Knowledge that Transforms

This study investigates the extent to which property‐casualty insurers select levels of loss reserves, net capital gains, and net stock transactions to meet solvency and tax reporting goals. Insurer solvency is reflected in financial measures known as IRIS (Insurance Regulatory Information System) ratios. IRIS ratios are generally enhanced by underestimating loss reserves, accelerating the realization of capital gains, postponing the realization of capital losses, issuing stock, and cutting dividends. Taxable income is reduced by reporting higher reserves and lower net capital gains on investments. We use simultaneous equations to model the three discretionary choices individually, while controlling for potential tradeoffs among the decisions. During the sample period of the study (1990‐95), there is a shift in the regulatory environment that we argue tends to reduce incentives to meet IRIS goals. Specifically, risk‐based capital (RBC) requirements were adopted in 1994. Although IRIS ratios continued to be used for solvency screening, their effect is expected to be diluted in the post‐RBC period. Our results provide qualified support for this claim. Evidence of the phenomenon is stronger when the choice variables are net capital gains and stock transactions, and weaker when loss reserves are considered. Two of the three discretionary choices affect taxable income: loss reserves and capital gains. We find that tax incentives are significantly associated with the loss reserve estimate throughout the sample period. In contrast, our results are only weakly consistent with the view that capital gains are timed to achieve tax relief.

This paper examines the relation between earnings and operating cash flow to derive and test an indicator of financial statement fraud. Accrual measurement concepts indicate that financial statement fraud should be associated with high levels of earnings relative to operating cash flow. We demonstrate that the excess of earnings over operating cash flow is extreme in most fraud cases in years immediately prior to the fraud discovery based on a sample of 56 fraud cases from 1978 to 1991. We compare the distribution of the earnings minus operating cash flow variable for fraud firms with that for a sample of 60,453 firm‐years for firms listed on COMPUSTAT. We test a logistic regression model in which the discovery/nondiscovery of fraud is the dependent variable, and earnings minus operating cash flow is the explanatory variable. Other control variables are included in the model based on prior studies. Results are consistent with expectations derived from accrual measurement theory. We then examine the predictive ability of the model using our sample of fraud firms and a sample of nonfraud firms in the same four‐digit SIC code industries. Observations for the fraud firms are for the fiscal year prior to the discovery of fraud. Observations for the nonfraud firms are for the same fiscal years as the fraud firms in the same industries. The predictive ability of the model, including the excess of earnings over operating cash flow, is substantially higher than the predictive ability of the model omitting this variable. We conclude that the earnings‐operating cash flow relation provides important information for those interested in identifying financial statement fraud, especially when considered in conjunction with other factors associated with fraud risk.

This paper examines how market prices, volume, and traders' dividend expectations respond to public information releases in laboratory markets for a long‐lived financial asset. The objective is to study deviations from the symmetric information risk‐neutral rational expectations (RE) benchmark, which predicts no trade in such settings. The results of a series of double‐auction and call markets are reported in which traders manage a portfolio of cash and asset shares over 15 rounds of trading. A public signal regarding the value of the liquidating dividend is released every third round, and traders' subjective expectations of the liquidating dividend are elicited each round as cash‐motivated forecasts. We find that, despite the public dividend signal, traders' dividend forecasts are heterogeneous. Forecasts and prices both underreact to the public signals, with prices under‐reacting more than forecasts. In general, price changes are not closely associated with public signals, and there is greater excess price volatility in double auctions than in call markets. Forty‐three percent of trades are inconsistent with the trader's forecasts, and inconsistent trades occur more frequently in the double‐auction markets. On average, approximately 10 percent of the outstanding shares are traded in each round, and trading volume is increasing in the mean absolute forecast revision and decreasing in the contemporaneous dispersion in forecasts. These results suggest that differential processing of the public signal and/or speculative trading for short‐term gain may help to explain why symmetric information RE predictions are often not supported in empirical and experimental settings. They also suggest that market reactions to public information releases may be influenced by market microstructure.

This study examines the predictive value of Management Discussion and Analysis (MD&A) information. More specifically, this study tests the association between properties of analysts' earnings forecasts and MD&A quality, where MD&A quality is measured by the Securities Exchange Commission (SEC). We find that high MD&A ratings are associated with less error and less dispersion in analysts' earnings forecasts after controlling for many other expected influences on analysts' forecasts. We also find that estimated regression coefficients are consistent with MD&A information having a substantial effect on earnings forecasts. Finally, we find our results are driven by forward‐looking disclosures about capital expenditures and operations, and also by historical disclosures about capital expenditures. These findings are consistent with the suggestion by many constituencies (including the SEC) that the type of information found in high quality MD&A is particularly relevant for predicting earnings.

Accounting accruals are managers' subjective estimates of future outcomes and cannot, by definition, be objectively verified by auditors prior to occurrence. This causes audits of high‐accrual firms to pose more uncertainty than audits of low‐accrual firms because of potential estimation error and a greater chance that high‐accrual firms have undetected asset realization and/or going concern problems that are related to the high level of accruals. One way that auditors can compensate for this risk exposure is to lower their threshold for issuing modified audit reports, an action that will increase modified reports and, therefore, lessen the likelihood of failing to issue a modified report when appropriate. We call this auditor reporting conservatism and test if high‐accrual firms in the United States, are more likely to receive modified audit reports for asset realization uncertainties and going concern problems. Empirical results for a large sample of U.S. publicly listed companies support the hypothesis that auditors are more conservative, that is, more likely to issue both types of modified audit reports for high‐accrual firms. Further analyses show that income‐increasing accruals are somewhat more likely to result in reporting conservatism than income‐decreasing accruals, and that only the Big Six group of auditors show evidence of reporting conservatism. These findings add to our understanding of the audit report formation process and the potentially important role played by accounting accruals in that process.

Stable URL:http://links.jstor.org/sici?sici=0021-8456%28199921%2937%3A1%3C191%3AWDIAK%3E2.0.CO%3B2-FJournal of Accounting Research is currently published by The Institute of Professional Accounting, Graduate School ofBusiness, University of Chicago.Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available athttp://www.jstor.org/about/terms.html. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtainedprior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content inthe JSTOR archive only for your personal, non-commercial use.Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained athttp://www.jstor.org/journals/grad-uchicago.html.Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printedpage of such transmission.The JSTOR Archive is a trusted digital repository providing for long-term preservation and access to leading academicjournals and scholarly literature from around the world. The Archive is supported by libraries, scholarly societies, publishers,and foundations. It is an initiative of JSTOR, a not-for-profit organization with a mission to help the scholarly community takeadvantage of advances in technology. For more information regarding JSTOR, please contact [email protected]://www.jstor.orgFri Jan 4 16:36:17 2008