Valeri Nikolaev

Learning Fundamentals from Text
Date Posted:Mon, 09 Dec 2024 00:00:00 -0600
We introduce a novel approach to learning the information that investors react to when processing textual information. We use the attention mechanism that learns to identify content that triggers market reactions to disclosed information. The explanatory power of the attention-based model significantly exceeds that of attention-free models. We then develop and analyze a comprehensive set of topics discussed in companies' annual reports. Segment information, goodwill and intangibles, revenues, and operating income are the topics that receive the most attention from investors. Despite their prominence in the public discourse, sustainability and governance are consistently among the least important topics judging by the market reactions. Building on our approach, we show that regulatory interventions can successfully enhance the relevance of textual communication. We also show that firms strategically position information within MD\&A to influence investor focus. Our findings underscore the value of attention-based analysis of corporate communications and open new avenues for future work.

Financial Statement Analysis with Large Language Models
Date Posted:Tue, 21 May 2024 14:39:47 -0500
We investigate whether an LLM can successfully perform financial statement analysis in a way similar to a professional human analyst. We provide standardized and anonymous financial statements to GPT4 and instruct the model to analyze them to determine the direction of future earnings. Even without any narrative or industry-specific information, the LLM outperforms financial analysts in its ability to predict earnings changes. The LLM exhibits a relative advantage over human analysts in situations when the analysts tend to struggle. Furthermore, we find that the prediction accuracy of the LLM is on par with the performance of a narrowly trained state-of-the-art ML model. LLM prediction does not stem from its training memory. Instead, we find that the LLM generates useful narrative insights about a company's future performance. Lastly, our trading strategies based on GPT's predictions yield a higher Sharpe ratio and alphas than strategies based on other models. Taken together, our results suggest that LLMs may take a central role in decision-making.

From Transcripts to Insights: Uncovering Corporate Risks Using Generative AI
Date Posted:Sat, 07 Oct 2023 19:52:29 -0500
We explore the value of generative AI in uncovering corporate risks. We use a Large Language Model (LLM) to construct firm-level measures of political, climate, and AI-related risks. The proposed measures possess significant information content and outperform dictionary-based measures in predicting firm-level volatility and explaining investment decisions. Information in risk assessments dominates that in risk summaries, establishing the value of general AI knowledge. Our measures continue to perform well outside the LLM's training window and at the aggregate level. They are also priced in equity markets. Collectively, generative AI offers an effective solution to the measurement of hard-to-quantify corporate risks.

The Impact of Climate Hazards on Banks? Long-Run Performance
Date Posted:Thu, 14 Sep 2023 07:15:55 -0500

We investigate the impact of extreme climate hazards on banks' long-term loan losses and profitability, with a focus on the transmission channels at play. Utilizing a comprehensive dataset of US hurricanes, we identify a distinctive pattern in bank performance. In the initial two years following a hurricane, banks exhibit reduced loan losses and improved profitability. However, this short-term improvement contrasts with increased loan losses and diminished profitability in the long run. We explore several explanations for these patterns, finding that short-term improvement in bank performance is partly attributable to governmental disaster aid. In the long term, however, loan quality deteriorates due to increased risks associated with lending to hurricane-impacted regions. This behavior contributes to a decline in banks' long-term performance. Furthermore, delays in recognizing loan losses exacerbate banks' risk-taking, amplifying long-term losses following hurricanes.

Contextualizing Profitability
Date Posted:Thu, 25 May 2023 18:54:41 -0500
We study the role of context in asset pricing by focusing on the narratives surrounding profitability. Using a large language model, we incorporate narrative context into the measurement of profitability. Contextualized profitability outperforms conventional profitability measures both in statistical and economic terms. Its predictive power stems from the model's ability to learn transitory vs. persistent variation in profits. Furthermore, the factor based on contextualized profitability is superior in pricing portfolios of assets and eliminates alpha in small extreme growth portfolios - the biggest challenge facing the five-factor model (Fama and French, 2015). Our results imply that incorporating narrative context not only improves investment strategies but also enhances the asset pricing tests.

Bloated Disclosures: Can ChatGPT Help Investors Process Information?
Date Posted:Fri, 21 Apr 2023 13:09:05 -0500
We probe the economic usefulness of Large Language Models (LLMs) in summarizing complex corporate disclosures using the stock market as a laboratory. We document that generative AI-based summaries are informative to investors. Using several approaches, we show that the summaries capture the most relevant information. For example, the sentiment of the summary is substantially more powerful in explaining market reactions to disclosure compared to the sentiment of the original document. We also demonstrate that an LLM is effective at excluding irrelevant sentences when constructing a summary. Motivated by these findings, we propose a novel measure, disclosure "bloat," which captures the extent to which disclosures contain less relevant information, and examine whether bloat exacerbates or reduces informational frictions. Bloat is associated with higher informational asymmetry among investors and this effect is primarily driven by its discretionary (unexpected) component. Collectively, our results indicate that generative AI adds considerable value in distilling information.

Context-Based Interpretation of Financial Information
Date Posted:Wed, 04 Jan 2023 07:53:50 -0600
Does the narrative context surrounding the numbers in financial statements improve the informativeness of these numbers? Answering this question empirically presents a methodological challenge. Leveraging recent advances in deep learning, we propose a method to uncover the value of interactions between numeric disclosures and their narrative context. We show that contextualization of accounting numbers makes them substantially more informative in shaping beliefs about a firm's future prospects. In fact, the informational value of interactions dominates the direct informational value of the narrative context. We corroborate this finding by showing that financial analysts incorporate the interactions between narrative and numeric information when making forecasts. Finally, we demonstrate the value of context by identifying rich firm-year-specific heterogeneity in earnings persistence.

REVISION: Firm-level Political Risk and Credit Markets
Date Posted:Tue, 02 Aug 2022 08:13:56 -0500
We take advantage of a new measure of political risk (Hassan et al. (2019)) to study the effects of firm level political risk on private debt markets. First, we use panel data tests and exploit the redrawing of US congressional districts to uncover plausibly exogenous variation in firm-level political risk. We show that borrowers’ political risk is causally linked to interest rates set by lenders. Second, we test for the transmission of political risk from lenders to borrowers. We predict and find that lender-level political risk propagates to borrowers through lending relationships. Furthermore, we introduce new text-based methods to understand the distinct sources of political risk to lenders and borrowers and provide textual evidence of the transmission of political risk from lenders to borrowers. Our analysis allows for endogenous matching between lenders and borrowers and indicates the role of network effects in diffusing political risk throughout the economy.

Firm-Level Political Risk and Credit Markets
Date Posted:Mon, 18 Jul 2022 20:37:47 -0500
We take advantage of a new measure of political risk (Hassan et al. (2019)) to study the effects of firmlevel political risk on private debt markets. First, we use panel data tests and exploit the redrawing of US congressional districts to uncover plausibly exogenous variation in firm-level political risk. We show that borrowers? political risk is causally linked to interest rates set by lenders. Second, we test for the transmission of political risk from lenders to borrowers. We predict and find that lender-level political risk propagates to borrowers through lending relationships. Furthermore, we introduce new text-based methods to understand the distinct sources of political risk to lenders and borrowers and provide textual evidence of the transmission of political risk from lenders to borrowers. Our analysis allows for endogenous matching between lenders and borrowers and indicates the role of network effects in diffusing political risk throughout the economy.

REVISION: Quality Transparency and Healthcare Competition
Date Posted:Tue, 29 Mar 2022 18:23:44 -0500
Transparency of quality in the healthcare sector primarily aims to facilitate patients' care decisions, however, it also provides useful information to competing healthcare providers. We study how competitors respond to increased transparency about rivals' quality by exploiting a regulatory change that initiated disclosure about the quality of all kidney dialysis facilities in the United States. We show that competitors are 27% more likely to open new facilities near low-quality incumbents after the transparency program is implemented. We also show that the effect of transparency on competition is restricted to states without licensing requirements that create barriers to entry. Evidence from patient referrals indicates that the new transparency regime increases the sensitivity of demand to quality and that the increase in competition is costly to low-quality incumbents, as they lose 31% of their new patient referrals—equivalent to a $3.74 million loss of a facility's annual ...

Demand for Stocks and Accounting Information
Date Posted:Wed, 02 Feb 2022 17:41:54 -0600
We use equity portfolio allocation decisions to study the relevance of accounting information for investors? demand for stocks. Investors? revealed preferences indicate that operating profit dominates gross profit and net income in explaining the aggregate demand for stocks. Further, accrual-based profitability measures dominate and largely subsume cash-based measures. However, these conclusions do not hold for investor-specific demands. We document significant heterogeneity across investors in the demand relevance of profitability measures. We predict and find that the relevance of accounting information varies as a function of investors? objectives. Furthermore, our findings reveal that individual investors? demands have an important effect on the equilibrium relation between stock prices and accounting profits.

REVISION: Quality Transparency and Healthcare Competition
Date Posted:Mon, 31 Jan 2022 15:39:59 -0600
Transparency of quality in the healthcare sector primarily aims to facilitate patients' care decisions, however, it also provides useful information to competing healthcare providers. We study how competitors respond to increased transparency about rivals' quality by exploiting a regulatory change that initiated disclosure about the quality of all kidney dialysis facilities in the United States. We show that competitors are 27% more likely to open new facilities near low-quality incumbents after the transparency program is implemented. We also show that the effect of transparency on competition is concentrated in states without licensing requirements that create barriers to entry. Evidence from patient referrals indicates that the new transparency regime increases the sensitivity of demand to quality and that the increase in competition is costly to low-quality incumbents, as they lose 31% of their referrals—equivalent to a $3.74 million loss of a facility's annual revenue—to ...

Quality Transparency and Healthcare Competition
Date Posted:Mon, 31 Jan 2022 05:26:23 -0600
Transparency about the quality of goods and services offered by firms improves consumer decisions; however, it also informs competitors' strategies. We study the effect of increased transparency about healthcare service quality on the competitive dynamics among healthcare providers, focusing on the US dialysis sector. Following the 2012 mandate for public disclosure of dialysis quality data, we observe an increase in the sensitivity of consumer demand to quality. It is manifested by the immediate reduction in patient referrals to lower-quality incumbents. We use a difference-in-differences design and also exploit variation in quality induced by staggered changes in measurement methodology to show that improved quality transparency attracts new competitors into markets with historically low quality, particularly in an environment with lower barriers to entry. The enhanced transparency leads to improvements in incumbents' quality of care, as evidenced by decreased hospitalizations and increased investments in skilled labor. We find no evidence of facility managers "gaming" their quality scores. Our findings underscore the efficacy of disclosure policies in fostering competition and improving healthcare quality and quantify these effects in the context of the dialysis sector.

REVISION: Quality Transparency and Healthcare Competition
Date Posted:Sun, 30 Jan 2022 19:32:56 -0600
Transparency of quality in the healthcare sector primarily aims to facilitate patients' care decisions, however, it also provides useful information to competing healthcare providers. We study how competitors respond to increased transparency about rivals' quality by exploiting a regulatory change that initiated disclosure about the quality of all kidney dialysis facilities in the United States. We show that competitors are 27% more likely to open new facilities near low-quality incumbents after the transparency program is implemented. We also show that the e ect of transparency on competition is concentrated in states without licensing requirements that create barriers to entry. Evidence from patient referrals indicates that the new transparency regime increases the sensitivity of demand to quality and that the increase in competition is costly to low-quality incumbents, as they lose 31% of their referrals—equivalent to a $3.74 million loss of a facility's annual revenue—to ...

REVISION: On Earnings and Cash Flows as Predictors of Future Cash Flows
Date Posted:Tue, 20 Jul 2021 13:42:59 -0500
Do accruals-based earnings provide better information about future operating cash flows than do operating cash flows themselves, as predicted by the Financial Accounting Standards Board's conceptual framework (FASB 1978)? While this is a foundational issue in accounting, because it addresses the information added by accrual accounting methods, testing it remains unsettled. We show that when comparing the predictive ability of operating cash flows with that of an equivalent earnings measure calculated on an accrual basis, earnings outperform operating cash flows. The result becomes more pronounced when allowance is made for cross-sectional differences in the relation between firms' earnings and future cash flows. In fact, even "bottom line" earnings then have similar explanatory power as operating cash flows.

REVISION: Financial Shocks to Lenders and the Composition of Financial Covenants
Date Posted:Thu, 10 Jun 2021 06:56:49 -0500
We provide evidence that financial shocks to lenders influence the composition of financial covenants in debt contracts. Using two distinct measures of lender-specific shocks—defaults in a lender’s corporate loan portfolio that occur outside the borrower’s region and industry, and non-corporate loan delinquencies—we show that lenders respond to financial shocks by increasing the number and strictness of performance-based but not of capital-based covenants in debt contracts. We examine two possible channels for this result. We find evidence consistent with lenders using stricter control rights because of concerns about capital depletion (a capital channel) and because of new information about lenders’ own screening ability (a learning channel). Our results indicate that lender preferences influence how accounting information is used in debt contracts.

REVISION: Accounting Measurement Intensity
Date Posted:Wed, 02 Jun 2021 04:59:19 -0500
We propose an empirical measure of metering problems, i.e., the difficulties of measuring productivity and rewards in firms. We build on the insight that these metering problems are reflected in the intensity with which firms apply Generally Accepted Accounting Principles when preparing their financial statements to capture economic transactions. We adapt a simple computational linguistics algorithm to identify textual patterns that uniquely signify heightened use of accounting measurement in preparation of accounting reports. We validate the output of this algorithm before computing time-varying, firm-level scores of accounting measurement intensity (AMI). We then show that AMI is associated with the decisions of professional users of accounting information. We also document that AMI is correlated with the cross-section of expected equity returns and with the cost of debt and non-price terms in the private loan market. In CEO compensation contracts, we see lower pay-performance ...

Accounting Measurement Intensity
Date Posted:Fri, 28 May 2021 07:19:50 -0500
Measurement is a ubiquitous component of markets and organizations. Despite its central place in the theory of the firm, the effect of measurement practices on firms' decisions and economic outcomes is not well-understood. We characterize companies by the intensity of their measurement practices to convert economic transactions into numbers reported in financial statements. In particular, we develop an algorithm that uses textual patterns to uniquely identify the application of measurement rules in firms' annual reports and construct firm-level scores of measurement intensity. We hypothesize that measurement-intensive firms are more likely to suffer from distortions when providing managerial incentives. We test theoretical predictions that link measurement intensity to firms' investment decisions, productivity, and the design of incentive
schemes. In line with these predictions, we find that more measurement-intensive firms exhibit lower levels of investment and hiring, lower total factor productivity and Tobin's Q, and attenuated the pay-performance sensitivity of CEO compensation contracts. Together, these findings are consistent with the predictions in Alchian and Demsetz (1972) that measurement problems are central to explaining firms' boundaries and contracting.

REVISION: Firm-level Political Risk and Credit Markets
Date Posted:Tue, 18 May 2021 04:00:27 -0500
We study two effects of firm-level political risk on debt markets. First, we take advantage of a new measure of political risk (Hassan et al. (2019) and the redrawing of US congressional districts to uncover plausibly exogenous variation in firm-level political risk. We show that changes in borrowers’ level of political risk lead to changes in interest rates set by lenders. Second, we test for the transmission of political risk among economic agents. We predict and find that lender-level political risk propagates to borrowers through lending relationships, which highlights the role of network effects in diffusing risk throughout the economy.

REVISION: Expected Loan Loss Provisioning: An Empirical Model
Date Posted:Tue, 18 May 2021 03:04:02 -0500
The new accounting standard requires that financial institutions estimate expected credit losses on their loan portfolios. The predictability of long-term losses, however, remains an open question. We develop a model that predicts long-term loan losses and incorporates adjustments for macroeconomic forecasts. The model combines cross-sectional predictions with a high-dimensional dynamic factor model that tracks aggregate losses over the business cycle. The model predicts long-term losses out-of-sample with significantly greater accuracy than the Harris et al. (2018) model and several other alternatives. It is also more effective at detecting bank failures. We use the model to estimate the present value of expected losses and the expected loss overhang for a given bank-quarter. The estimated present values subsume information in reported allowances and in fair value disclosures about long-term losses; the evidence is also consistent with loss overhang distorting banks’ decisions. The ...

On Earnings and Cash Flows as Predictors of Future Cash Flows
Date Posted:Tue, 11 May 2021 14:11:12 -0500
Do accruals-based earnings provide better information about future operating cash flows than do operating cash flows themselves, as predicted by the Financial Accounting Standards Board's conceptual framework (FASB 1978)? While this is a foundational issue in accounting, because it addresses the information added by accrual accounting methods, testing it remains unsettled. We show that when comparing the predictive ability of operating cash flows with that of an equivalent earnings measure calculated on an accrual basis, earnings outperform operating cash flows. The result becomes more pronounced when allowance is made for cross-sectional differences in the relation between firms' earnings and future cash flows. In fact, even "bottom line" earnings then have similar explanatory power as operating cash flows.

REVISION: Financial Shocks to Lenders and the Composition of Financial Covenants
Date Posted:Tue, 16 Mar 2021 11:15:37 -0500
We provide evidence that financial shocks to lenders influence the composition of financial covenants in debt contracts. Using two distinct measures of lender-specific shocks—defaults in a lender’s corporate loan portfolio that occur outside the borrower’s region and industry, and non-corporate loan delinquencies—we show that lenders respond to financial shocks by increasing the number and strictness of performance-based but not of capital-based covenants in debt contracts. We examine two possible channels for this result. We find evidence consistent with lenders using stricter control rights because of concerns about capital depletion (a capital channel) and because of new information about lenders’ own screening ability (a learning channel). Our results indicate that lender preferences influence how accounting information is used in debt contracts.

REVISION: Firm-level Political Risk and Credit Markets
Date Posted:Tue, 16 Mar 2021 07:37:44 -0500
We study two effects of firm-level political risk on debt markets. First, we take advantage of a new measure of political risk (Hassan et al. (2019) and the redrawing of US congressional districts to uncover plausibly exogenous variation in firm-level political risk. We show that changes in borrowers’ level of political risk lead to changes in interest rates set by lenders. Second, we test for the transmission of political risk among economic agents. We predict and find that lender-level political risk propagates to borrowers through lending relationships, which highlights the role of network effects in diffusing risk throughout the economy.

REVISION: FASB was Right: Earnings Beat Cash Flows when Predicting Future Cash Flows
Date Posted:Thu, 31 Dec 2020 05:29:56 -0600
Do accruals-based accounting earnings provide better information to investors about future operating cash flows than operating cash flows themselves, as predicted by FASB’s conceptual framework? The most recent evidence (Nallareddy et al., 2020) is that operating cash flows, measured correctly using cash flow statement data, consistently outperform earnings. However this evidence compares operating cash flows with “bottom line” earnings, handicapping earnings by including non-operating and transitory components with no corresponding operating cash flow. Operating earnings consistently dominate operating cash flow’s predictive ability in a battery of tests, especially after addressing cross-sectional differences among firms.

REVISION: Accounting Measurement Intensity
Date Posted:Sat, 12 Dec 2020 04:56:34 -0600
We propose an empirical measure of firms' metering problems. We build on the notion that metering problems are reflected in the intensity with which firms apply Generally Accepted Accounting Principles (GAAP) to map economic transactions onto financial statements. We develop an algorithm to identify textual patterns that uniquely signify the use of accounting measurements, and construct firm-level scores of accounting measurement intensity, AMI. Metering problems are an important source of transaction costs that affect form boundaries and productivity; we show that firms with higher AMI exhibit lower levels of investment and hiring. Furthermore, we provide evidence that metering problems are associated with lower total factor productivity and with lower firm growth, as measured by Tobin's Q. We then examine metering frictions that reduce firms' access to capital. Specifically, we show that AMI is positively associated with the cost of debt as well as with measures of information ...

REVISION: FASB was Right: Earnings Beat Cash Flows when Predicting Future Cash Flows
Date Posted:Fri, 09 Oct 2020 05:58:27 -0500
Do accruals-based accounting earnings provide better information to investors about future operating cash flows than operating cash flows themselves, as predicted by FASB’s conceptual framework? The most recent evidence (Nallareddy et al., 2020) is that operating cash flows, measured correctly using cash flow statement data, consistently outperform earnings. However this evidence compares operating cash flows with “bottom line” earnings, handicapping earnings by including non-operating and transitory components with no corresponding operating cash flow. Operating earnings consistently dominate operating cash flow’s predictive ability in a battery of tests, especially after addressing cross-sectional differences among firms.

REVISION: Financial Shocks to Lenders and the Composition of Financial Covenants
Date Posted:Mon, 28 Sep 2020 03:28:29 -0500
We show that financial shocks to lenders affect the composition of covenants in new debt contracts in a way that cannot be explained by borrower fundamentals. Using two distinct measures of lender-specific shocks—defaults in a lender’s corporate loan portfolio that occur outside the borrower’s region and industry, and non-corporate loan delinquencies—we show that lenders respond to financial shocks by increasing the use and strictness of performance-based and negative covenants, while reducing the use of capital covenants. We investigate two possible channels for these effects, specifically, the capital channel (lenders are concerned about capital depletion) and the learning channel (defaults carry information about lenders’ screening ability), and find evidence in support of both. Our results indicate that lenders’ preferences influence the use of accounting information in debt contracts.

FASB was Right: Earnings Beat Cash Flows when Predicting Future Cash Flows
Date Posted:Fri, 11 Sep 2020 18:24:58 -0500
Do accruals-based accounting earnings provide better information to investors about future operating cash flows than operating cash flows themselves, as predicted by FASB?s conceptual framework? The most recent evidence (Nallareddy et al., 2020) is that operating cash flows, measured correctly using cash flow statement data, consistently outperform earnings. However this evidence compares operating cash flows with ?bottom line? earnings, handicapping earnings by including non-operating and transitory components with no corresponding operating cash flow. Operating earnings consistently dominate operating cash flow?s predictive ability in a battery of tests, especially after addressing cross-sectional differences among firms.

REVISION: FASB was Right: Earnings Beat Cash Flows when Predicting Future Cash Flows
Date Posted:Fri, 11 Sep 2020 09:24:59 -0500
Do accruals-based accounting earnings provide better information to investors about future operating cash flows than operating cash flows themselves, as predicted by FASB's conceptual framework? The most recent evidence (Nallareddy et al., 2020) is that operating cash flows, when measured correctly using cash ow statement data, consistently outperform earnings. However this evidence is based on \bottom line" earnings, which handicaps earnings by including non-operating components with no corresponding operating cash flow. Operating earnings consistently dominate operating cash flow's predictive ability in a battery of tests, especially after addressing cross-sectional differences among firms.

Accounting Measurement Intensity
Date Posted:Tue, 30 Jun 2020 17:19:00 -0500
We propose an empirical measure of firms' metering problems. We build on the notion that metering problems are reflected in the intensity with which firms apply Generally Accepted Accounting Principles (GAAP) to map economic transactions onto financial statements. We develop an algorithm to identify textual patterns that uniquely signify the use of accounting measurements, and construct firm-level scores of accounting measurement intensity, AMI. Metering problems are an important source of transaction costs that affect form boundaries and productivity; we show that firms with higher AMI exhibit lower levels of investment and hiring. Furthermore, we provide evidence that metering problems are associated with lower total factor productivity and with lower firm growth, as measured by Tobin's Q. We then examine metering frictions that reduce firms' access to capital. Specifically, we show that AMI is positively associated with the cost of debt as well as with measures of information asymmetry among equity investors, including the probability of informed trade and the coverage of a firm by financial analysts. Finally, we present evidence that metering problems influence firms' contracts, and show that these problems link to non-price terms in debt contracts and to the pay-performance sensitivity of CEO compensation contracts. Together, these findings are consistent with the predictions in Alchian and Demsetz (1972) that metering problems affect firms' boundaries and contracts with

REVISION: Accounting Measurement Intensity
Date Posted:Tue, 30 Jun 2020 08:19:00 -0500
We propose an empirical measure of metering problems, i.e., the difficulties of measuring productivity and rewards in firms. We build on the insight that these metering problems are reflected in the intensity with which firms apply Generally Accepted Accounting Principles when preparing their financial statements to capture economic transactions. We adapt a simple computational linguistics algorithm to identify textual patterns that uniquely signify heightened use of accounting measurement in preparation of accounting reports. We validate the output of this algorithm before computing time-varying, firm-level scores of accounting measurement intensity (AMI). We then show that AMI is associated with the decisions of professional users of accounting information. We also document that AMI is correlated with the cross-section of expected equity returns and with the cost of debt and non-price terms in the private loan market. In CEO compensation contracts, we see lower pay-performance ...

REVISION: Firm-level Political Risk and Credit Markets
Date Posted:Tue, 23 Jun 2020 02:08:12 -0500
We examine the effect of firm-level political risk on debt markets. While prior research relies mainly on economy-wide proxies for political risk, Hassan et al. (2019) suggests that a substantial amount of political risk plays out at the firm-level. We use their measure to show that borrower-level political risk is reflected in the cost and liquidity of public debt, the cost of private debt, as well as in debt issuance decisions. We address challenges to a causal interpretation of these findings by using exogenous variation in the political risk of firms caused by the redrawing of electoral district boundaries after the decennial census of 2010. Furthermore, we show that lender-level political risk influences the supply of credit and of loan pricing. Taking advantage of the granularity of the political risk measure, we also show that lender-specific changes in political risk propagate to borrowers and co-lenders, suggesting the importance of network effects in amplifying the effects ...

REVISION: Expected Loan Loss Provisioning: An Empirical Model
Date Posted:Thu, 07 May 2020 03:19:48 -0500
The new accounting standard requires that _nancial institutions provision for life-time expected losses on their loan portfolios. We develop a model for estimating long-term expected loan losses that incorporates a wide range of bank- and aggregate-level predictors of future losses. The model combines cross-sectional predictions with a high-dimensional dynamic factor model that tracks sector-wide losses over the business cycle. We show that our model predicts long-term losses out-of-sample with much greater accuracy than does the Harris et al. (2018) model, which is more effective over the short-term. As an application of the model, we construct a proxy for expected lifetime losses and measure expected loss overhang (Bushman and Williams (2015)) at the bank-quarter level. We find that the estimated lifetime losses subsume information about long-term losses contained in the reported allowances (prior to the regime change) and has an order-of-magnitude higher predictive ability. The ...

REVISION: Financial Shocks to Lenders and the Composition of Financial Covenants
Date Posted:Mon, 13 Apr 2020 03:09:47 -0500
We show that financial shocks to lenders affect the composition of covenants in new debt contracts in a way that cannot be explained by borrower fundamentals. Using two distinct measures of lender-specific shocks — defaults in a lender’s corporate loan portfolio that occur outside the borrower’s region and industry, and non-corporate loan delinquencies — we show that lenders respond to financial shocks by increasing the use and strictness of performance-based and negative covenants, while reducing the use of capital covenants. We investigate two possible channels for these effects, specifically, the capital channel (lenders are concerned about capital depletion) and the learning channel (defaults carry information about lenders’ screening ability), and find evidence in support of both. Overall, our results indicate that lenders’ preferences influence the use of accounting information in debt contracts.

REVISION: Firm-level Political Risk and Credit Markets
Date Posted:Tue, 24 Mar 2020 12:12:20 -0500
We examine the effect of firm-level political risk on debt markets. While prior research relies mainly on economy-wide proxies for political risk, Hassan et al. (2019) suggests that a substantial amount of political risk plays out at the firm-level. We use their measure to show that borrower-level political risk is reflected in the cost and liquidity of public debt, the cost of private debt, as well as in debt issuance decisions. We address challenges to a causal interpretation of these findings by using exogenous variation in the political risk of firms caused by the redrawing of electoral district boundaries after the decennial census of 2010. Furthermore, we show that lender-level political risk influences the supply of credit and of loan pricing. Taking advantage of the granularity of the political risk measure, we also show that lender-specific changes in political risk propagate to borrowers and co-lenders, suggesting the importance of network effects in amplifying the effects ...

Firm-level Political Risk and Credit Markets
Date Posted:Wed, 12 Jun 2019 17:20:18 -0500
We take advantage of a new composite measure of political risk (Hassan et al., 2019) to study the effects of firm-level political risk on private debt markets. First, we use panel data tests and exploit the redrawing of US congressional districts to uncover plausibly exogenous variation in firm-level political risk. We show that borrowers? political risk is linked to interest rates set by lenders. Second, we test for the transmission of political risk from lenders to borrowers. We predict and find that lender-level political risk propagates to borrowers through lending relationships. Our analysis allows for endogenous matching between lenders and borrowers and indicates the presence of network effects in diffusing political risk throughout the economy. Finally, we introduce new text-based methods to analyze the distinct sources of political risk to lenders and borrowers and provide textual evidence of the transmission of political risk from lenders to borrowers.

REVISION: Firm-level Political Risk and Credit Markets
Date Posted:Wed, 12 Jun 2019 08:21:34 -0500
We examine the effect of firm-level political risk on debt markets. While prior research relies mainly on economy-wide proxies for political risk (such as the economic policy uncertainty index), Hassan et al. [2019] suggests that a substantial part of political risk plays out at the firm-level. We use their measure of political risk to show that borrower-level political risk is reflected in the pricing and liquidity of public debt, the cost of private debt, and credit default swap spreads and recovery rates. We also document the strength of pricing effects for persistent versus temporary variation in firm-level political risk.Furthermore, we show that lender-level political risk influences the supply of credit and has a significant effect on loan pricing. Taking advantage of the granularity of our measure, we also show that firm-specific changes in political risk propagate across firms and lenders, suggesting the importance of network effects in amplifying the effects of political ...

REVISION: Financial Shocks and Corporate Investment Activity: The Role of Financial Covenants
Date Posted:Wed, 01 May 2019 06:55:08 -0500
We examine whether economic shocks to credit institutions differentially affect the use and strictness of different accounting-based covenants in debt contracts, and whether these effects represent a channel through which shocks to lenders propagate to the real sector. To capture lender-specific shocks, we use variation in payment defaults experienced by lenders outside the borrower’s region and industry. We find that lenders respond to payment defaults by shifting towards performance-based covenants (and away from capital-based covenants), and by increasing the strictness of performance covenants. In turn, these changes in covenants constrain future investments among relationship borrowers. We also find that subsequent to contract initiation, lender-specific shocks affect corporate investment. Overall, our results suggest that credit-supply frictions influence the type and strictness of covenants in debt contracts, and that financial covenants represent a channel through which ...

REVISION: Expected Loan Loss Provisioning: An Empirical Model
Date Posted:Thu, 07 Mar 2019 11:09:43 -0600
Recently introduced accounting standards require that financial institutions provision for expected losses on their loan portfolios. Understanding the economic consequences of provisioning for expected losses is of significant interest to academics and regulators. We develop an empirical model of expected loan loss provisioning and use it to construct a bank-year measure of under-provisioning for expected losses. The model relies on forward-looking bank- and macro-economic indicators of future losses. The estimated expected losses are substantially more informative in explaining realized losses as compared to the reported numbers. Unlike the reported provisions, the estimated provisions for expected losses behave in a counter-cyclical fashion. Using our measure of under-provisioning, we find evidence consistent with under-provisioning for expected losses distorting banks’ lending, financing, and dividend decisions. While in practice banks need not provision in the way predicted by ...

Expected Loan Loss Provisioning: An Empirical Model
Date Posted:Fri, 01 Mar 2019 20:04:12 -0600
The new accounting standard requires that financial institutions estimate expected credit losses on their loan portfolios. The predictability of long-term losses, however, remains an open question. We develop a model that predicts long-term loan losses and incorporates adjustments for macroeconomic forecasts. The model combines cross-sectional predictions with a high-dimensional dynamic factor model that tracks aggregate losses over the business cycle. The model predicts long-term losses out-of-sample with significantly greater accuracy than the Harris et al. (2018) model and several other alternatives. It is also more effective at detecting bank failures. We use the model to estimate the present value of expected losses and the expected loss overhang for a given bank-quarter. The estimated present values subsume information in reported allowances and in fair value disclosures about long-term losses; the evidence is also consistent with loss overhang distorting banks? decisions. The model provides a useful benchmark to study loan loss provisioning.

REVISION: Expected Loan Loss Provisioning: An Empirical Model
Date Posted:Fri, 01 Mar 2019 10:05:42 -0600
Recently introduced accounting standards require that financial institutions provision for expected losses on their loan portfolios. Understanding the economic consequences of provisioning for expected losses is of significant interest to academics and regulators. We develop an empirical model of expected loan loss provisioning and use it to construct a bank-year measure of under-provisioning for expected losses. The model relies on forward-looking bank- and macro-economic indicators of future losses. The estimated expected losses are substantially more informative in explaining realized losses as compared to the reported numbers. Unlike the reported provisions, the estimated provisions for expected losses behave in a counter-cyclical fashion. Using our measure of under-provisioning, we find evidence consistent with under-provisioning for expected losses distorting banks’ lending, financing, and dividend decisions. While in practice banks need not provision in the way predicted by ...

REVISION: Earnings, Retained Earnings, and Book-to-Market in the Cross Section of Expected Returns
Date Posted:Sun, 20 Jan 2019 04:58:22 -0600
Book value of equity consists of two economically different components: retained earnings and contributed capital. We predict that book-to-market strategies work because the retained earnings component of the book value of equity includes the accumulation and, hence, the averaging of past earnings. Retained earnings-to-market predicts the cross section of average returns in U.S. and international data and subsumes book-to-market. Contributed capital-to-market has no predictive power. We show that retained earnings-to-market -- and, by extension, book-to- market -- predicts returns because it is a good proxy for underlying earnings yield (Ball, 1978; Berk, 1995) and not because book value represents intrinsic value.

REVISION: Identifying Accounting Quality
Date Posted:Tue, 15 Jan 2019 04:54:24 -0600
I develop a new approach to understanding accounting accruals. I start by introducing a model that explicitly incorporates the role of accruals in measuring firm performance. Using this model, I characterize accounting quality by the degree to which accruals fulfill their performance measurement objective. To identify accounting quality, I exploit the property that both earnings and cash flows represent noisy measures of the unobservable economic performance, and that they converge as the measurement horizon extends. This allows decomposing the variance of accruals into both the performance measurement component and the accounting error component, as well as identifying the variance of the unobservable economic performance itself. I implement several model specifications and consider generalizations. My analysis suggests that the variance of accruals explained by performance measurement significantly exceeds the variance explained by accounting error. I conclude that accruals ...

REVISION: Earnings, Retained Earnings, and Book-to-Market in the Cross Section of Expected Returns
Date Posted:Mon, 10 Sep 2018 07:06:44 -0500
Book value of equity consists of two economically different components: retained earnings and contributed capital. We predict that book-to-market strategies work because the retained earnings component of the book value of equity includes the accumulation and, hence, the averaging of past earnings. Retained earnings-to-market predicts the cross section of average returns in U.S. and international data and subsumes book-to-market. Contributed capital-to-market has no predictive power. We show that retained earnings-to-market -- and, by extension, book-to- market -- predicts returns because it is a good proxy for underlying earnings yield (Ball, 1978; Berk, 1995) and not because book value represents intrinsic value.

REVISION: Earnings, Retained Earnings, and Book-to-Market in the Cross Section of Expected Returns
Date Posted:Wed, 18 Jul 2018 13:24:54 -0500
Book value of equity consists of two economically different components: retained earnings and contributed capital. We predict that book-to-market strategies work because the retained earnings component of the book value of equity includes the accumulation and, hence, the averaging of past earnings. Retained earnings-to-market predicts the cross section of average returns in U.S. and international data and subsumes book-to-market. Contributed capital-to-market has no predictive power. We show that retained earnings-to-market -- and, by extension, book-to- market -- predicts returns because it is a good proxy for underlying earnings yield (Ball, 1978; Berk, 1995) and not because book value represents intrinsic value.

REVISION: Identifying Accounting Quality
Date Posted:Tue, 15 May 2018 04:36:50 -0500
In this paper, I develop a new approach to modeling and understanding accounting accruals. I introduce a model that explicitly incorporates the role of accruals in measuring firm performance. Using this model, I characterize accounting quality by the degree to which accruals fulfill their performance measurement objective. To identify accounting quality, the model exploits the institutional properties of accounting information that both earnings and cash flows represent noisy measures of the unobservable economic performance, and that they converge as the measurement horizon extends. These properties allow decomposing the variance of accruals into both the performance measurement component and the accounting error component, as well as identifying the variance of the unobservable economic performance itself. I implement several model specifications and consider a number of generalizations. My analysis suggests that, on average, the portion of accruals that facilitates performance ...

REVISION: Financial Shocks and Corporate Investment Activity: The Role of Financial Covenants
Date Posted:Fri, 04 May 2018 09:11:13 -0500
We examine whether shocks to credit institutions affect the choice among accounting-based covenants in private debt contracts and whether this effect represents a channel through which shocks to lenders affect corporate investment. We exploit plausibly exogenous variation in the payment defaults experienced by lenders outside the borrower’s region and industry. We find that financial institutions respond to payment default shocks by shifting the composition of financial covenants towards performance-based covenants (away from capital-based covenants) in newly signed credit agreements. In turn, the increased reliance on performance covenants constrains borrowers’ future investments, particularly among relationship-based borrowers. We also find that lender-specific shocks after a contract is in place affect investments, and that this effect varies depending on the composition of the covenants in place. Overall, our results are consistent with financial covenants being a channel through ...

REVISION: Financial Shocks and Corporate Investment Activity: The Role of Financial Covenants
Date Posted:Tue, 17 Apr 2018 14:59:18 -0500
We examine whether shocks to credit institutions affect the choice among accounting-based covenants in private debt contracts and whether this effect represents a channel through which shocks to lenders affect corporate investment. We exploit plausibly exogenous variation in the payment defaults experienced by lenders outside the borrower’s region and industry. We find that financial institutions respond to payment default shocks by shifting the composition of financial covenants towards performance-based covenants (away from capital-based covenants) in newly signed credit agreements. In turn, the increased reliance on performance covenants constrains borrowers’ future investments, particularly among relationship-based borrowers. We also find that lender-specific shocks after a contract is in place affect investments, and that this effect varies depending on the composition of the covenants in place. Overall, our results are consistent with financial covenants being a channel through ...

Contracting on GAAP Changes: Large Sample Evidence
Date Posted:Mon, 12 Mar 2018 14:50:50 -0500
We explore revealed preferences for the contractual treatment of changes to GAAP in a large sample of private credit agreements issued by publicly held U.S. firms. We document a significant time-trend toward excluding GAAP changes from the determination of covenant compliance over the period from 1994 to 2012. This trend is positively associated with proxies for standard setters? shift in focus toward relevance and international accounting harmonization. At the firm level, borrowers facing higher uncertainty are more likely to write contracts that include GAAP changes, but these firms also show a more pronounced time-trend toward excluding GAAP changes. While this evidence is broadly consistent with an efficiency role for GAAP changes in debt contracting, it is also consistent with a shift in standard setters? focus offering a partial explanation of why fewer contracts rely on GAAP changes in 2012 than in 1994.

New: Contracting on GAAP Changes: Large Sample Evidence
Date Posted:Mon, 12 Mar 2018 05:50:50 -0500
We explore revealed preferences for the contractual treatment of changes to GAAP in a large sample of private credit agreements issued by publicly held U.S. firms. We document a significant time-trend toward excluding GAAP changes from the determination of covenant compliance over the period from 1994 to 2012. This trend is positively associated with proxies for standard setters’ shift in focus toward relevance and international accounting harmonization. At the firm level, borrowers facing higher uncertainty are more likely to write contracts that include GAAP changes, but these firms also show a more pronounced time-trend toward excluding GAAP changes. While this evidence is broadly consistent with an efficiency role for GAAP changes in debt contracting, it is also consistent with a shift in standard setters’ focus offering a partial explanation of why fewer contracts rely on GAAP changes in 2012 than in 1994.

Financial Shocks to Lenders and the Composition of Financial Covenants
Date Posted:Tue, 05 Dec 2017 19:08:41 -0600
We provide evidence that financial shocks to lenders influence the composition of financial covenants in debt contracts. Using two distinct measures of lender-specific shocks?defaults in a lender?s corporate loan portfolio that occur outside the borrower?s region and industry, and non-corporate loan delinquencies?we show that lenders respond to financial shocks by increasing the number and strictness of performance-based but not of capital-based covenants in debt contracts. We examine two possible channels for this result. We find evidence consistent with lenders using stricter control rights because of concerns about capital depletion (a capital channel) and because of new information about lenders? own screening ability (a learning channel). Our results indicate that lender preferences influence how accounting information is used in debt contracts.

REVISION: Financial Sector Shocks and Corporate Investment Activity: The Role of Financial Covenants
Date Posted:Tue, 05 Dec 2017 09:08:43 -0600
We examine whether shocks to financial institutions affect the choice and composition of accounting-based covenants in private debt contracts and whether this effect represents a channel through which financial shocks affect corporate investment. We exploit plausibly exogenous variation in the payment defaults experienced by lenders that are not in the borrower’s region and industry. We find that financial institutions respond to payment default shocks by shifting the composition of financial covenants towards performance-based covenants (away from capital-based covenants) in newly signed credit agreements. In turn, the increased reliance on performance covenants constrains borrowers’ future investments, particularly among relationship-based borrowers. We also find that lender-specific shocks after the contract is in place affect investments, and that this effect varies depending on the composition of the covenants in place. Overall, the results are consistent with financial ...

REVISION: Earnings, Retained Earnings, and Book-to-Market in the Cross Section of Expected Returns
Date Posted:Mon, 25 Sep 2017 13:58:09 -0500
We delve into what causes the relation between book-to-market and the cross section of stock returns. Book value of equity consists of two main components that we expect contain different information about expected returns: retained earnings and contributed capital. Retained earnings-to-market subsumes book-to-market's power to predict the cross section of stock returns in pre- and post-Compustat U.S. data as well as in international data. Contributed capital-to-market has no predictive power. Retained earnings represent the accumulated difference between earnings and dividends. We show that retained earnings-to-market's predictive power stems entirely from accumulated earnings. Our thesis is that retained earnings-to-market---and, by extension, book-to-market---predicts returns because it is a good proxy for earnings yield (Ball,1978; Berk, 1995).

REVISION: Identifying Accounting Quality
Date Posted:Fri, 15 Sep 2017 05:05:10 -0500
I develop a new approach to understanding accounting accruals. Unlike prior studies, I explicitly address the economic role of accruals in performance measurement. I characterize accounting quality in terms of a new construct, namely, the degree to which accruals facilitate performance measurement. Further, I develop a flexible empirical strategy for identifying accounting quality. The core identifying assumptions derive from institutional properties of both earnings and cash flows: that both are noisy measures of the same economic performance and they converge as the time horizon extends. These assumptions characterize moments of earnings, cash flows, and accruals solved to recover the variance of performance and accounting error in accruals. I implement several model specifications and consider a number of generalizations. My analysis suggests that the variance of the performance component exceeds accounting error and explains a high fraction of accruals’ variance. I conclude that ...

REVISION: Identifying Accounting Quality
Date Posted:Tue, 12 Sep 2017 10:31:55 -0500
I develop a new approach to understanding accounting accruals. Unlike prior studies, I explicitly address the economic role of accruals in performance measurement. I characterize accounting quality in terms of a new construct, namely, the degree to which accruals facilitate performance measurement. Further, I develop a flexible empirical strategy for identifying accounting quality. The core identifying assumptions derive from institutional properties of both earnings and cash flows: that both are noisy measures of the same economic performance and they converge as the time horizon extends. These assumptions characterize moments of earnings, cash flows, and accruals solved to recover the variance of performance and accounting error in accruals. I implement several model specifications and consider a number of generalizations. My analysis suggests that the variance of the performance component exceeds accounting error and explains a high fraction of accruals’ variance. I conclude that ...

Discussion of 'Borrower Private Information Covenants and Loan Contract Monitoring'
Date Posted:Tue, 18 Jul 2017 11:47:46 -0500
Carrizosa and Ryan (2017) explore the use of private information covenants, which contractually oblige borrowers to provide their lenders with private information: projected or intra-quarter financial statements. The authors offer evidence that creditors acquire private information about borrowers via information covenants after a contract is in place. This in turn facilitates the creditor monitoring process, subject to a cost-benefit tradeoff. I discuss how the study fits into the literature and provide additional perspective on some of its arguments. I contend that the cost side and hence the trade-offs associated with information covenants are less clear and have yet to be established empirically. I discuss complementary information mechanisms that deserve attention and raise several research design issues. I also argue that the study can shed light on an open question in the disclosure literature.

New: Discussion of 'Borrower Private Information Covenants and Loan Contract Monitoring'
Date Posted:Tue, 18 Jul 2017 02:47:50 -0500
Carrizosa and Ryan (2017) explore the use of private information covenants, which contractually oblige borrowers to provide their lenders with private information: projected or intra-quarter financial statements. The authors offer evidence that creditors acquire private information about borrowers via information covenants after a contract is in place. This in turn facilitates the creditor monitoring process, subject to a cost-benefit tradeoff. I discuss how the study fits into the literature and provide additional perspective on some of its arguments. I contend that the cost side and hence the trade-offs associated with information covenants are less clear and have yet to be established empirically. I discuss complementary information mechanisms that deserve attention and raise several research design issues. I also argue that the study can shed light on an open question in the disclosure literature.

REVISION: Earnings, Retained Earnings, and Book-to-Market in the Cross Section of Expected Returns
Date Posted:Tue, 07 Mar 2017 23:40:53 -0600
Book value of equity consists of two main parts: retained earnings and contributed capital. Retained earnings-to-market subsumes book-to-market's predictive power in the cross section of stock returns, despite comprising only 42% of book value on average. Contributed capital has no predictive power. Retained earnings represent the difference between accumulated past earnings and accumulated past dividends. We find that the predictive power of retained earnings arises entirely from accumulated past earnings. Our results imply that book-to-market predicts returns because it is a proxy for earnings yield (Ball, 1978). These results cast doubt on the notion that book-to-market identities over- and undervalued securities.

Earnings, Retained Earnings, and Book-to-Market in the Cross Section of Expected Returns
Date Posted:Wed, 01 Mar 2017 23:01:41 -0600
Book value of equity consists of two economically different components: retained earnings and contributed capital. We predict that book-to-market strategies work because the retained earnings component of the book value of equity includes the accumulation and, hence, the averaging of past earnings. Retained earnings-to-market predicts the cross section of average returns in U.S. and international data and subsumes book-to-market. Contributed capital-to-market has no predictive power. We show that retained earnings-to-market -- and, by extension, book-to- market -- predicts returns because it is a good proxy for underlying earnings yield (Ball, 1978; Berk, 1995) and not because book value represents intrinsic value.

REVISION: Earnings, Retained Earnings, and Book-to-Market in the Cross Section of Expected Returns
Date Posted:Wed, 01 Mar 2017 13:01:42 -0600
Book value of equity consists of two main parts: retained earnings and contributed capital. Retained earnings-to-market subsumes book-to-market's predictive power in the cross section of stock returns, despite comprising only 42% of book value on average. Contributed capital has no predictive power. Retained earnings represent the difference between accumulated past earnings and accumulated past dividends. We find that the predictive power of retained earnings arises entirely from accumulated past earnings. Our results imply that book-to-market predicts returns because it is a proxy for earnings yield (Ball, 1978). These results cast doubt on the notion that book-to-market identities over- and undervalued securities.

REVISION: Contracting on GAAP Changes: Large Sample Evidence
Date Posted:Wed, 01 Mar 2017 09:34:13 -0600
We explore revealed preferences for the contractual treatment of changes to GAAP in a large sample of private credit agreements issued by publicly held U.S. firms. We document a significant time-trend towards excluding GAAP changes from the determination of covenant compliance over the period from 1994 to 2012. This trend is positively associated with proxies for standard setters’ shift in focus towards relevance and international accounting harmonization. At the firm level, borrowers facing higher uncertainty are more likely to write contracts that include GAAP changes, but these firms also show a more pronounced time-trend towards excluding GAAP changes. While this evidence is broadly consistent with an efficiency role for GAAP changes in debt contracting, it is also consistent with a shift in standard setters’ focus offering a partial explanation of why fewer contracts rely on GAAP changes in 2012 than in 1994.

REVISION: Identifying Accounting Quality
Date Posted:Fri, 06 Jan 2017 05:51:15 -0600
I develop a new approach to understanding accounting accruals. Unlike prior studies, I explicitly address the economic role of accruals in performance measurement. I characterize accounting quality in terms of a new construct, namely, the degree to which accruals facilitate performance measurement. Further, I develop a flexible empirical strategy for identifying accounting quality. The core identifying assumptions derive from institutional properties of both earnings and cash flows: that both are noisy measures of the same economic performance and they converge as the time horizon extends. These assumptions characterize moments of earnings, cash flows, and accruals solved to recover the variance of performance and accounting error in accruals. I implement several model specifications and consider a number of generalizations. My analysis suggests that the variance of the performance component exceeds accounting error and explains a high fraction of accruals’ variance. I conclude that ...

REVISION: Scope for Renegotiation in Private Debt Contracts
Date Posted:Tue, 01 Nov 2016 12:42:27 -0500
I provide new evidence on the renegotiation of financial contracts using a comprehensive sample of over 90,000 debt contract renegotiations. I study whether the demand for monitoring determines the renegotiation intensity, defined as either the renegotiation frequency over a period of time or the time between renegotiations. Theory suggests that frequent debt contract renegotiation trades off the benefits of enhanced monitoring with the costs of suboptimal creditor intervention. Consistent with this tradeoff, I find that proxies for the increased demand for monitoring, such as financing constraints and the audit premium, exhibit a higher renegotiation intensity. In turn, the costs of creditor monitoring, proxied by the presence of growth options and R&D, are associated with a lower renegotiation intensity. I also find that contractual monitoring mechanisms, such as syndicate concentration and control rights, exhibit robust positive associations with renegotiation intensity. The ...

REVISION: Identifying Accounting Quality
Date Posted:Tue, 01 Nov 2016 12:29:55 -0500
I develop a new approach to understanding accounting accruals. Unlike prior studies, I explicitly address the economic role of accruals in performance measurement. I characterize accounting quality in terms of a new construct, namely, the degree to which accruals facilitate performance measurement. Further, I develop a flexible strategy for identifying accounting quality. The core identifying assumptions derive from institutional properties of both earnings and cash flows: that both are noisy measures of the same economic performance and they converge as the time horizon extends. These assumptions characterize moments of earnings, cash flows, and accruals solved to recover the variance of performance and accounting error in accruals. I implement several model specifications and consider a number of generalizations. My analysis suggests that the variance of the performance component exceeds accounting error and explains a high fraction of accruals’ variance. I conclude that accruals ...

REVISION: Contracting on GAAP Changes: Large Sample Evidence
Date Posted:Tue, 04 Oct 2016 13:31:27 -0500
We explore revealed preferences for including versus excluding the changes to GAAP in credit agreements issued by U.S. publicly traded firms over the period from 1994 to 2012. We document a significant time-trend towards excluding GAAP changes from debt contracts. This trend has a positive association with proxies for the standard setters’ shift in focus towards relevance and international accounting harmonization. Borrowers facing higher uncertainty are more likely to write contracts that include GAAP changes, but this group of firms shows a more pronounced trend towards excluding GAAP changes. The evidence is broadly consistent with GAAP changes playing an efficiency role in debt markets. However, changes in the standard setters’ focus can, in part, explain the reduction in this role over the past two decades.

Accounting Information in Financial Contracting: The Incomplete Contract Theory Perspective
Date Posted:Fri, 15 Jul 2016 13:45:16 -0500
This paper reviews theoretical and empirical work on financial contracting that is relevant to accounting researchers. Its primary objective is to discuss how the use of accounting information in contracts enhances contracting efficiency and to suggest avenues for future research. We argue that incomplete contract theory broadens our understanding of both the role accounting information plays in contracting and the mechanisms through which efficiency gains are achieved. By discussing its rich theoretical implications, we expect incomplete contract theory to prove useful in motivating future research and in offering directions to advance our knowledge of how accounting information affects contract efficiency.

REVISION: Accounting Information in Financial Contracting: The Incomplete Contract Theory Perspective
Date Posted:Fri, 10 Jun 2016 10:38:01 -0500
This paper reviews theoretical and empirical work on financial contracting that is relevant to accounting researchers. Its primary objective is to discuss how the use of accounting information in contracts enhances contracting efficiency and to suggest avenues for future research. We argue that incomplete contract theory broadens our understanding of both the role accounting information plays in contracting and the mechanisms through which efficiency gains are achieved. By discussing its rich theoretical implications, we expect incomplete contract theory to prove useful in motivating future research and in offering directions to advance our knowledge of how accounting information affects contract efficiency.

REVISION: Identifying Accounting Quality
Date Posted:Fri, 25 Mar 2016 22:08:14 -0500
I develop a new approach to modelling accounting accruals and provide an econometric strategy to identify the quality of accruals and earnings. Unlike prior studies, I characterize accounting accruals in terms of the performance and accounting noise components. The characterization is intuitive and captures the role of accruals in performance measurement. The identifying assumptions derive from the notion that both earnings and cash flows can be viewed as noisy measures of the same economic performance and that they converge as the time horizon extends. These assumptions translate into moment conditions that can be solved to separate and recover the variance of accounting error and the portion of accruals that measures economic performance. I implement the baseline model, consider a number of generalizations and discuss possible specification issues. The paper opens a number of avenues for future research.

REVISION: Accounting Information in Financial Contracting: The Incomplete Contract Theory Perspective
Date Posted:Tue, 01 Mar 2016 09:48:12 -0600
This paper reviews theoretical and empirical work on financial contracting that is relevant to accounting researchers. Its primary objective is to discuss how the use of accounting information in contracts enhances contracting efficiency and to suggest avenues for future research. We argue that incomplete contract theory broadens our understanding of both the role accounting information plays in contracting and the mechanisms through which efficiency gains are achieved. By discussing its rich theoretical implications, we expect incomplete contract theory to prove useful in motivating future research and in offering directions to advance our knowledge of how accounting information affects contract efficiency.

REVISION: Accounting Information in Financial Contracting: The Incomplete Contract Theory Perspective
Date Posted:Tue, 05 Jan 2016 03:06:56 -0600
This paper reviews theoretical and empirical work on financial contracting that is relevant to accounting researchers. Its primary objective is to discuss how the use of accounting information in contracts enhances contracting efficiency and to suggest avenues for future research. We argue that incomplete contract theory broadens our understanding of both the role accounting information plays in contracting and the mechanisms through which efficiency gains are achieved. By discussing its rich theoretical implications, we expect incomplete contract theory to prove useful in motivating more research and in offering directions to advance our knowledge of how accounting information affects contract efficiency.

REVISION: Deflating Profitability
Date Posted:Sat, 12 Dec 2015 05:23:01 -0600
Gross profit scaled by book value of total assets predicts the cross-section of average returns. Novy-Marx (2013) concludes that it outperforms other measures of profitability such as bottom-line net income, cash flows, and dividends. One potential explanation for the measure’s predictive ability is that its numerator - gross profit - is a “cleaner” measure of economic profitability. An alternative explanation lies in the measure’s deflator. We find that net income equals gross profit in predictive power when they have consistent deflators. Deflating profit by the book value of total assets results in a variable that is the product of profitability and the ratio of the market value of equity to the book value of total assets, which is priced. We then construct an alternative measure of profitability, operating profitability, which better matches current expenses with current revenue. This measure exhibits a far stronger link with expected returns than either net income or gross ...

Accounting Information in Financial Contracting: The Incomplete Contract Theory Perspective
Date Posted:Tue, 13 Oct 2015 11:55:28 -0500
This paper reviews theoretical and empirical work on financial contracting that is relevant to accounting researchers. Its primary objective is to discuss how the use of accounting information in contracts enhances contracting efficiency and to suggest avenues for future research. We argue that incomplete contract theory broadens our understanding of both the role accounting information plays in contracting and the mechanisms through which efficiency gains are achieved. By discussing its rich theoretical implications, we expect incomplete contract theory to prove useful in motivating future research and in offering directions to advance our knowledge of how accounting information affects contract efficiency.

REVISION: Identifying Accounting Quality
Date Posted:Tue, 13 Oct 2015 02:58:03 -0500
I develop a new approach to modelling accounting accruals and provide an econometric strategy to identify the quality of accruals and earnings. Unlike prior studies, I characterize accounting accruals in terms of the performance and accounting noise components. The characterization is intuitive and captures the role of accruals in performance measurement. The identifying assumptions derive from the notion that both earnings and cash flows can be viewed as noisy measures of the same economic performance and that they converge as the time horizon extends. These assumptions translate into moment conditions that can be solved to separate and recover the variance of accounting error and the portion of accruals that measures economic performance. I implement the baseline model, consider a number of generalizations and discuss possible specification issues. The paper opens a number of avenues for future research.

REVISION: Accounting Information in Financial Contracting: The Incomplete Contract Theory Perspective
Date Posted:Tue, 13 Oct 2015 02:55:28 -0500
The central question in accounting literature on financial contracting is: how does the reliance on accounting information in contracts facilitate transactions between financiers and those who require financing? Suppose an entrepreneur (or manager) has access to a positive NPV investment project but lacks financing while a financier has funds but no access to such a project. How can the reliance on accounting information enhance the contractual relationship between these two parties and how does the use of accounting information affect the choice and design of financial claims? We discuss the answers to these questions with particular attention to the use of accounting information in debt contracts.

REVISION: Accruals, Cash Flows, and Operating Profitability in the Cross Section of Stock Returns
Date Posted:Mon, 21 Sep 2015 05:14:46 -0500
Accruals are the non-cash component of earnings. They represent adjustments made to cash flows to generate a profit measure largely unaffected by the timing of receipts and payments of cash. Prior research uncovers two anomalies: expected returns increase in profitability and decrease in accruals. We show that cash-based operating profitability (a measure that excludes accruals) outperforms measures of profitability that include accruals. Further, cash-based operating profitability subsumes accruals in predicting the cross section of average returns. An investor can increase a strategy's Sharpe ratio more by adding just a cash-based operating profitability factor to the investment opportunity set than by adding both an accruals factor and a profitability factor that includes accruals.

REVISION: Accruals, Cash Flows, and Operating Profitability in the Cross Section of Stock Returns
Date Posted:Thu, 17 Sep 2015 02:55:50 -0500
Accruals are the non-cash component of earnings. They represent adjustments made to cash flows to generate a profit measure largely unaffected by the timing of receipts and payments of cash. Prior research uncovers two anomalies: expected returns increase in profitability and decrease in accruals. We show that cash-based operating profitability (a measure that excludes accruals) outperforms measures of profitability that include accruals. Further, cash-based operating profitability subsumes accruals in predicting the cross section of average returns. An investor can increase a strategy's Sharpe ratio more by adding just a cash-based operating profitability factor to the investment opportunity set than by adding both an accruals factor and a profitability factor that includes accruals.

REVISION: Accruals, Cash Flows, and Operating Profitability in the Cross Section of Stock Returns
Date Posted:Wed, 08 Jul 2015 00:36:01 -0500
Accruals are the non-cash component of earnings. They represent adjustments made to cash flows to generate a profit measure largely unaffected by the timing of receipts and payments of cash. Prior research uncovers two anomalies: expected returns increase in profitability and decrease in accruals. We show that a cash-based operating profitability measure (that excludes accruals) outperforms other measures of profitability (that include accruals) and subsumes accruals in predicting the cross section of average returns. An investor can increase a strategy's Sharpe ratio more by adding just a cash-based operating profitability factor to the investment opportunity set than by adding both an accruals factor and a profitability factor that includes accruals.

Outside Blockholders? Monitoring of Management and Debt Financing: An Alternative Perspective.
Date Posted:Wed, 17 Jun 2015 10:19:46 -0500
Liao (2015) argues that the monitoring by large outside shareholders (blockholders) exacerbates the conflict between debt and equity and in turn affects the choice and structure of debt financing. The study contends that private debt is more immune to the increase in debt-equity conflict. Consistent with this argument, companies with outside blockholders are inclined to issue private debt over public debt. Further, private debt exhibits less price protection but relies on more protective covenants than does public debt. The findings are interesting and intuitive. I evaluate the economic arguments in the paper and discuss some of the challenges that the study faces. My conclusion is that the interpretation of the results is more complex than the one the study presents. I offer a broader framework that can be used to shed light on why the governance structure combines equity blockholders and private debt issuance. I also discuss several questions to be addressed by future research.

New: Outside Blockholders’ Monitoring of Management and Debt Financing: An Alternative Perspective.
Date Posted:Wed, 17 Jun 2015 01:19:47 -0500
Liao (2015) argues that the monitoring by large outside shareholders (blockholders) exacerbates the conflict between debt and equity and in turn affects the choice and structure of debt financing. The study contends that private debt is more immune to the increase in debt-equity conflict. Consistent with this argument, companies with outside blockholders are inclined to issue private debt over public debt. Further, private debt exhibits less price protection but relies on more protective covenants than does public debt. The findings are interesting and intuitive. I evaluate the economic arguments in the paper and discuss some of the challenges that the study faces. My conclusion is that the interpretation of the results is more complex than the one the study presents. I offer a broader framework that can be used to shed light on why the governance structure combines equity blockholders and private debt issuance. I also discuss several questions to be addressed by future research.

REVISION: Scope for Renegotiation in Private Debt Contracts
Date Posted:Thu, 30 Apr 2015 05:15:32 -0500
Frequent contract renegotiation is a puzzling phenomenon. I attempt to shed more light on this subject by examining the economic determinants and information content of the renegotiations of financial contracts. My sample approximates the population of material private debt contract renegotiations in the U.S. I find that the frequency of renegotiation has a rich set of cross-sectional determinants, including exogenous uncertainty and investment opportunities. One of the strongest determinants of renegotiation frequency is financing frictions (agency and information problems). Because the demand for information increases with such frictions, the evidence is consistent with renegotiation being an integral part of the monitoring process carried out by private lenders. In line with this hypothesis, I also find that the extent to which lenders rely on different monitoring mechanisms is positively associated with renegotiation frequency. Additionally, renegotiations transmit new ...

Disproportional Control Rights and the Governance Role of Debt
Date Posted:Wed, 29 Apr 2015 12:28:41 -0500
We examine the governance role of debt in the context of US-based dual class ownership structures. We hypothesize that the use of debt alleviates the conflict between shareholder classes by balancing the power of controlling insiders. We document that dual class firms have higher leverage and a greater propensity to issue private debt; they also more frequently use cash sweeps and performance-based covenants. Dual class firms with greater agency conflicts and a greater need to access the capital market appear to rely more extensively on debt. These findings are consistent with controlling insiders bonding against the agency costs associated with dual class ownership. The governance role of debt is further corroborated by the valuation effect of debt for dual class companies. Private debt issuances trigger greater positive market reactions to the inferior dual class stock in relation to both the superior dual class stock and a matched sample of single class firms. Further, leverage attenuates the previously documented adverse effect of dual class status on Tobin?s Q. Taken together, our analyses suggest that dual class firms use debt as a complementary governance mechanism.

New: Disproportional Control Rights and the Governance Role of Debt
Date Posted:Wed, 29 Apr 2015 03:28:42 -0500
We examine the governance role of debt in the context of US-based dual class ownership structures. We hypothesize that the use of debt alleviates the conflict between shareholder classes by balancing the power of controlling insiders. We document that dual class firms have higher leverage and a greater propensity to issue private debt; they also more frequently use cash sweeps and performance-based covenants. Dual class firms with greater agency conflicts and a greater need to access the capital market appear to rely more extensively on debt. These findings are consistent with controlling insiders bonding against the agency costs associated with dual class ownership. The governance role of debt is further corroborated by the valuation effect of debt for dual class companies. Private debt issuances trigger greater positive market reactions to the inferior dual class stock in relation to both the superior dual class stock and a matched sample of single class firms. Further, leverage ...

REVISION: Accruals, Cash Flows, and Operating Profitability in the Cross Section of Stock Returns
Date Posted:Sat, 18 Apr 2015 10:08:13 -0500
Accruals are the non-cash component of earnings. They represent adjustments made to cash flows to generate a profit measure largely unaffected by the timing of receipts and payments of cash. Prior research finds that expected returns increase in firm profitability. However, firms with high accruals generate lower returns than firms with low accruals, and this "accrual anomaly" strengthens when evaluated using asset pricing models that include a profitability factor. We show that a cash-based operating profitability measure (that excludes accruals) outperforms other measures of profitability (that include accruals) and subsumes accruals in predicting the cross section of average returns. Surprisingly, an investor can increase a strategy's Sharpe ratio more by adding just a cash-based operating profitability factor to his investment opportunity set than by adding both an accruals factor and a profitability factor that includes accruals.

Accruals, Cash Flows, and Operating Profitability in the Cross Section of Stock Returns
Date Posted:Wed, 01 Apr 2015 20:57:58 -0500
Accruals are the non-cash component of earnings. They represent adjustments made to cash flows to generate a profit measure largely unaffected by the timing of receipts and payments of cash. Prior research uncovers two anomalies: expected returns increase in profitability and decrease in accruals. We show that cash-based operating profitability (a measure that excludes accruals) outperforms measures of profitability that include accruals. Further, cash-based operating profitability subsumes accruals in predicting the cross section of average returns. An investor can increase a strategy's Sharpe ratio more by adding just a cash-based operating profitability factor to the investment opportunity set than by adding both an accruals factor and a profitability factor that includes accruals.

REVISION: Accruals, Cash Flows, and Operating Profitability in the Cross Section of Stock Returns
Date Posted:Wed, 01 Apr 2015 11:57:58 -0500
Accruals are the non-cash component of earnings. They represent adjustments made to cash flows to generate a profit measure largely unaffected by the timing of receipts and payments of cash. Prior research finds that expected returns increase in firm profitability. However, firms with high accruals generate lower returns than firms with low accruals, and this "accrual anomaly" strengthens when evaluated using asset pricing models that include a profitability factor. We show that a cash-based operating profitability measure (that excludes accruals) outperforms other measures of profitability (that include accruals) and subsumes accruals in predicting the cross section of average returns. The cash-based operating profitability measure explains expected returns over a ten year horizon, which is inconsistent with initial mispricing of earnings or its cash and accruals components.

REVISION: Identifying Accounting Quality
Date Posted:Tue, 02 Dec 2014 00:44:13 -0600
I offer a parsimonious model of the performance measurement function of accounting accruals and develop an econometric framework that permits the identification of accounting quality. The identification strategy relies on a new way of characterizing the dynamics of accounting accruals in terms of performance measurement and the accounting noise components. The characterization is intuitive and captures the institutional characteristics of accrual accounting. The identifying assumptions derive from the accounting property that both earnings and cash flows are noisy measures of the same underlying performance. My approach relies on GMM to discriminate between the accounting error and the portion of accruals that captures the underlying economic performance. The proposed framework also offers a new way of testing for the presence of earnings management.

REVISION: Identifying Accounting Quality
Date Posted:Thu, 16 Oct 2014 01:09:52 -0500
I develop an econometric framework that permits the identification of accounting quality. The identification strategy relies on a new way of characterizing the dynamics of accounting accruals in terms of performance measurement and accounting noise components. The characterization is intuitive and does not hinge on strong assumptions about the earnings and accrual processes or about managerial preferences. The identifying assumptions derive from the accounting property that both earnings and cash flows are noisy measures of the same underlying performance. My approach uses a GMM estimation to discriminate between the accounting error and the portion of accruals that captures the underlying economic performance. The proposed framework also offers a new way of testing for the presence of earnings management.

REVISION: Deflating Profitability
Date Posted:Thu, 09 Oct 2014 04:22:45 -0500
Gross profit scaled by book value of total assets predicts the cross-section of average returns. Novy-Marx (2013) concludes that it outperforms other measures of profitability such as bottom-line net income, cash flows, and dividends. One potential explanation for the measure’s predictive ability is that its numerator—gross profit—is a “cleaner” measure of economic profitability. An alternative explanation lies in the measure’s deflator. We find that net income equals gross profit in predictive power when they have consistent deflators. Deflating profit by the book value of total assets results in a variable that is the product of profitability and the ratio of the market value of equity to the book value of total assets, which is priced. We then construct an alternative measure of profitability, operating profitability, which better matches current expenses with current revenue. This measure exhibits a far stronger link with expected returns than either net income or gross profit. ...

REVISION: Identifying Accounting Quality
Date Posted:Sat, 30 Aug 2014 02:59:54 -0500
I develop an econometric framework that allows the identification of accounting quality. The strategy relies on a new way of characterizing the dynamics of accounting accruals. The characterization is intuitive and does not hinge on strong assumptions about the earnings and accrual processes or about managerial preferences. The identifying assumptions derive from two accounting properties, namely, that both earnings and cash flows reflect the same underlying performance and that accruals and accounting errors must reverse over time. My approach uses a GMM estimation to discriminate between the accounting error and the portion of accruals that captures the underlying economic performance. The proposed framework also offers a new way of testing for the presence of earnings management.

Identifying Accounting Quality
Date Posted:Sat, 23 Aug 2014 19:54:44 -0500
I develop a new approach to understanding accounting accruals. I start by introducing a model that explicitly incorporates the role of accruals in measuring firm performance. Using this model, I characterize accounting quality by the degree to which accruals fulfill their performance measurement objective. To identify accounting quality, I exploit the property that both earnings and cash flows represent noisy measures of the unobservable economic performance, and that they converge as the measurement horizon extends. This allows decomposing the variance of accruals into both the performance measurement component and the accounting error component, as well as identifying the variance of the unobservable economic performance itself. I implement several model specifications and consider generalizations. My analysis suggests that the variance of accruals explained by performance measurement significantly exceeds the variance explained by accounting error. I conclude that accruals successfully meet their primary objective.

REVISION: Identifying Accounting Quality
Date Posted:Sat, 23 Aug 2014 10:54:45 -0500
I develop an econometric strategy that allows identification of accounting quality. The strategy relies on a new way of characterizing the dynamics of accounting accruals. The characterization is intuitive and does not hinge on strong assumptions about the earnings and accrual processes, or about managerial preferences. The identifying assumptions derive from two accounting properties, namely, that both earnings and cash flows reflect the same underlying performance and that accruals and accounting errors must reverse over time. My approach discriminates between the accounting error and the part of accruals that captures the underlying economic performance. The proposed framework also offers a new way of testing for the presence of earnings management. Implementation issues and empirical evidence are discussed in a companion paper (Nikolaev 2014).

REVISION: Deflating Profitability
Date Posted:Fri, 15 Aug 2014 02:14:11 -0500
Gross profit scaled by book value of total assets predicts the cross-section of average returns. Novy-Marx (2013) concludes that it outperforms other measures of profitability such as bottom-line net income, cash flows, and dividends. One potential explanation for the measure's predictive ability is that its numerator - gross profit - is a "cleaner" measure of economic profitability. An alternative explanation lies in the measure's deflator. We find that net income equals gross profit in predictive power when they have consistent deflators. We show that deflating profit by the book value of total assets interacts profitability with the ratio of the market value of equity to the book value of total assets, which is priced. We then construct an alternative measure of profitability, operating profitability, which better matches current expenses with current revenue. This measure exhibits a far stronger link with expected returns than either net income or gross profit. It predicts ...

REVISION: Debt Contracts and the Need for Mandatory Accounting Changes
Date Posted:Sat, 09 Aug 2014 08:33:59 -0500
We describe a mechanism through which accounting standard setters can facilitate the contracting process and improve economic resource allocation. Contracts cannot anticipate all future contingencies and, therefore, cannot specify optimal accounting treatments or necessary adjustments to GAAP in many eventualities. This contractual incompleteness opens the scope for opportunistic behavior in unanticipated states, which, being rationally anticipated at contract initiation, distorts the allocation of economic resources. Standard setters can alleviate the friction by acting as arbiters that complete GAAP ex post. We empirically test whether mandatory GAAP changes play an efficiency role by examining the revealed preferences for including vs. excluding mandatory GAAP changes in debt contracts. We find evidence consistent with standard setters playing such a role, but less so over time. Overall, the evidence suggests that there is an economic rationale for standard setting in debt ...

REVISION: Deflating Profitability
Date Posted:Wed, 21 May 2014 07:25:51 -0500
Gross profit scaled by book value of total assets predicts the cross-section of average returns. Novy-Marx (2013) concludes that it outperforms other measures of profitability such as earnings, cash flows, and dividends. One potential explanation for the measure's predictive ability is that its numerator – gross profit – is a cleaner measure of economic profitability. An alternative explanation lies in the measure's deflator. We find that net income equals gross profit in predictive power when both measures are constructed using consistent deflators. We then construct an alternative measure of profitability, operating profitability, which better matches current expenses with current revenue. This measure exhibits a far stronger link with expected returns than either net income or gross profit.

REVISION: Deflating Profitability
Date Posted:Tue, 13 May 2014 11:53:44 -0500
Gross profit scaled by book value of total assets predicts the cross-section of average returns. Novy-Marx (2013) concludes that it outperforms other measures of profitability such as earnings, cash flows, and dividends. One potential explanation for the measure's predictive ability is that its numerator --- gross profit --- is a cleaner measure of economic profitability. An alternative explanation lies in the measure's deflator. We find that net income equals gross profit in predictive power when both measures are constructed using consistent deflators. We then construct an alternative measure of profitability, operating profitability, which better matches current expenses with current revenue. This measure exhibits a far stronger link with expected returns than either net income or gross profit.

REVISION: Deflating Gross Profitability
Date Posted:Tue, 29 Apr 2014 06:39:27 -0500
Gross profit scaled by book value of total assets predicts the cross-section of average returns. Novy-Marx (2013) concludes that it outperforms other measures of profitability such as earnings, cash flows, and dividends. One potential explanation for the measure's predictive ability is that its numerator --- gross profit --- is a cleaner measure of economic profitability. An alternative explanation lies in the measure's deflator. We find that net income equals gross profit in predictive power when both measures are constructed using consistent deflators. We then construct an alternative measure of profitability, operating profitability, which better matches current expenses with current revenue. This measure exhibits a far stronger link with expected returns than either net income or gross profit.

REVISION: Deflating Gross Profitability
Date Posted:Tue, 08 Apr 2014 04:00:43 -0500
Gross profit scaled by book value of total assets predicts the cross-section of average returns. Novy-Marx (2013) concludes that it outperforms other measures of profitability such as earnings, cash flows, and dividends and is negatively correlated with the value premium. One potential explanation for the measure's predictive ability is that its numerator - gross profit - is a "cleaner" measure of economic profitability. An alternative explanation lies in the measure's deflator. We find that net income equals gross profit in predictive power when both measures are constructed using consistent deflators. We then construct an alternative measure of profitability, operating profitability, based on economic intuition about which expenses most closely relate to current revenue. This measure exhibits a far stronger link with expected returns than either net income or gross profit.

REVISION: Deflating Gross Profitability
Date Posted:Mon, 07 Apr 2014 02:33:51 -0500
Gross profit scaled by book value of total assets predicts the cross-section of average returns. Novy-Marx (2013) concludes that it outperforms other measures of profitability such as earnings, cash flows, and dividends and is negatively correlated with the value premium. One potential explanation for the measure's predictive ability is that its numerator - gross profit - is a "cleaner" measure of economic profitability. An alternative explanation lies in the measure's deflator. We find that net income equals gross profit in predictive power when both measures are constructed using consistent deflators. We then construct an alternative measure of profitability, operating profitability, based on economic intuition about which expenses most closely relate to current revenue. This measure exhibits a far stronger link with expected returns than either net income or gross profit.

Deflating Profitability
Date Posted:Thu, 27 Mar 2014 23:48:28 -0500
Gross profit scaled by book value of total assets predicts the cross-section of average returns. Novy-Marx (2013) concludes that it outperforms other measures of profitability such as bottom-line net income, cash flows, and dividends. One potential explanation for the measure?s predictive ability is that its numerator - gross profit - is a ?cleaner? measure of economic profitability. An alternative explanation lies in the measure?s deflator. We find that net income equals gross profit in predictive power when they have consistent deflators. Deflating profit by the book value of total assets results in a variable that is the product of profitability and the ratio of the market value of equity to the book value of total assets, which is priced. We then construct an alternative measure of profitability, operating profitability, which better matches current expenses with current revenue. This measure exhibits a far stronger link with expected returns than either net income or gross profit. It predicts returns as far as ten years ahead, seemingly inconsistent with irrational pricing explanations.

REVISION: Deflating Gross Profitability
Date Posted:Thu, 27 Mar 2014 14:48:28 -0500
Gross profit scaled by book value of total assets predicts the cross-section of average returns. Novy-Marx (2013) concludes that it outperforms other measures of profitability such as earnings, cash flows, and dividends and is negatively correlated with the value premium. One potential explanation for the measure's predictive ability is that its numerator - gross profit - is a "cleaner" measure of economic profitability. An alternative explanation lies in the measure's deflator. We find that net income equals gross profit in predictive power when both measures are constructed using consistent deflators. We then construct an alternative measure of profitability, operating profitability, based on economic intuition about which expenses most closely relate to current revenue. This measure exhibits a far stronger link with expected returns than either net income or gross profit.

Econometrics of the Basu Asymmetric Timeliness Coefficient and Accounting Conservatism
Date Posted:Thu, 28 Nov 2013 06:31:08 -0600
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 context of a model with accounting income incorporating different types of information with different lags, and with noise. We demonstrate that the asymmetric timeliness coefficient varies with firm characteristics affecting their information environments, such as the length of the firm's operating and investment cycles, and its degree of diversification. We particularly examine one characteristic, the extent to which "unbooked" information (such as revised expectations about rents and growth options) is independent of other information, and discuss the conditions under which a proxy for this characteristic is the market-to-book ratio. We also conclude that much criticism of the Basu regression misconstrues researchers? objectives.

New: Econometrics of the Basu Asymmetric Timeliness Coefficient and Accounting Conservatism
Date Posted:Wed, 27 Nov 2013 20:31:10 -0600
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 context of a model with accounting income incorporating different types of information with different lags, and with noise. We demonstrate that the asymmetric timeliness coefficient varies with firm characteristics affecting their information environments, such as the length of the firm's operating and investment cycles, and its degree of diversification. We particularly examine one characteristic, the extent to which "unbooked" information (such as revised expectations about rents and growth ...

Contracting on GAAP Changes: Large Sample Evidence
Date Posted:Fri, 02 Aug 2013 13:43:16 -0500
We explore revealed preferences for the contractual treatment of changes to GAAP in a large sample of private credit agreements issued by publicly held U.S. firms. We document a significant time-trend towards excluding GAAP changes from the determination of covenant compliance over the period from 1994 to 2012. This trend is positively associated with proxies for standard setters? shift in focus towards relevance and international accounting harmonization. At the firm level, borrowers facing higher uncertainty are more likely to write contracts that include GAAP changes, but these firms also show a more pronounced time-trend towards excluding GAAP changes. While this evidence is broadly consistent with an efficiency role for GAAP changes in debt contracting, it is also consistent with a shift in standard setters? focus offering a partial explanation of why fewer contracts rely on GAAP changes in 2012 than in 1994.

REVISION: Debt Contracts and the Need for Mandatory Accounting Changes
Date Posted:Fri, 02 Aug 2013 08:43:16 -0500
We describe a mechanism through which accounting standard setters can facilitate the contracting process and improve economic resource allocation. Contracts cannot anticipate all future contingencies and, therefore, cannot specify optimal accounting treatments or necessary adjustments to GAAP in many eventualities. This contractual incompleteness opens the scope for opportunistic behavior in unanticipated states, which, being rationally anticipated at contract initiation, distorts the ...

REVISION: Debt Contracts and the Need for Mandatory Accounting Changes
Date Posted:Fri, 02 Aug 2013 08:43:12 -0500
We describe a mechanism through which accounting standard setters can facilitate the contracting process and improve economic resource allocation. Contracts cannot anticipate all future contingencies and, therefore, cannot specify optimal accounting treatments or necessary adjustments to GAAP in many eventualities. This contractual incompleteness opens the scope for opportunistic behavior in unanticipated states, which, being rationally anticipated at contract initiation, distorts the ...

Econometrics of the Basu Asymmetric Timeliness Coefficient and Accounting Conservatism
Date Posted:Fri, 02 Aug 2013 06:52:21 -0500
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 context of a model with accounting income incorporating different types of information with different lags, and with noise. We demonstrate that the asymmetric timeliness coefficient varies with firm characteristics affecting their information environments, such as the length of the firm?s operating and investment cycles, and its degree of diversification. We particularly examine one characteristic, the extent to which ?unbooked? information (such as revised expectations about rents and growth options) is independent of other information, and discuss the conditions under which a proxy for this characteristic is the market-to-book ratio. We also conclude that much criticism of the Basu regression misconstrues researchers? objectives.

New: Econometrics of the Basu Asymmetric Timeliness Coefficient and Accounting Conservatism
Date Posted:Fri, 02 Aug 2013 01:52:21 -0500
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 ...

REVISION: Does Fair Value Accounting for Non-Financial Assets Pass the Market Test?
Date Posted:Fri, 07 Jun 2013 15:23:42 -0500
The choice between fair value and historical cost accounting is the subject of long-standing controversy among accounting academics and regulators. Nevertheless, the market-based evidence on this subject is very limited. We study the choice of fair value versus historical cost accounting for non-financial assets in setting where market forces rather than regulators determine the outcome. In general, we find a very limited use of fair value accounting. However, the observed variation is ...

REVISION: Scope for Renegotiation in Private Debt Contracts
Date Posted:Tue, 02 Apr 2013 08:10:36 -0500
Frequent contract renegotiation is a puzzling phenomenon. I study whether debt contract renegotiation can be explained by contracting frictions and the associated contract design choices. In line with theory, the scope for renegotiation is higher among companies with higher uncertainty, greater agency conflicts, and lower information frictions. Syndicate size and performance pricing are associated with a lower scope for renegotiation. The opposite is true for creditor control rights that ...

REVISION: Scope for Renegotiation in Private Debt Contracts
Date Posted:Wed, 06 Mar 2013 06:44:05 -0600
: Frequent contract renegotiation is puzzling from a theory standpoint and remains to be understood empirically. I focus on contracting frictions to explain the scope for renegotiation of private debt contracts. Unlike prior work, I study a large sample of renegotiations subject to lender majority consent. My findings indicate that the scope for renegotiation rises with information uncertainty and is inversely associated with information asymmetry and lack of verifiability. The scope for ...

REVISION: Does Fair Value Accounting for Non-Financial Assets Pass the Market Test?
Date Posted:Wed, 27 Feb 2013 14:27:05 -0600
The choice between fair value and historical cost accounting is the subject of long-standing controversy among accounting academics and regulators. Nevertheless, the market-based evidence on this subject is very limited. We study the choice of fair value versus historical cost accounting for non-financial assets in a setting where market forces rather than regulators determine the outcome. In general, we find a very limited use of fair value accounting. However, the observed variation is ...

Does Fair Value Accounting for Non-Financial Assets Pass the Market Test?
Date Posted:Wed, 13 Feb 2013 17:46:31 -0600
The choice between fair value and historical cost accounting is the subject of long-standing controversy among accounting academics and regulators. Nevertheless, the market-based evidence on this subject is very limited. We study the choice of fair value versus historical cost accounting for non-financial assets in setting where market forces rather than regulators determine the outcome. In general, we find a very limited use of fair value accounting. However, the observed variation is consistent with market forces determining choice. Fair value accounting is used when reliable fair value estimates are available at low cost and when they convey information about operating performance. For example, with very few exceptions, firms? managers commit to historical cost accounting for plant and equipment. Our findings contribute to the policy debate by documenting the market solution to one of the central questions in the accounting literature. Our findings indicate that despite its conceptual merits, fair value is unlikely to become the primary valuation method for illiquid non-financial assets on a voluntary basis.

REVISION: Does Fair Value Accounting for Non-Financial Assets Pass the Market Test?
Date Posted:Wed, 13 Feb 2013 12:46:34 -0600
The choice between fair value and historical cost accounting is the subject of long-standing controversy among accounting academics and regulators. Nevertheless, the market-based evidence on this subject is very limited. We study the choice of fair value versus historical cost accounting for non-financial assets in setting where market forces rather than regulators determine the outcome. In general, we find a very limited use of fair value accounting. However, the observed variation is ...

REVISION: Econometrics of the Basu Asymmetric Timeliness Coefficient and Accounting Conservatism
Date Posted:Thu, 10 Jan 2013 02:08:49 -0600
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 ...

REVISION: Econometrics of the Basu Asymmetric Timeliness Coefficient and Accounting Conservatism
Date Posted:Tue, 08 Jan 2013 01:23:20 -0600
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 ...

REVISION: On Estimating Conditional Conservatism
Date Posted:Mon, 03 Dec 2012 01:51:20 -0600
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 ...

REVISION: Does Fair Value Accounting for Non-Financial Assets Pass the Market Test?
Date Posted:Mon, 12 Nov 2012 16:28:09 -0600
The choice between fair value and historical cost accounting is the subject of long-standing controversy among accounting academics and regulators. Nevertheless, the market-based evidence on this subject is very limited. We study the choice of fair value versus historical cost accounting for non-financial assets in a setting where market forces rather than regulators determine the outcome. In general, we find a very limited use of fair value accounting. However, the observed variation is ...

REVISION: Does Fair Value Accounting for Non-Financial Assets Pass the Market Test?
Date Posted:Wed, 06 Jun 2012 04:58:54 -0500
Whether fair value dominates historical cost accounting in a market for accounting practices is an important question subject to much controversy among academics and regulators. IFRS adoption offers a unique setting to study managers’ preferences for fair value vs. historical cost accounting for non-financial assets when market forces, rather than regulators, determine the choice. We find that, with few important exceptions, managers pre-commit to historical cost accounting for plant, ...

REVISION: Does Fair Value Accounting for Non-Financial Assets Pass the Market Test?
Date Posted:Wed, 30 May 2012 16:34:10 -0500
We study managers’ revealed preferences for fair value or historical cost accounting for non-financial assets when market forces, rather than regulators, determine the choice. We document that almost all managers pre-commit to historical cost accounting for plant, equipment, and intangible assets, suggesting that fair value for illiquid non-financial assets is associated with net firm-specific costs. However, for the more liquid assets groups, property and investment property, the observed ...

Scope for Renegotiation in Private Debt Contracts
Date Posted:Fri, 02 Mar 2012 12:45:52 -0600
I provide new evidence on the renegotiation of financial contracts using a comprehensive sample of over 90,000 debt contract renegotiations. I study whether the demand for monitoring determines the renegotiation intensity, defined as either the renegotiation frequency over a period of time or the time between renegotiations. Theory suggests that frequent debt contract renegotiation trades off the benefits of enhanced monitoring with the costs of suboptimal creditor intervention. Consistent with this tradeoff, I find that proxies for the increased demand for monitoring, such as financing constraints and the audit premium, exhibit a higher renegotiation intensity. In turn, the costs of creditor monitoring, proxied by the presence of growth options and R&D, are associated with a lower renegotiation intensity. I also find that contractual monitoring mechanisms, such as syndicate concentration and control rights, exhibit robust positive associations with renegotiation intensity. The evidence supports theories that emphasize the strategic aspect of control rights. Finally, renegotiations reveal new information to the market, consistent with their role in reducing information asymmetries. Overall, the evidence suggests the demand for monitoring is an important driver of renegotiation.

REVISION: Scope for Renegotiation and Debt Contract Design
Date Posted:Fri, 02 Mar 2012 04:09:45 -0600
Despite the importance of renegotiation in contract theory, few empirical studies are available on this subject. I examine a sample of over 16,500 debt contract amendments to study the ex ante determinants of renegotiation. Unlike prior research, I focus on renegotiations that require lender majority consent and measure the scope for renegotiation using time to renegotiation. I find that the highest risk borrowers renegotiate their contracts in an almost continuous fashion. The evidence ...

REVISION: The Endogeneity Bias in the Relation between Cost-of-Debt Capital and Corporate Disclosure Policy
Date Posted:Mon, 09 Jan 2012 19:14:48 -0600
The purpose of this paper is twofold. First, we provide a discussion of the problems associated with endogeneity in empirical accounting research. We emphasize problems arising when endogeneity is caused by (1) unobservable firm specific factors and (2) omitted variables and discuss the merits and drawbacks of using panel data techniques to address these causes. Second, we investigate the magnitude of endogeneity bias in Ordinary Least Squares regressions of cost-of-debt capital on firm ...

REVISION: On Estimating Conditional Conservatism
Date Posted:Sun, 20 Nov 2011 19:28:43 -0600
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 ...

REVISION: Capital Versus Performance Covenants in Debt Contracts
Date Posted:Mon, 26 Sep 2011 18:41:58 -0500
Building on contracting theory, we argue that financial covenants control the conflicts of interest between lenders and borrowers via two different mechanisms. Capital covenants control agency problems by aligning debtholder-shareholder interests. Performance covenants serve as tripwires that limit agency problems via the transfer of control to lenders in states where the value of their claim is at risk. Companies trade off these mechanisms. Capital covenants impose costly restrictions on ...

REVISION: Capital Versus Performance Covenants in Debt Contracts
Date Posted:Thu, 30 Jun 2011 01:38:41 -0500
Building on contracting theory, we argue that financial covenants control the conflicts of interest between lenders and borrowers via two different mechanisms. Capital covenants control agency problems by aligning debtholder-shareholder interests. Performance covenants serve as tripwires that limit agency problems via the transfer of control to lenders in states where the value of their claim is at risk. Companies trade off these mechanisms. Capital covenants impose costly restrictions on ...

REVISION: Capital Versus Performance Covenants in Debt Contracts
Date Posted:Tue, 28 Jun 2011 16:03:23 -0500
We study the contracting role of financial covenants classified into two types. We argue that capital covenants control agency problems by maintaining equity capital sufficient to align debtholder-shareholder objectives ex ante, whereas performance covenants serve as tripwires that address agency problems by facilitating control transfers and re-negotiations ex post. We find that capital and performance covenants are used in different contracting environments. Performance covenants are strong ...

REVISION: On Estimating Conditional Conservatism
Date Posted:Wed, 02 Mar 2011 17:47:23 -0600
Patatoukas and Thomas (2010) identify an important empirical regularity with the potential to bias estimates of conditional conservatism (asymmetric earnings timeliness) and argue that it is caused by scale effects. They advise researchers to avoid using conditional conservatism estimates or making inferences from prior research using them, a view we regard as excessively alarmist. Our theoretical and empirical analyses suggest the explanation lies in the correlation between the expected ...

REVISION: On Estimating Conditional Conservatism
Date Posted:Wed, 16 Feb 2011 18:17:56 -0600
Patatoukas and Thomas (2010) identify an important empirical regularity with the potential to bias estimates of conditional conservatism (asymmetric earnings timeliness) and argue that it is caused by scale effects. They advise researchers to avoid using conditional conservatism estimates or making inferences from prior research using them, a view we regard as excessively alarmist. Our theoretical and empirical analyses suggest the explanation lies in the correlation between the expected ...

REVISION: On Estimating Conditional Conservatism
Date Posted:Sat, 12 Feb 2011 15:02:17 -0600
Patatoukas and Thomas (2010) identify an important empirical regularity with the potential to bias estimates of conditional conservatism (asymmetric earnings timeliness) and argue that it is caused by scale effects. They advise researchers to avoid using conditional conservatism estimates or making inferences from prior research using them, a view we regard as excessively alarmist. Our theoretical and empirical analyses suggest the explanation lies in the correlation between the expected ...

On Estimating Conditional Conservatism
Date Posted:Sat, 12 Feb 2011 00:00:00 -0600
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 possible bias in firm-level cross-sectional estimates of conditional conservatism (asymmetric earnings timeliness) which they attribute to scale effects. They advise researchers to avoid using conditional conservatism estimates or making inferences from prior research using them, a view we regard as excessively alarmist. Our theoretical and empirical analyses suggest the explanation is a correlated omitted variables problem that can be addressed in a straightforward fashion, for example by fixed-effects regression. We show that cross-sectional correlation between the expected components of earnings and returns confounds the relation between the news components, and biases estimates of how earnings incorporates the news in returns (e.g., timeliness). We also show that the correlation between the expected components of earnings and returns depends on the sign of returns, biasing estimates of asymmetric timeliness. When firm-specific effects in earnings are taken into account, estimates of asymmet

REVISION: Capital versus Performance Covenants in Debt Contracts
Date Posted:Wed, 26 Jan 2011 12:30:29 -0600
We study the contracting role of financial covenants classified into two types. We argue that capital covenants control agency problems by maintaining equity capital sufficient to align debtholder-shareholder objectives ex ante, whereas performance covenants serve as tripwires that address agency problems by facilitating control transfers and re-negotiations ex post. We find that capital and performance covenants are used in different contracting environments. Performance covenants are strong ...

Capital Versus Performance Covenants in Debt Contracts
Date Posted:Wed, 26 Jan 2011 00:00:00 -0600
Building on contracting theory, we argue that financial covenants control the conflicts of interest between lenders and borrowers via two different mechanisms. Capital covenants control agency problems by aligning debtholder-shareholder interests. Performance covenants serve as tripwires that limit agency problems via the transfer of control to lenders in states where the value of their claim is at risk. Companies trade off these mechanisms. Capital covenants impose costly restrictions on capital structure, while performance covenants require contractible accounting information to be available. Consistent with these arguments, we find that the use of performance covenants relative to capital covenants is positively associated with (1) the financial constraints of the borrower, (2) the extent to which accounting information portrays credit risk, (3) the likelihood of contract renegotiation, and (4) the presence of contractual restrictions on managerial actions. Our findings suggest that accounting-based covenants can improve contracting efficiency in two conceptually different ways.

REVISION: Does Fair Value Accounting for Non-Financial Assets Pass the Market Test?
Date Posted:Wed, 15 Sep 2010 11:54:05 -0500
We study managers’ revealed preferences for fair value or historical cost accounting for non-financial assets when market forces, rather than regulators, determine the choice. We document that almost all managers pre-commit to historical cost accounting for plant, equipment, and intangible assets, suggesting that fair value for illiquid non-financial assets is associated with net firm-specific costs. However, for the more liquid assets groups, property and investment property, the observed ...

REVISION: Debt Covenants and Accounting Conservatism
Date Posted:Sun, 29 Aug 2010 10:29:56 -0500
Using a sample of over 5,000 debt issues, I test whether firms with more extensive use of covenants in their public debt contracts exhibit timelier recognition of economic losses in accounting earnings. Covenants govern the transfer of decision-making and control rights from shareholders to bondholders when a company approaches financial distress and thereby limit managers’ abilities to expropriate bondholder wealth. Covenants are expected to constrain managerial opportunism, however, only if ...

REVISION: Econometrics of the Basu Asymmetric Timeliness Coefficient and Accounting Conservatism
Date Posted:Tue, 27 Apr 2010 10:43:01 -0500
Despite its popularity, the asymmetric timeliness coefficient has been challenged as a valid measure of conditional conservatism. We propose a model in which accounting income contemporaneously incorporates one component of price revision, incorporates another with a lag unless below a threshold (e.g., losses), invariably incorporates another with a lag, and adds uncorrelated “noise.” We demonstrate validity in this framework. We derive a negative relation between asymmetric timeliness ...

New: Disproportional Control Rights and the Bonding Role of Debt
Date Posted:Fri, 04 Dec 2009 11:33:53 -0600
We examine how firms’ capital structure choices vary with the presence of dual-class ownership and the degree of disproportional control associated with it. We document that, compared to a propensity-matched sample of single-class firms, dual-class firms have higher leverage, greater propensity to issue private debt, more long-term debt, and greater reliance on financial covenants. Within our dual-class sample, the use of debt financing increases with the degree of disproportional control via ...

Disproportional Control Rights and the Bonding Role of Debt
Date Posted:Fri, 04 Dec 2009 00:00:00 -0600
We examine how firms? capital structure choices vary with the presence of dual-class ownership and the degree of disproportional control associated with it. We document that, compared to a propensity-matched sample of single-class firms, dual-class firms have higher leverage, greater propensity to issue private debt, more long-term debt, and greater reliance on financial covenants. Within our dual-class sample, the use of debt financing increases with the degree of disproportional control via voting rights or board election rights. This evidence is consistent with controlling insiders bonding against the agency problems associated with dual-class ownership through their capital structure choices. Also consistent with this view, we document that leverage attenuates (and ultimately reverses) the adverse effect of dual-class status on Tobin?s q and cost of equity capital, and is associated with increased institutional investment in dual-class firms. Taken together, our evidence suggests that debt plays a governance role and disciplines insiders in dual-class firms.

REVISION: Debt Covenants and Accounting Conservatism
Date Posted:Wed, 02 Dec 2009 10:58:21 -0600
Using a sample of over 5,000 debt issues, I test whether firms with more extensive use of covenants in their public debt contracts exhibit timelier recognition of economic losses in accounting earnings. Covenants govern the transfer of decision-making and control rights from shareholders to bondholders when a company approaches financial distress and thereby limit managers’ abilities to expropriate bondholder wealth. Covenants are expected to constrain managerial opportunism, however, only if ...

REVISION: Does fair value accounting for non-financial assets pass the market test?
Date Posted:Wed, 21 Oct 2009 21:46:28 -0500
We examine whether companies choose fair value over historical cost when both valuation methods become available and when consistency in their application is expected. While prior research establishes the value relevance of fair value revaluations, the evidence is largely conditional on a company's discretionary choice to revalue assets. Little is known, however, about companies’ choice of fair value over historical cost and its determinants. We study a setting where companies need to ...

Disproportional Control and Insider Entrenchment: Evidence from Capital Structure Choices and Institutional Investment
Date Posted:Wed, 02 Sep 2009 00:00:00 -0500
A dual-class ownership structure, accompanied by disproportional control rights, is traditionally considered to be an inferior form of governance. We examine how the capital structure choices made by dual-class firms (i.e., by their controlling shareholders or insiders), as well as the investment choices made by the non-controlling institutional investors in these firms, vary with the presence of dual-class ownership and the degree of disproportional control it entails. We consider two sources of disproportional control: the difference between voting rights and cash flow rights and the difference between board election rights and cash flow rights. We find that dual-class firms, as well as firms with higher levels of disproportional control, have higher levels of leverage, a greater likelihood of issuing private debt, a higher fraction of long-term debt, and greater reliance on financial covenants. We also find that dual-class firms have significantly higher levels of institutional ownership, including ownership by institutions that are activist types, face stricter prudence laws, and have longer horizons. Overall, our evidence is not consistent with dual-class ownership promoting rent-seeking behavior. On the contrary, our evidence supports the view that insiders choose other mechanisms, debt in particular, to commit to not expropriate non-controlling shareholders.

REVISION: Econometrics of the Basu Asymmetric Timeliness Coefficient and Accounting Conservatism
Date Posted:Fri, 15 May 2009 09:52:06 -0500
Despite its popularity, the asymmetric timeliness coefficient has been challenged as a valid measure of conditional conservatism. We propose a model in which accounting income contemporaneously incorporates one component of price revision, incorporates another with a lag unless below a threshold (e.g., losses), invariably incorporates another with a lag, and adds uncorrelated “noise.” We demonstrate validity in this framework. We derive a negative relation between asymmetric timeliness ...

REVISION: Econometrics of the Basu Asymmetric Timeliness Coefficient and Accounting Conservatism
Date Posted:Wed, 29 Apr 2009 20:35:57 -0500
The literature has embraced the Basu (1997) asymmetric timeliness coefficient as a valid measure of conditional conservatism. The coefficient is the incremental slope on negative returns in a piecewise-linear regression of accounting income on stock returns. We present a simple, intuitive analysis demonstrating the validity of this model. We also demonstrate a negative relation between market-to-book ratios and asymmetric timeliness coefficients, due to different accounting vs. economic ...

REVISION: Who Uses Fair-Value Accounting for Non-Financial Assets After IFRS Adoption?*
Date Posted:Thu, 05 Mar 2009 11:01:58 -0600
We examine whether and why companies prefer fair value to historical cost when they can choose between the two valuation methods. With the exception of investment property owned by real estate companies, historical cost by far dominates fair value in practice. Indeed, fair value accounting is not used for plant, equipment, and intangible assets. We find that companies using fair value accounting rely more on debt financing than companies that use historical cost. This evidence is consistent ...

REVISION: Who Uses Fair-Value Accounting for Non-Financial Assets After IFRS Adoption?*
Date Posted:Sat, 28 Feb 2009 04:31:40 -0600
We examine whether and why companies prefer fair value to historical cost when they can choose between the two valuation methods. With the exception of investment property owned by real estate companies, historical cost by far dominates fair value in practice. Indeed, fair value accounting is not used for plant, equipment, and intangible assets. We find that companies using fair value accounting rely more on debt financing than companies that use historical cost. This evidence is consistent ...

REVISION: *Who Uses Fair-Value Accounting for Non-Financial Assets Following IFRS Adoption?
Date Posted:Wed, 17 Sep 2008 18:51:05 -0500
This study examines whether and why fair value is preferred to historical cost accounting in practice. We study companies' choices in a setting where they can freely choose between these two valuation methods. We find that historical cost by far dominates the choice of fair value with the exception of investment property owned by companies with primary activity in real estate. More specifically, for plant, equipment, and intangible assets close to none of the companies examined use fair value ...

Does Fair Value Accounting for Non-Financial Assets Pass the Market Test?
Date Posted:Wed, 17 Sep 2008 00:00:00 -0500
The choice between fair value and historical cost accounting is the subject of long-standing controversy among accounting academics and regulators. Nevertheless, the market-based evidence on this subject is very limited. We study the choice of fair value versus historical cost accounting for non-financial assets in a setting where market forces rather than regulators determine the outcome. In general, we find a very limited use of fair value accounting. However, the observed variation is consistent with market forces determining the choice. Fair value accounting is used when reliable fair value estimates are available at a low cost and when they convey information about operating performance. For example, with very few exceptions, firms? managers commit to historical cost accounting for plant and equipment. Our findings contribute to the policy debate by documenting the market solution to one of the central questions in the accounting literature. Our findings indicate that despite its conceptual merits, fair value is unlikely to become the primary valuation method for illiquid non-financial assets on a voluntary basis.

REVISION: Debt Covenants and Accounting Conservatism
Date Posted:Mon, 21 Jan 2008 13:04:07 -0600
Please enter abstract text here. Using a sample of more than 5,000 debt issues, I examine whether firms with more covenant restrictions in their public debt contracts exhibit more timely recognition of economic losses in accounting earnings. Covenants limit the manager's ability to take actions leading to bondholder wealth expropriation by governing the transfer of control rights from shareholders to bondholders when a firm approaches financial distress. Given most covenants become binding ...

Debt Covenants and Accounting Conservatism
Date Posted:Mon, 21 Jan 2008 00:00:00 -0600
Using a sample of over 5,000 debt issues, I test whether firms with more extensive use of covenants in their public debt contracts exhibit timelier recognition of economic losses in accounting earnings. Covenants govern the transfer of decision-making and control rights from shareholders to bondholders when a company approaches financial distress and thereby limit managers? abilities to expropriate bondholder wealth. Covenants are expected to constrain managerial opportunism, however, only if the accounting system recognizes economic losses in earnings in a timely fashion. Thus, the demand for timely loss recognition should increase with a contract?s reliance on covenants. Consistent with this conjecture, I find evidence that reliance on covenants in public debt contracts is positively associated with the degree of timely loss recognition. I also find evidence that the presence of prior private debt mitigates this relationship.

REVISION: Econometrics of the Basu Asymmetric Timeliness Coefficient and Accounting Conservatism
Date Posted:Thu, 25 Oct 2007 20:48:49 -0500
The literature has embraced the Basu (1997) asymmetric timeliness coefficient as a valid measure of conditional conservatism. The coefficient is the incremental slope on negative returns in a piecewise-linear regression of accounting income on stock returns. We present a simple, intuitive analysis demonstrating the validity of this model. We also demonstrate a negative relation between market-to-book ratios and asymmetric timeliness coefficients, due to different accounting vs. economic ...

Econometrics of the Basu Asymmetric Timeliness Coefficient and Accounting Conservatism
Date Posted:Fri, 13 Jul 2007 00:00:00 -0500
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 context of a model with accounting income incorporating different types of information with different lags, and with noise. We demonstrate that the asymmetric timeliness coefficient varies with firm characteristics affecting their information environments, such as the length of the firm?s operating and investment cycles, and its degree of diversification. We particularly examine one characteristic, the extent to which ?unbooked? information (such as revised expectations about rents and growth options) is independent of other information, and discuss the conditions under which a proxy for this characteristic is the market-to-book ratio. We also conclude that much criticism of the Basu regression misconstrues researchers? objectives.

REVISION: Econometrics of the Basu Asymmetric Timeliness Coefficient and Accounting Conservatism
Date Posted:Thu, 12 Jul 2007 19:09:00 -0500
Following its introduction in Basu (1997) and its application in an international context in Ball, Kothari, and Robin (2000), the asymmetric timeliness coefficient has been embraced by the accounting literature as a valid measure of conditional conservatism, which Basu (1997, p. 7) defines as "the accountant's tendency to require a higher degree of verification to recognize good news as gains than to recognize bad news as losses." The coefficient is estimated from a piecewise-linear regression ...

REVISION: Agency Theory of Overvalued Equity as an Explanation for the Accrual Anomaly
Date Posted:Fri, 18 Aug 2006 09:30:40 -0500
We show that the agency theory of overvalued equity (see Jensen, 2005, and others) rather than investors' fixation on accruals explains the accrual anomaly, i.e., abnormal returns to an accrual trading strategy (see Sloan, 1996). Under the agency theory of overvalued equity, managers of overvalued firms are likely to manage their firms' accruals upwards to prolong the overvaluation. Overvaluation, however, cannot be sustained indefinitely and we expect price reversals for high accrual firms ...

REVISION: Agency Theory of Overvalued Equity as an Explanation for the Accrual Anomaly
Date Posted:Wed, 28 Dec 2005 11:46:34 -0600
We show that the agency theory of overvalued equity (see Jensen, 2005, and others) rather than investors' fixation on accruals explains the accrual anomaly, i.e., abnormal returns to an accrual trading strategy (see Sloan, 1996). Under the agency theory of overvalued equity, managers of overvalued firms are likely to manage their firms' accruals upwards to prolong the overvaluation. Overvaluation, however, cannot be sustained indefinitely and we expect price reversals for high accrual firms.

Agency Theory of Overvalued Equity as an Explanation for the Accrual Anomaly
Date Posted:Wed, 28 Dec 2005 00:00:00 -0600
We show that the agency theory of overvalued equity (see Jensen, 2005) rather than investors' fixation on accruals explains the accrual anomaly, i.e., abnormal returns to an accrual trading strategy (see Sloan, 1996).Under the agency theory of overvalued equity, managers of overvalued firms are likely to manage their firms' accruals upwards to prolong the overvaluation.Thus, high-accrual portfolios are likely to be over-represented with over-valued firms.Overvaluation, however, cannot be sustained indefinitely and we expect price reversals for high accrual firms.In contrast, undervalued firms do not face incentives to report low accruals, so undervalued firms are not concentrated in low accrual decile portfolios.Therefore, across the accrual decile portfolios, we predict and find an asymmetric relation between accruals and both prior and subsequent returns.In addition, consistent with the predictions of the agency theory of overvalued equity, we find high, but not low, accrual firms' investment-financing decisions and insider trading activity are distorted, and analyst forecast optimism is concentrated among the high-accrual decile portfolios.Overall, return behavior, analyst optimism, investment-financing decisions, and insider trading activity are all consistent with the agency theory of overvalued equity, but do not support investor fixation on accruals.

REVISION: The Endogeneity Bias in the Relation between Cost-of-Debt Capital and Corporate Disclosure Policy
Date Posted:Fri, 05 Aug 2005 10:17:37 -0500
The purpose of this paper is twofold. First, we provide a discussion of the problems associated with endogeneity in empirical accounting research. We emphasize problems arising when endogeneity is caused by (1) unobservable firm specific factors and (2) omitted variables and discuss the merits and drawbacks of using panel data techniques to address these causes. Second, we investigate the magnitude of endogeneity bias in Ordinary Least Squares regressions of cost-of-debt capital on firm ...

The Endogeneity Bias in the Relation between Cost-of-Debt Capital and Corporate Disclosure Policy
Date Posted:Fri, 05 Aug 2005 00:00:00 -0500
The purpose of this paper is twofold. First, we provide a discussion of the problems associated with endogeneity in empirical accounting research. We emphasize problems arising when endogeneity is caused by (1) unobservable firm specific factors and (2) omitted variables and discuss the merits and drawbacks of using panel data techniques to address these causes. Second, we investigate the magnitude of endogeneity bias in Ordinary Least Squares regressions of cost-of-debt capital on firm disclosure policy. We document how including a set of variables which theory suggests to be related with both cost-of-debt capital and disclosure and using fixed effects estimation in a panel dataset reduces the endogeneity bias and produces consistent results. This analysis reveals that the effect of disclosure policy on cost-of-debt capital is 200% higher than what is found in Ordinary Least Squares estimation. Finally, we provide direct evidence that disclosure is impacted by unobservable firm-specific factors that are also correlated with cost-of-capital.

The Endogeneity Bias in the Relation Between Cost-of-Debt Capital and Corporate disclosure Policy
Date Posted:Thu, 02 Jun 2005 10:47:26 -0500
The purpose of this paper is twofold. First, we provide a discussion of the problems associated with endogeneity in empirical accounting research. We emphasize problems arising when endogeneity is caused by (1) unobservable firm specific factors and (2) omitted variables and discuss the merits and drawbacks of using panel data techniques to address these causes. Second, we investigate the magnitude of endogeneity bias in Ordinary Least Squares regressions of cost-of-debt capital on firm ...

The Endogeneity Bias in the Relation between Cost-of-Debt Capital and Corporate Disclosure Policy
Date Posted:Thu, 02 Jun 2005 00:00:00 -0500
The purpose of this paper is twofold. First, we provide a discussion of the problems associated with endogeneity in empirical accounting research. We emphasize problems arising when endogeneity is caused by (1) unobservable firm specific factors and (2) omitted variables and discuss the merits and drawbacks of using panel data techniques to address these causes. Second, we investigate the magnitude of endogeneity bias in Ordinary Least Squares regressions of cost-of-debt capital on firm disclosure policy. We document how including a set of variables which theory suggests to be related with both cost-of-debt capital and disclosure and using fixed effects estimation in a panel dataset reduces the endogeneity bias and produces consistent results. This analysis reveals that the effect of disclosure policy on cost-of-debt capital is 200% higher than what is found in Ordinary Least Squares estimation. Finally, we provide direct evidence that disclosure is impacted by unobservable firm-specific factors that are also correlated with cost-of-capital.