Knowledge that Transforms

This is an accepted manuscript of an article published by Wiley in Contemporary Accounting Research.

The revelation of material negative events about a firm, including issues such as fraud, restatements, or internal control material weaknesses (ICMWs), may destabilize the firm’s corporate governance equilibrium as it works to remediate the event or effects thereof. Prior research investigates the association between the revelation of fraud and restatements and both board and management turnover. We extend that research, proposing and testing a conceptual model of the process that firms use to remediate negative events in general and ICMWs specifically, with a focus on the role of governance structure changes. Using a sample of 733 firms revealing an ICMW compared to 3,602 firms with unqualified internal control reports, results reveal a positive association between disclosure of ICMWs and subsequent turnover of members of boards of directors, audit committees, and top management. Focusing on the ICMW sample and comparing the 511 firms that remediate their ICMWs to the 222 firms that do not, results illustrate a positive association between remediation of ICMWs and improvements in the characteristics of boards of directors, audit committees, and top management. Data Availability: Data are publicly available from sources identified in the paper.

We examine whether Canadian firms issuing convertible debt over the period 1996–2003 structured issuances to minimize reported leverage. Over this sample period, some firms using payment-in-kind (PIK) provisions providing them with the option to make interest and/or principal payments in company shares were able to record significant amounts of the issuance as equity. In a sample of 195 convertible debt offerings, we find significant variation in accounting treatment, ranging from firms recording the entire issuance as debt to some recording the entire issuance as equity. We find evidence consistent with the contention that reporting benefits are an important reason why high-leverage corporations with material convertible debt transactions used PIK provisions. In contrast, our evidence suggests that the future financial flexibility ensuing from the use of PIK provisions was an important determinant of income trusts’ use of this feature. We acknowledge, however, that during our sample period PIK provisions simultaneously provide both financial flexibility and reporting benefits to any issuer, whether corporation or trust. Finally, we document a negative share price reaction on the part of convertible debt issuers employing PIK provisions at the time when the likelihood of the introduction of more restrictive accounting rules increased. This negative reaction is driven by the corporations in our sample, with the income trusts largely unaffected. Our findings are relevant to standard setters as they debate alternative models for distinguishing between equity and liabilities.

We re-investigate the market pricing of special items, with particular emphasis on how managers " frame " these non-operating earnings components via their inclusion or exclusion from " street " earnings, the earnings numbers that firms disclose in their press releases and that analysts track and forecast. When managers include the special items in " street earnings (i.e., " street " = GAAP), the market overprices them, believing the special items to be more persistent than they actually are. As a result, there is a negative relationship between the special items and future stock returns in the following year. However, when managers exclude special items from " street " earnings (i.e., " street " not equal GAAP), the market recognizes their transitory characteristic and the relationship between special items and returns is insignificant in the following year. We also demonstrate that the decision to include (exclude) special items with (from) " street " earnings is associated with whether inclusion or exclusion of special items a) increases earnings numbers, b) smoothes the earnings series, or c) helps managers to meet earnings benchmarks. These results suggest that the decision to include or exclude special items from " street " earnings is associated with managerial incentives to manage earnings numbers rather than signal the persistence of special items.