Knowledge that Transforms

This paper analyzes security returns of bank holding companies and insurance companies during periods surrounding the adoption of SFAS 115. We find bank share prices were negatively affected by the examined events, but find little share price reaction for insurance companies. Our evidence suggests banks were adversely affected by the standard because of problems with the standard's market value accounting approach. Cross-sectional analysis of event period returns shows that banks that more frequently traded their investments, with longer maturing investments, and that are more fully hedged against interest rate changes, were the most negatively impacted by the standard.

This paper examines the impact of twenty-three pronouncements related to fair value accounting (FVA) rules on equity prices of financial institutions. The results document that announcements that signal an increased (decreased) probability of issuance of FVA standards produce negative (positive) abnormal stock price reactions for sample banks. Further, the magnitude of the stock price reactions is negatively related to a bank's primary capital ratio and positively related to the ratio of the book value of the investment portfolio to total assets and the ratio of the difference between the market and book value of the investment portfolio to total assets.

We extend the contracting paradigm advanced in Smith and Watts (1992) to consider cross-sectional associations between investment opportunities and the sensitivity of CEO compensation to performance measures. We predict stronger associations between compensation and performance for firms with greater investment opportunities. We also predict greater use of market-based, rather than accounting-based, performance indicators as a basis for incentive payments when investment opportunities are substantial components of firm value. Results for specifications of 1992 and 1993 changes in compensation paid to CEOs of 1,249 publicly-traded U.S. firms are consistent with these hypotheses.

This study investigates whether investors incorporate the value of a firm's outstanding employee stock options into its stock price. I estimate the outstanding options' value for a sample of firms for which outstanding fixed options exceed 5% of outstanding common shares in 1988. I find a negative correlation between the value of outstanding options and a firm's share price. The correlation is stronger (i) for the option's intrinsic value than for the option's time value, (ii) for options that are later in their vesting stage than earlier in their vesting stage, and (iii) for large firms than for small firms. In addition, the FASB's method for calculating compensation expense has no explanatory power in the presence of this paper's calculation of the options' value.

Research has shown that managers display self-serving behavior in a variety of discretionary information production decisions. We test whether such behavior is also manifest in discretionary information disclosure decisions — in particular, in the common stock return performance comparisons now required in corporate proxy statements. We find evidence that the industry and peer-company stock return benchmarks, and broader market indices, chosen by management for those comparisons are downward biased, thereby overstating relative reporting-firm performance. Cross-sectionally, the extent of the bias varies with key reporting-firm attributes, including firm performance and the character of firm ownership structure.

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.