Knowledge that Transforms

GAAP mandates the full expensing of R&D in financial statements, presumably because of concerns with the reliability, objectivity, and value-relevance of R&D capitalization. To address these concerns, we estimate the R&D capital of a large sample of public companies and find these estimates to be statistically reliable and economically meaningful. We then adjust the reported earnings and book values of sample firms for the R&D capitalization and find that such adjustments are value-relevant to investors. Finally, we document a significant intertemporal association between firms' R&D capital and subsequent stock returns, suggesting either a systematic mispricing of the shares of R&D-intensive companies, or a compensation for an extra-market risk factor associated with R&D.

This paper shows through increasing disclosure requirements may induce firms to reduce their value-relevant disclosures. In the absence of segment reporting requirements, an incumbent firm may voluntarily disclose value-relevant information because it can use other, value-irrelevant, information to jam proprietary disclosures. However, when required to disclose segment data, the incumbent may aggregate proprietary information with other value-relevant information to deter entry by a rival. Hence, the firm does not disclose value-relevant information it would have revealed voluntarily in the absence of segment disclosure requirements. In such situations, requiring more disaggregate disclosures can actually decrease price efficiency.

The papers by Subramanyam (1996) and Kasanen, Kinnunen, and Niskanen (KKN, 1996) both consider why managers manipulate accounting accruals. Subramanyam finds that discretionary accruals are associated with several performance measures, and concludes that managers' accrual choices increase the informativeness of accounting earnings. However, a strong competing alternative is that the ‘Jones model’ systematically mismeasures discretionary accruals, so that they contain a significant non-discretionary component. Unlike many US studies, KKN find strong evidence of earnings management in Finland, where Finnish managers set earnings to satisfy the demand for dividends by keiretsu-like institutional investors.

For the first time in the literature, we provide evidence of dividend-based earnings management. The credibility of the contracting view of earnings management is enhanced by studies in different institutional settings. In this paper, the institutional setting is a debt-dominated capital market. On one hand, the implicit contract driving the earnings management behavior in our (keiretsu-type) financial environment is the smooth dividend stream expected by the large institutional equity holders. This creates a need for companies to report earnings high enough to pay out dividends. On the other hand, managing earnings upwards is costly because of tax consequences. We find that the predicted and actual earnings management are in the same direction, and the reported earnings depend on the dividend-based target earnings in Finland during 1970–1989. Our results provide new testable hypotheses for earnings management in companies that have owners with preference for stable dividends.

This paper investigates the value-relevance of banks' derivatives disclosures provided under SFAS 119. The findings suggest that the fair value estimates for derivatives help explain cross-sectional variation in bank share prices and that the fair values have incremental explanatory power over and above notional amounts of derivatives. I also conduct cross-sectional tests to provide preliminary evidence on the usefulness of derivatives disclosures in examining banks' risk-management strategies. While I find that banks, on average, are reducing their risk exposures using derivatives, further analysis reveals that only 47% of the sample banks appear to use derivatives to reduce risk.

Amir and Lev (1996) address two interesting issues: the value-relevance of reported financial information for fast-changing, science-based companies and the value-relevance of nonfinancial information incremental to financial information. Using a sample of cellular phone companies, they report that the financial accounting information is only value-relevant after the inclusion of the nonfinancial information and that the nonfinancial information they examine is value-relevant both by itself and incremental to the financial information. I first discuss details specific to the tests conducted by Amir and Lev before discussing some of the implications offered by Amir and Lev.

In the preceding papers, Beaver and Engel and Adiel investigate managerial discretion in the financial services industry. This comment evaluates the contribution and limitations of both papers and suggests avenues for further extensions.

The study examines the capital market pricing of discretionary and nondiscretionary components of a major accrual in the banking industry, the allowance for loan losses. The analysis employs a two-stage approach in which the allowance account is first decomposed into estimates of its nondiscretionary and discretionary components. The second stage evaluates the market's valuation of the estimates of the components. Evidence suggests that the capital market perceives the allowance to be comprised of two components, a nondiscretionary component which is negatively priced and a discretionary component whose incremental pricing coefficient is positive.

I develop a benchmark for evaluating whether fair values disclosed by banks differ from investors' estimates of the market value of financial assets and liabilities. Using this benchmark, I conclude that the hypothesis that disclosed fair values closely approximate investors' estimates should be rejected. I present evidence suggesting that the procedure used in establishing fair values results in an understatement of the value of financial assets an an overstatement of liabilities. I also conclude that the reaction of bank stocks to the adoption of SFAS 105, 107, and 115 is more consistent with regulatory concerns and not with potential adverse effects of those statements for contracting.

The papers by Venkatachalam (1996) and Aboody (1996) provide some interesting evidence on issues that are important to accounting regulators as well as accounting academics. However, for econometric as well as economic reasons, there are limits to what we can learn from this type of research (cross-sectional ‘levels’ studies). Careful attention to methodological issues in this type of research design can reduce, but likely will not eliminate, these interpretational difficulties.