REVISION: Accounting Informs Investors and Earnings Management is Rife: Two Questionable Beliefs
Date Posted: May 15, 2013
This short essay is based on a presentation at the panel discussion on “The Most Incorrect Beliefs in Accounting” at the American Accounting Association Meetings in 2012. It addresses the inordinate amount of attention given in the literature to accounting’s role in providing new information for equity investors, and to allegedly rampant “earnings management.”
REVISION: Econometrics of the Basu Asymmetric Timeliness Coefficient and Accounting Conservatism
Date Posted: Jan 10, 2013
A substantial literature investigates conditional conservatism, defined as asymmetric accounting recognition of economic shocks (“news”), and how it depends on various market, political and institutional variables. Studies typically assume the Basu (1997) asymmetric timeliness coefficient (the incremental slope on negative returns in a piecewise-linear regression of accounting income on stock returns) is a valid conditional conservatism measure. We analyze the measure’s validity, in the co
REVISION: On Estimating Conditional Conservatism
Date Posted: Dec 03, 2012
The concept of conditional conservatism has provided new insight into financial reporting and has stimulated considerable research since Basu (1997) developed it. While the concept encapsulated in the adage “anticipate no profits but anticipate all losses” is reasonably clear, estimating it is the subject of some discussion, notably by Dietrich et al. (2007), Givoly et al. (2007), and Ball, Kothari and Nikolaev (2011). Recently, Patatoukas and Thomas (2011) report important evidence of possi
REVISION: Mark-to-Market Accounting and Information Asymmetry in Banks
Date Posted: Aug 21, 2012
We examine the relation between mark-to-market (MTM) accounting for securities and information asymmetry among bank investors. Relative to historical cost, MTM incorporates more timely information in financial statements. The primary effect of more timely disclosure most likely is to reduce information asymmetry. Nevertheless, models in which public information triggers private information acquisition imply some offsetting increase in asymmetry due to differential information production among in
New: The Information Value of the Annual Earnings Report
Date Posted: Aug 13, 2012
This working paper is the first draft of our co-authored publication, "An Empirical Evaluation of Accounting Income Numbers," Journal of Accounting Research 6, 1968, pp.159-78. While undated, it subsequently was presented at the November 1967 Seminar on the Analysis of Security Prices organized by the Center for Research in Security Prices (CRSP) at the University of Chicago. It was included in the November 1967 Proceedings of the Seminar on the Analysis of Security Prices.
In 1986, the publi
New: Audited Financial Reporting and Voluntary Disclosure as Complements: A Test of the Confirmation Hypo
Date Posted: Nov 11, 2011
We examine the 'confirmation' hypothesis that audited financial reporting and disclosure of managers’ private information are complements, because independent verification of outcomes disciplines and hence enhances disclosure credibility. Committing to higher audit fees (a measure of financial statement verification) is associated with management forecasts that are more frequent, specific, timely, accurate and informative to investors. Because private information disclosure and audited financial
REVISION: Aggregate Earnings and Asset Prices
Date Posted: Aug 30, 2011
A principal-components analysis demonstrates that common earnings factors explain a substantial portion of
rm-level earnings variation, implying earnings shocks have substantial systematic components and are not almost fully diversifiable as prior literature has concluded. Furthermore, the principal components of earnings and returns are highly correlated, implying aggregate earnings risks and return risks are related. In contrast to previous studies, the correlation we report between the syste
REVISION: Audited Financial Reporting and Voluntary Disclosure as Complements: A Test of the Confirmation Hypo
Date Posted: Jul 04, 2011
We examine the “confirmation” hypothesis, that audited, backward-looking financial outcomes and disclosure of managers’ private forward-looking information are complements, because independent audit disciplines and hence enhances disclosure credibility. Committing to higher audit fees (a measure of the extent of financial outcome verification and thus the accuracy and freedom from manipulation of reported outcomes), is associated with management forecasts that are more frequent, specific, timely
REVISION: The Global Financial Crisis and the Efficient Market Hypothesis: What Have We Learned?
Date Posted: Dec 11, 2009
The sharp economic downturn and turmoil in the financial markets, commonly referred to as the “global financial crisis,” has spawned an impressive outpouring of blame. The efficient market hypothesis - the idea that competitive financial markets ruthlessly exploit all available information when setting security prices - has been singled out for particular attention. Like all good theories, market efficiency has major limitations, even though it continues to be the source of important and endurin
New: The Complementary Roles of Audited Financial Reporting and Voluntary Disclosure: A Test of the Confi
Date Posted: Oct 17, 2009
We examine the complementarity between voluntary disclosure and reporting audited financial statement outcomes. We test the “confirmation” hypothesis, that reporting audited, backward-looking outcomes disciplines and hence enhances the precision and credibility of managers’ disclosure of private forward-looking information. Using management earnings forecasts as the voluntary disclosure variable, we report that committing to higher audit fees (a measure of the extent of financial statement verif
How Naive Is the Stock Market's Use of Earnings Information?
Date Posted: Sep 04, 2009
Rendleman Jones and Latane (1987) and Bernard and Thomas (1990) report evidence supporting their hypothesis that investors use a "naive" seasonal random walk model in forming expectations of quarterly earnings. Using the Bernard and Thomas (1990) data we show that the market acts as if it: (1) does not use a seasonal random walk model; (2) does incorporate past earnings changes in forming expectations; (3) does use the correct signs in exploiting serial correlation in seasonally-differenced qu
REVISION: Aggregate Earnings and Asset Prices
Date Posted: Aug 02, 2009
A principal-components analysis demonstrates that common earnings factors explain a substantial portion of firm-level earnings variation, implying earnings shocks have substantial systematic components and are not almost fully diversifiable as prior literature has concluded. Furthermore, the principal components of earnings and returns are highly correlated, implying aggregate earnings risks and return risks are related. In contrast to previous studies, the correlation we report between the syst
REVISION: Market and Political/Regulatory Perspectives on the Recent Accounting Scandals
Date Posted: May 14, 2009
Not surprisingly, the recent accounting scandals look different when viewed from the perspectives of the political/regulatory process and of the market for corporate governance and financial reporting. We do not have the opportunity to observe a world in which either market or political/regulatory processes operate independently, and the events are recent and not well-researched, so untangling their separate effects is somewhat conjectural. This paper offers conjectures on issues such as: What c
New: Market and Political/Regulatory Perspectives on the Recent Accounting Scandals
Date Posted: Apr 29, 2009
Not surprisingly, the recent accounting scandals look different when viewed from the perspectives of the political/regulatory process and of the market for corporate governance and financial reporting. We do not have the opportunity to observe a world in which either market or political/regulatory processes operate independently, and the events are recent and not well-researched, so untangling their separate effects is somewhat conjectural. This paper offers conjectures on issues such as: What c
REVISION: Earnings Quality in U.K. Private Firms
Date Posted: Apr 26, 2009
UK private and public companies face substantially equivalent regulation on auditing, accounting standards and taxes. We hypothesize that private-company financial reporting nevertheless is lower quality due to different market demand, regulation notwithstanding. A large UK sample supports this hypothesis. Quality is operationalized using Basu's (1997) time-series measure of timely loss recognition and a new accruals-based method. The result is not affected by controls for size, leverage, indust
Accounting Depreciation and Product Prices
Date Posted: Mar 09, 2009
We argue that accounting depreciation either is the firm s calculation of the cost of a durable factor, or is information used in determining (implicitly or explicitly) the factor cost. Simple competitive-economic theory then implies a relation between accounting depreciation and product prices. We hypothesize that this relation is strengthened by various accounting techniques, including the inclusion of depreciation charges in standard costs, budgets and actual performance measures, as well as
Is Research On Trading Rules Implementable? The Case Of Short-Term Contrarian Strategies
Date Posted: Mar 09, 2009
Research on trading rule profitability usually simulates trading on historical data. These data usually are obtained from files such as CRSP, which estimate closing prices as the last trade (at the closing bid or the closing ask, or neither), or the bid-ask average (in the absence of a last trade). A trading rule could not normally be implemented at these prices, for even a smaller number of shares. A simulated contrarian strategy transforms noise in closing price estimates into return biases, b
Commitment, Historical Cost Accounting and Accounting Depreciation
Date Posted: Mar 09, 2009
We conjecture that accounting depreciation reduces the over- and under-investment problem in acquiring and utilizing fixed assets. By forcing the agent to cover depreciation charges of assets the agent proposes to buy, the agent commits to generate cash flows in excess of depreciation charges (through either additional revenues or cost savings). Moreover, the book value of undepreciated historical cost commits the agent to maintain the asset's productive capacity. Various accounting techniques,
The Effect of International Institutional Factors on Properties of Accounting Earnings
Date Posted: Mar 09, 2009
International differences in the demand for accounting income predictably affect the way it incorporates economic income (dividend-adjusted change in market value) over time. We characterize the "shareholder" and "stakeholder" corporate governance models of common and code law countries respectively as resolving information asymmetry by public disclosure and private communication. Also, code law directly links accounting income to current payouts (to employees, managers, shareholders and governm
Incentives versus Standards: Properties of Accounting Income in Four East Asian Countries, and Impli...
Date Posted: Mar 09, 2009
The East Asian countries of Hong Kong, Malaysia, Singapore and Thailand provide a rare opportunity to study the interaction between the accounting standards under which financial statements are prepared and the incentives of managers and auditors who prepare them. Their accounting standards are largely derived from common law sources [UK, US and International Accounting Standards (IAS)], which are widely viewed as higher quality than code law standards. However, economic and political influences
Earnings Quality in U.K. Private Firms
Date Posted: Mar 09, 2009
UK private and public companies face substantially equivalent regulation on auditing, accounting standards and taxes. We hypothesize that private-company financial reporting nevertheless is lower quality due to different market demand, regulation notwithstanding. A large UK sample supports this hypothesis. Quality is operationalized using Basu's (1997) time-series measure of timely loss recognition and a new accruals-based method. The result is not affected by controls for size, leverage, indust
REVISION: Incentives Versus Standards: Properties of Accounting Income in Four East Asian Countries
Date Posted: Feb 07, 2009
The East Asian countries of Hong Kong, Malaysia, Singapore and Thailand provide a rare opportunity to study the interaction between the accounting standards under which financial statements are prepared and the incentives of managers and auditors who prepare them. Their accounting standards are largely derived from common law sources [UK, US and International Accounting Standards (IAS)], which are widely viewed as higher quality than code law standards. However, economic and political influences
REVISION: How Much New Information is There in Earnings?
Date Posted: Aug 21, 2008
We quantify the relative importance of earnings announcements in providing new information to the share market, using the r-squared in a regression of securities' calendar year returns on their four quarterly earnings announcement window returns. The r-squared, which averages approximately five to nine percent, measures the proportion of total information incorporated in share prices over a year that is associated with earnings announcements. We conclude that the average quarterly announcement i
REVISION: What is the Actual Economic Role of Financial Reporting?
Date Posted: Jun 01, 2008
This short essay is based on a presentation at the panel discussion on Big Unanswered Questions in Accounting at the American Accounting Association Meetings in 2007. It poses the question: what is the actual economic role of financial reporting? and discusses why this question is important, why it is unanswered, and what types of inventive research design are needed to help answer it. Examples are given of the types of questions involved.
New: What is the Actual Economic Role of Financial Reporting?
Date Posted: Feb 10, 2008
This short essay is based on a presentation at the panel discussion on "Big Unanswered Questions in Accounting" at the American Accounting Association Meetings in 2007. It poses the question "what is the actual economic role of financial reporting?" and discusses why this is an important question, why it is unanswered, and the types of inventive research design needed to help answer it. Examples of the types of questions involved are given.
REVISION: Is Financial Reporting Shaped By Equity Markets or By Debt Markets? An International Study of Timeli
Date Posted: Dec 17, 2007
We hypothesize debt markets - not equity markets - are the primary influence on association metrics studied since Ball and Brown (1968). Debt markets demand high scores on timeliness, conservatism and Lev's (1989) RSQ, because debt covenants utilize reported numbers. Equity markets do not rate financial reporting consistently with these metrics, because (among other things) they control for the total information incorporated in equity prices. Single-country studies shed little light on the relat
New: Earnings Quality at Initial Public Offerings
Date Posted: Dec 08, 2007
Financial reporting around the time of IPOs is consistent with listed firms reporting more conservatively than previously as private firms, consistent with the results in Ball and Shivakumar (2005). We hypothesize that IPO firms supply the higher quality financial reports demanded by public investors, who face higher information asymmetry than private investors. The market mechanisms for enforcing this demand include monitoring by internal and external auditors, boards, analysts, rating agencies
REVISION: Is Financial Reporting Shaped by Equity Markets or by Debt Markets? An International Study of Timeli
Date Posted: Oct 02, 2007
We hypothesize debt markets - not equity markets - are the primary influence on "association" metrics studied since Ball and Brown (1968). Debt markets demand high scores on timeliness, conservatism and Lev's (1989) R2, because debt covenants utilize reported numbers. Equity markets do not rate financial reporting consistently with these metrics, because (among other things) they control for the total information incorporated in equity prices. Single-country studies shed little light on the rela
New: International Financial Reporting Standards (IFRS): Pros and Cons for Investors
Date Posted: Sep 13, 2006
Accounting in shaped by economic and political forces. It follows that increased worldwide integration of both markets and politics (driven by reductions in communications and information processing costs) makes increased integration of financial reporting standards and practice almost inevitable. But most market and political forces will remain local for the foreseeable future, so it is unclear how much convergence in actual financial reporting practice will (or should) occur. Furthermore, ther
New: Earnings Quality at Initial Public Offerings
Date Posted: Jul 25, 2006
Financial reporting around the time of IPOs is consistent with listed firms reporting more conservatively than previously as private firms, consistent with the results in Ball and Shivakumar (2005). We hypothesize that IPO firms supply the higher quality financial reports demanded by public investors, who face higher information asymmetry than private investors. The market mechanisms for enforcing this demand include monitoring by internal and external auditors, boards, analysts, rating agencies
The Role of Accruals in Asymmetrically Timely Gain and Loss Recognition
Date Posted: Jan 17, 2005
We investigate the role of accrual accounting in the asymmetrically timely recognition of unrealized gains and losses (i.e., prior to the actual realization of those losses in cash). This role of accrual accounting has not been directly recognized in the literature. We show that non-linear accruals models are a substantial specification improvement, explaining up to three times the amount of variation in accruals as conventional linear specifications such as Jones (1991). Conversely, we conclude