Knowledge that Transforms

Abstract Prior literature and anecdotal evidence, most recently provided by allegations relative to Enron, Global Crossing, and WorldCom, suggest that failing firms (defined here as prebankruptcy firms) may be motivated to engage in fraudulent financial reporting to conceal their distress. I examine two research questions: (1) Are failing firms' prebankruptcy financial statements more likely to exhibit signs of material income increasing earnings manipulation than those of nonfailing firms? (2) Do auditors detect the overstatements in firms that they perceive to be failing? I predict and find that as (ex post) bankrupt firms that do not (ex ante) appear to be distressed approach bankruptcy, their financial statements reflect significantly greater material income‐increasing accrual magnitudes in nongoing‐concern years than do control firms. The accrual behavior of these firms resembles that of bankrupt firms that the Securities and Exchange Commission (SEC) has sanctioned for fraud. Like sanctioned firms, the nonstressed bankrupt firms display significantly greater (material) increases in receivables; inventory; property, plant, and equipment; sales; net working capital, current, and discretionary accruals in prebankruptcy nongoing‐concern years than do control firms. They also display significantly more negative changes in cash flows from operations and net cash and a greater disparity between accrual‐based net income and operating cash flows than do control firms, consistent with Lee, Ingram, and Howard 1999. Finally, I predict and find that these firms' going‐concern years reflect evidence consistent with auditor‐prompted reversal of previous overstatements. These results are based on parametric and nonparametric tests for various subsample combinations drawn from a sample of 293 bankrupt firms representing approximately 2,500 observations.

Abstract To date, the discussion of the Lev and Thiagarajan 1993 fundamentals in the prior literature has been exclusively in the context of the stock market. Our study is the first to examine the value‐relevance of these fundamentals for default risk. By focusing on the market for new bond issues, we examine the value‐relevance of the fundamental score using expected rather than realized returns. Also, by focusing on the bond market we provide a different perspective than that brought by prior studies relying solely on stock prices. We find the fundamentals to be priced in the market for new bond issues as indicators of expected future earnings and to be value‐relevant in enabling the market to discern differences in bond credit quality over and above the published bond ratings.

Abstract Statement of Financial Accounting Standards No. 109 (SFAS No. 109) allows firms to use their discretion to set arbitrarily high valuation allowances against deferred tax assets. Firms can then later use these "hidden reserves" to manage earnings. Our evidence indicates that most banks do not record a valuation allowance to manage earnings, but rather to follow the guidelines of SFAS No. 109. However, if the bank is sufficiently well capitalized to absorb the current‐period impact on capital, then the amount of the valuation allowance increases with a bank's capital. In later years, bank managers adjust the valuation allowance to smooth earnings. The magnitude of the discretionary adjustment increases with the deviation of unadjusted earnings from the forecast or historical earnings.

Abstract This paper examines the linkages between discretionary accruals (DAs), managerial share ownership, management compensation, and audit fees. It draws on the theory that managers of firms with high management ownership are likely to use DAs to communicate value‐relevant information, while managers of firms with high accounting‐based compensation are likely to use DAs opportunistically to manage earnings to improve their compensation. OLS regression results of 648 Australian firms show that (1) there is a positive association between DAs and audit fees; (2) managerial ownership negatively affects the positive relationship between DAs and audit fees; and (3) this negative impact is further found to be weaker for firms with high accounting‐based management compensation.

We compare and contrast some existing ordinary least squares (OLS)- and generalized method of moments (GMM)-based tests of asset pricing models with a new more general test. This new test is valid under the assumption that returns are elliptically distributed, a necessary and sufficient assumption of the linear capital asset pricing model (CAPM). This new test fails to reject the CAPM on a dataset of stocks sorted by market valuations, whereas similar tests constructed from OLS and GMM estimation methods reject the linear CAPM. We also find that outliers reduce the OLS-estimated mispricing of the linear CAPM on monthly returns sorted by previous performance, that is, momentum. Monte Carlo evidence supports superior size and power properties of the new test relative to OLS- and GMM-based tests. Copyright 2003, Oxford University Press.

This article is a critical survey of models designed for pricing fixed-income securities and their associated term structures of market yields. Our primary focus is on the interplay between the theoretical specification of dynamic term structure models and their empirical fit to historical changes in the shapes of yield curves. We begin by overviewing the dynamic term structure models that have been fit to treasury or swap yield curves and in which the risk factors follow diffusions, jump-diffusion, or have “switching regimes.” Then the goodness-of-fit of these models is assessed relative to their abilities to (i) match linear projections of changes in yields onto the slope of the yield curve; (ii) match the persistence of conditional volatilities, and the shapes of term structures of unconditional volatilities, of yields; and (iii) to reliably price caps, swaptions, and other fixed-income derivatives. For the case of defaultable securities we explore the relative fits to historical yield spreads.