earnings management than its rival, produces more than it would in a full-information environment, and earns greater profits. Our analysis leads to new, testable relations among earnings management, reported and actual earnings, and industry structure.

ABSTRACT: Leone et al. (2006) conclude that CEO cash compensation is more sensitive to negative stock returns than to positive stock returns, due to Boards of Directors enforcing an ex post settling up on CEOs. Dechow (2006) conjectures that Leone et al.’s (2006) results might be due to the sign of stock returns misclassifying firm performance. Using three-way performance partitions, we find no asymmetry in CEO cash compensation for firms with low stock returns. Further, we find that CEO cash compensation is less sensitive to poor earnings performance than it is to better earnings performance. Thus, we find no evidence consistent with ex post settling up for poor firm performance, even among the very worst performing firms with strong corporate governance. We find similar results when examining changes in CEO bonus pay and when partitioning firm performance using earnings-based measures. In sum, our results suggest that CEO cash compensation is not punished for poor firm performance.

ABSTRACT: We investigate the determinants of hedge fund internal controls and their association with the fees that funds charge investors. Hedge funds are subject to minimal regulation. Hence, hedge fund managers voluntarily implement internal controls, and managers and investors freely contract on fees. We find that internal controls are stronger in funds with higher potential agency costs. Further, internal controls are stronger in funds domiciled in jurisdictions that provide investors with limited legal redress for fraud and financial misstatements. Short selling funds, however, are more likely to protect information about their investment positions by implementing weaker internal controls. With respect to fees, we find that the percentage of positive profits that the manager receives increases in the strength of the fund’s internal controls. Finally, removing the manager from setting and reporting the fund’s official net asset value, along with reputational incentives and monitoring by leverage providers, are all associated with lower likelihoods of future regulatory investigations of fraud and/or financial misstatement.