Knowledge that Transforms

This paper investigates auditors' assessments of earnings manipulation risk and corporate governance risk, and their planning and pricing decisions in the presence of these identified risks. To conduct this investigation, we use engagement partners' assessments of their existing clients made during the participating public accounting firm's client continuance risk assessment process. We find that auditors plan increased effort and billing rates for clients with earnings manipulation risk, and that the positive relationships between earnings manipulation risk and both effort and billing rates are greater for clients that also have heightened corporate governance risk. These findings provide evidence that auditors assess situations involving both an aggressive management and inadequate corporate governance, and that there is a relationship between those assessments and auditors' planning and pricing decisions.

I describe a model of earnings and earnings growth and I demonstrate how this model may be used to obtain estimates of the expected rate of return on equity capital. These estimates are compared with estimates of the expected rate of return implied by commonly used heuristics—viz., the PEG ratio and the PE ratio. Proponents of the PEG ratio (which is the price-earnings [PE] ratio divided by the short-term earnings growth rate) argue that this ratio takes account of differences in short-run earnings growth, providing a ranking that is superior to the ranking based on PE ratios. But even though the PEG ratio may provide an improvement over the PE ratio, it is arguably still too simplistic because it implicitly assumes that the short-run growth forecast also captures the long-run future. I provide a means of simultaneously estimating the expected rate of return and the rate of change in abnormal growth in earnings beyond the (short) forecast horizon—thereby refining the PEG ratio ranking. The method may also be used by researchers interested in determining the effects of various factors (such as disclosure quality, cross-listing, etc.) on the cost of equity capital. Although the correlation between the refined estimates and estimates of the expected rate of return implied by the PEG ratio is high, supporting the use of the PEG ratio as a parsimonious way to rank stocks, the estimates of the expected rate of return based on the PEG ratio are biased downward. This correlation is much lower and the downward bias is much larger for estimates of the expected rate of return based on the PE ratio. I provide evidence that stocks for which the downward bias is higher can be identified a priori.

We examine the efficiency implications of a manager's financial reporting system choice and disclosure management. When a manager has some private information that is not captured by a firm's financial reporting system and may manipulate the financial report at some cost, we show that the manager may not choose the most precise financial reporting system. We examine how reporting system choice varies with the precision of the manager's private information captured by the reporting system, precision of information that is not captured by the reporting system, and the manager's cost of manipulating the report. We consider the effect of reporting discretion on the efficiency with which investors allocate resources.

We examine the value relevance and reliability of brand assets recognized by 33 U.K. firms, and the stock price reaction to the announcement of brand capitalization. We find that brand assets are value relevant, i.e., associated with market values. However, the market capitalization rates of brands of firms with low contracting incentives are higher than those of firms with high contracting incentives to capitalize and overstate brand values. Thus, there could be substantial differences in the extent of bias or error in brand valuations of firms with different levels of contracting incentives, i.e., brand asset measures might not be reliable. The stock price reaction during the 21 days surrounding the first announcement of brand recognition is significantly positively associated with the recognized brand amount. However, the brand coefficient is only a small fraction of what would be expected if markets did not impute any value to brands before firms recognized them. Few previous value-relevance studies have examined intangible assets recognized in financial statements, and none have examined the effects of contracting incentives on the reliability of the reported values of intangible assets.

We investigate whether the accruals anomaly is a manifestation of the glamour stock phenomenon documented in the finance literature. Value (glamour) stocks, characterized by low (high) past sales growth, high (low) book-to-market (B/M), high (low) earnings-to-price (E/P), and high (low) cash flow-to-price (C/P), are known to earn positive (negative) future abnormal returns. Note that “C” or cash flow is operationalized in the finance literature as earnings adjusted for depreciation. Sloan (1996) shows that firms with low (high) total accruals earn positive (negative) future abnormal returns. We find that a new variable, operating cash flows measured as earnings adjusted for depreciation and working capital accruals, scaled by price (CFO/P) captures mispricing attributed to the four traditional value-glamour proxies and accruals. Interpretation of this finding depends on the reader's priors. If the reader believes that value-glamour phenomenon can be operationalized only as C/P, and not CFO/P, then one would conclude that CFO/P is a parsimonious variable that captures the mispricing attributes of two distinct anomalies, value glamour and accruals. However, if a reader views the value-glamour anomaly broadly as a fundamentals-to-price anomaly, then (1) the CFO/P variable can be considered an expanded value-glamour proxy and; (2) our results are consistent with Beaver's (2002) conjecture that the accruals anomaly is the glamour stock phenomenon in disguise.

We examine whether U.K. managers use the flexibility provided under the partial method for deferred taxes to measure unrecognized deferred taxes opportunistically. We first test whether firm-specific operational and opportunistic factors are associated with the level of unrecognized deferred taxes. The tests provide evidence certain U.K. managers opportunistically measure deferred taxes to manage leverage, consistent with arguments by commentators that deferred taxes heavily influence leverage indicators that play a prominent role in the U.K. contracting framework. Because the proper identification and measurement of both operational and opportunistic determinants of unrecognized deferred taxes influence our tests, we additionally investigate whether unrecognized taxes relate to future deferred tax reversals and future operating profitability of the firm. These tests show the components of deferred taxes predict both future deferred tax reversals and indicators of future profitability of the firm as predicted. Taken together, our results indicate that, on average, the existence of balance sheet management does not nullify the predictive power of (unrecognized) deferred taxes for future deferred tax reversals and for profitability measures. One implication of the results is that the recent U.K. standard change eliminating the partial provision method for deferred taxes potentially has reduced the usefulness of deferred tax disclosures.