Knowledge that Transforms

In this study, we hypothesize and find that financial statement analysis of firm profitability drivers applied at the aggregate level yields timely insights that are relevant for forecasting real economic activity. We first show that focusing on the 100 largest firms offers a cost-effective way to extract information embedded in accounting profitability data of the entire stock market portfolio. We then show that accounting profitability data aggregated across the 100 largest firms have predictive content for subsequent real Gross Domestic Product (GDP) growth. We also show that stock market returns have predictive content for future real GDP growth, while their predictive power varies with the length of the measurement window with annual stock market returns being the most powerful. Importantly, we find that the predictive content of our indices of aggregate accounting profitability drivers is incremental to that of annual stock market returns. An in-depth investigation of consensus survey forecasts shows that professional macro forecasters revise their expectations of real economic activity in the direction of the predictive content of aggregate accounting profitability drivers and stock market returns. Although macro forecasters are fully attuned to stock market return data, their forecasts of real GDP growth can be improved in a statistically and economically significant way using our indices of aggregate accounting profitability drivers. Our findings suggest that professional macro forecasters and stock market investors do not fully impound the predictive content of aggregate accounting profitability drivers when forecasting real economic activity. In additional analysis, we examine the association between stock market returns and the portion of subsequent real GDP growth that is predictable based on our indices of aggregate accounting profitability drivers but that is not anticipated by stock market investors. We find that this portion is positively related to stock market returns, suggesting that the macro predictive content of aggregate accounting profitability drivers is relevant for stock valuation. Overall, our study brings financial statement analysis to the forefront as an incrementally useful tool for gauging the prospects of the real economy that should be of interest to academics and practitioners. JEL Classification: E01; E32; E60; M41. Data Availability: Data are available from public sources indicated in the text.

We examine the extent to which firms use past performance as a basis for setting earnings targets in their bonus plans and assess the implications of such targets for managerial incentives. We find that high-profitability firms commonly decrease earnings targets when their managers fail to meet prior-year targets but rarely increase targets. Conversely, we find that low-profitability firms commonly increase earnings targets when their managers meet or exceed prior-year targets but rarely decrease targets. This target-revision process yields a serial correlation in target difficulty—targets remain relatively easy (or difficult) through time. We also find that firms are reluctant to revise earnings targets below zero, resulting in an unusually high frequency of zero earnings targets that are abnormally difficult to achieve. Collectively, our findings suggest that firms incorporate past performance information into targets, yet they do so only to a limited extent. This is consistent with theoretical arguments that highlight the benefits of contractual commitments. Data Availability: Data used in this study cannot be made public due to the confidentiality agreement with the sponsoring organization.

The use of relative performance evaluation (RPE) in compensation contracts for CEOs at growth-option (GO) firms that operate in more volatile environments can provide insurance against common exogenous shocks and thus reduce the amount of risk that CEOs face. However, the implementation of RPE for high-GO firms can be impaired by these firms' inability to find a peer group that captures common risk exposure. This paper studies GO firms' reliance on RPE and finds that the use of RPE in CEO compensation contracts varies negatively with a firm's level of growth options. The tests use three proxies for growth options: the market-to-book value of assets, research and development expenses scaled by assets, and a factor obtained from a principal component analysis. The results are robust to controlling for the impact of other firm characteristics on pay-for-performance sensitivities. Data Availability: All data are obtained from publicly available sources.

This study examines the empirical relation between voluntary participation in the Internal Revenue Service's (IRS) Compliance Assurance Process (CAP) audit program, and tax uncertainty disclosed in financial statements pursuant to Financial Interpretation No. 48 (FIN 48). Based on the findings of prior analytical and empirical research, we formulate and test hypotheses about the likelihood of voluntary CAP participation and the resulting effect on FIN 48 tax reserves. We find that firms with moderate-sized FIN 48 reserves are more likely to participate in CAP than firms with either small or large reserves, indicating an inverted U-shaped relation between CAP participation rates and firms' tax reserves. After controlling for non-random sample selection, we find that CAP firms significantly reduce their FIN 48 reserves by about 16.5 percent relative to non-CAP firms. However, this reduction is concentrated among firms with moderate-sized FIN 48 reserves. These cross-sectional differences are consistent with FIN 48 reserves reflecting both tax uncertainty and tax aggressiveness. JEL Classifications: M41; M42; M48; H25. Data Availability: FIN 48 data and confidential tax data on CAP participants are obtained from the Internal Revenue Service (IRS) Large Business & International (LB&I), Planning, Analysis, Inventory, and Research Division (PAIR). The CAP data are not publicly available; the FIN 48 data were compiled and validated by the IRS and made available to one of the authors. All other data are available from public sources identified in this treatise. Because tax data are confidential and protected by data nondisclosure agreements under the Internal Revenue Code, all statistics are presented in the aggregate; no statistics with three or fewer observations are disclosed. Any opinions are those of the authors and do not necessarily reflect the views of the IRS.

We provide theory and experimental evidence consistent with an unintended, causal relation between Corporate Social Responsibility (CSR) performance and investors' estimates of fundamental value that can be attenuated by investors' explicit assessment of CSR performance. Consistent with “affect-as-information” theory from psychology, we find that investors who are exposed to, but do not explicitly assess, CSR performance derive higher fundamental value estimates in response to positive CSR performance, and lower fundamental value estimates in response to negative CSR performance. Explicit assessment of CSR performance, however, significantly diminishes this effect, indicating that the effect among investors who do not explicitly assess CSR performance is unintended; i.e., they unintentionally use their affective reactions to CSR performance in estimating fundamental value. Supplemental findings shed light on consequences of these fundamental value estimates: investors who do not explicitly assess CSR performance rely on their unintentionally influenced estimates of fundamental value to increase the price they are willing to pay to invest in the stock of a firm with positive CSR performance. Overall, our theory and findings contribute to the CSR and affect literatures in accounting by revealing the contingent nature of how and to what extent CSR performance influences investors' beliefs about firm value and the bids these investors are likely to make in equity markets. Data Availability: Contact the authors.

This paper investigates whether so-called anomalous returns predicted by accounting numbers reflect normal returns for risk or abnormal returns. It does so via a model showing how accounting numbers inform about normal returns if pricing were rational. The model equates expected returns to expectations of earnings and earnings growth, so that any variable that forecasts earnings and earnings growth also indicates the required return if the market prices those outcomes as risky. The empirical results confirm that many accounting anomaly variables (such as accruals, asset growth, and investment) forecast forward earnings and growth, and in the same direction in which they forecast returns. While the lack of an agreed-upon asset pricing model for required returns rules out definitive conclusions, the paper provides both a framework and supporting empirical results indicating that the observed “anomalous” returns associated with accounting numbers are consistent with rational pricing.

We examine (1) whether the accounting, governance, and investing practices of Berkshire Hathaway investees are consistent with Warren Buffett's public statements on what constitutes good accounting, governance, and investing practices and (2) whether these practices are associated with Berkshire's initial “selection” or Buffett's subsequent “influence.” Compared to control firms, we find that Berkshire investees are highly likely to follow Buffett's investment philosophy, somewhat likely to follow his preferred accounting, disclosure, and compensation policies, but unlikely to follow the board-related governance practices that we can measure. Second, we find some evidence that the business practices of future Berkshire investees are more aligned with Buffett's beliefs in the pre-investment period compared to control firms. Third, we find relatively modest evidence that investees improve a few of their business practices subsequent to Berkshire's initial investment. However, and overall, Buffett does not appear to be especially influential in the subsequent accounting, governance, and investing decisions of Berkshire investees, likely because he has already taken into account the attributes he cares most about in the initial investment decision. Data Availability: Except for the Gunning Fog Index and family firm status, other data in this study are available from commercial providers, e.g., CDA/Spectrum Institutional Money Manager Holdings, Compustat, CRSP.

In an incomplete market with heterogeneous prior beliefs, we show that public information can have a substantial impact on the ex ante cost of capital, trading volume, and investor welfare. The Pareto efficient public information system is the system enjoying the maximum ex ante cost of capital and the maximum expected abnormal trading volume. Imperfect public information increases the gains-to-trade based on heterogeneously updated posterior beliefs. In an exchange economy, this leads to higher growth in the investors' certainty equivalents and, thus, a higher equilibrium interest rate, whereas the ex ante risk premium is unaffected by the informativeness of the public information system. Similar results are obtained in a production economy, but the impact on the ex ante cost of capital is dampened compared to the exchange economy due to welfare-improving reductions in real investments to smooth the investors' certainty equivalents over time.

Family firms are characterized by less separation between ownership and control (Type 1 agency problem), but greater conflict of interest between controlling insiders and non-controlling outside investors (Type 2 agency problem). Although strong board governance is known to decrease the Type 1 agency problem, its effectiveness in mitigating the adverse consequences of the Type 2 agency problem has not been well documented in the literature. We show that strongly governed family firms are more likely to choose specialist auditors and exhibit higher earnings quality than nonfamily firms. Weakly governed family firms demand lower audit effort and exhibit earnings quality that is no different from that of nonfamily firms. Within family firms, we show that strongly governed family firms choose higher quality audits in the form of a greater use of specialist auditors and higher audit efforts, and exhibit higher earnings quality than other family firms. These findings provide consistent evidence that strong board governance can effectively mitigate the adverse consequences of the Type 2 agency problem on financial reporting and transparency in family firms. Data Availability: The data used are available from the public sources identified in the study.

We examine the disclosure of non-GAAP earnings information in quarters containing transitory gains to investigate whether the primary motivation for these managers to disclose non-GAAP earnings is to inform or mislead. In this setting, non-GAAP earnings are more informative than GAAP earnings, even though they are lower than GAAP earnings. Thus, managers motivated to inform stakeholders about sustainable earnings will disclose non-GAAP earnings information excluding the gain, whereas managers motivated to report higher earnings will obscure the transitory nature of the gain by focusing on GAAP earnings. We find evidence that managers' disclosure choices vary widely across firms, and these choices affect investors' perceptions of core operating earnings. We then contrast how the same firm discloses non-GAAP earnings in the presence of transitory losses to provide additional evidence on the motives of individual firms' disclosures. We conclude that the most pervasive motivation to disclose non-GAAP earnings in the presence of transitory gains is to inform. An economically significant proportion of firms, however, appear opportunistic in that they only disclose non-GAAP earnings information when it increases investors' perceptions of core operating earnings. Our evidence is important because we speak to the influence that each motive has on the choice to disclose non-GAAP earnings and we provide evidence on the underlying motives behind specific firms' disclosures. Data Availability: All data are available from the sources cited in the text.