11 Financial: Financial Reporting Quality / Credit Ratings / Earnings Smoothing / Earnings Comparability (FAR3)

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Chair: Boochun Jung
Associate Professor, Shidler College of Business, University of Hawai’i-Mānoa, United States


Recent Submissions

Now showing 1 - 10 of 16
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    Modeling Earnings Discontinuities: A Maximum Likelihood Approach
    ( 2017-09-02) Basu, Sudipta ; Byzalov, Dmitri
    We develop new distribution discontinuity tests for detecting earnings management and analyzing its determinants. We embed Burgstahler and Dichev’s (1997) intuition on benchmark-driven earnings management in a likelihood-based model that addresses important limitations of the existing distribution discontinuity tests. Our method offers large improvements in test performance relative to both histogram-based tests of the existence of earnings discontinuity and logit-based tests of the determinants of earnings discontinuity, and it changes some of the major findings in the earnings discontinuity literature. Future research on distribution discontinuities could benefit from adopting our likelihood-based tests.
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    Potential Prison Time and Earnings Management
    ( 2017-09-01) Costin, Claire ; Rakestraw, Joseph
    We examine the association between earnings management and the maximum potential prison time a director may receive resulting from a self-serving transaction that is neither disclosed nor approved. Executives face incentives and disincentives to manage earnings. We hypothesize and find a negative relation between potential prison time and earnings management. Further, we show that the negative relation between potential prison time and earnings management is stronger in countries where the population has more confidence in the court system. These findings suggest that potential prison time serves as a powerful disincentive to manage earnings.
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    Does Fair Value Accounting Reduce Prices and Create Illiquidity?
    ( 2017-09-01) Lunawat, Radhika ; Pronin, Kira ; Stecher, Jack ; Zhang, Gaoqing
    Concerns about the use of fair value accounting commonly focus on the sensitivity of market prices to exogenous liquidity shocks. In this paper, we show that the use of fair value accounting for assets without an active market endogenously creates illiq- uidity. The underlying mechanism is the discretion in fair value reports when prices are unavailable. Firms use this discretion to report aggressively, leading to two market e ects. On the plus side, by revealing an upper bound on an asset's value, fair value reporting leads to lower prices than would occur in a conservative regime. This is an indication that prices are more e cient than under conservatism, as the reports protect investors from paying information rents. The downside is that fair value reports cannot credibly convey a lower bound on an asset's value, causing illiquidity. We con rm these e ects in a laboratory experiment.
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    The Effect of Fair Value versus Historical Cost on Stock Price Crash Risks: Evidence from Investment Property
    ( 2017-09-01) Liu, Sophia ; Hsu, Audrey Wenhsin ; Wu, Grace Shu-Hsing
    The accounting standard used in China for investment property, Chinese Accounting Standards 3 (CASs) is comparable to IAS 40 Investment Property while there are two crucial differences: (1) an entity is allowed to use the fair value method if and only if the local property market is active or if the fair value of an entity’s investment property can be estimated reliably through the values and other information of the same or similar category of properties. In other words, CAS 3 is more prudential and restricted on the use of fair value model; (2) CAS 3 does not require an entity which uses the cost method to recognize investment property to also disclose the fair values of property in the footnotes. Using a sample of publicly traded firms that hold investment property from 2007 through 2011 in China, we conduct purer tests to shield some light on the effect of fair value reporting for investment property on firm opacity and stock price dynamics in an emerging market. We find that firms that recognize investment property at fair value in China experience an increase in crash risks, consistent with the notion that fair value reporting for investment property in China does not convey managerial private information regarding firm value while could be the channel to conceal information, and hence exhibit higher stock price crash risks. We further find evidence that the association between the fair value reporting and increased crash risks is mitigated when managers operating in firms with strong corporate governance.
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    Reporting Concerns about Earnings Quality: An Examination of Corporate Managers
    ( 2017-08-31) Schaefer, Tammie ; Brazel, Joseph ; Lucianetti, Lorenzo
    Using an experiment with corporate financial managers (e.g., CFOs, controllers), we find that when red flags are present in the financial statements under their review, managers identify those red flags and, in turn, have greater concerns over earnings quality. In addition, when pressure to meet a financial target is high, managers are more concerned about earnings quality when red flags are present. We also document that when red flags are present, managers are more likely to report both internally to their CEO and, if their concerns are not resolved internally, externally to their auditor. Pressure to meet a financial target directly influenced the decision to report internally, but not externally. Additional analyses contemplate the countervailing personal costs associated with reporting or not reporting earnings quality concerns. We demonstrate the important role short-term costs play in external reporting decisions. Finally, we provide initial evidence that corporate managers with a longer tenure at their position (public accounting background) are less (more) likely to report externally.
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    When are Fair Value Estimates Comparable? Evidence from the SFAS No. 157 Fair Value Hierarchy
    ( 2017-08-31) Black, Jonathan ; Chen, Jeff ; Marc Cussatt
    One motivation for expanding fair value accounting is to improve financial statement comparability by matching the timing of valuation across companies. However, the effect of fair value accounting on comparability also relies on consistent measurement methods and inputs. As the quantity of items reported using fair value estimation expands it is likely that firms will use a larger variety of measurement techniques, which could impede the comparability of fair value estimates across companies. Thus, we investigate whether the difference in exposure to fair value estimates across firms reduces the comparability of these estimates. Due to the increasing discretion in estimates across the SFAS 157 hierarchy of fair value assets, we also predict that inconsistent measurement will reduce comparability more for level 2 and 3 assets relative to level 1 assets. Results from firm-pair regressions provide evidence that firm-pairs with more diverse proportions of assets valued at fair value have less comparable fair value estimates. Furthermore, we find that differences in more discretionary estimates (Level 2 and 3) are more strongly associated with decreases in comparability than differences in less discretionary Level 1 estimates. We extend our main results to two cross-sectional hypotheses, providing evidence that comparability is reduced even further for subsamples where the firm-pairs have the incentive and ability to introduce discretion into fair value estimates. Taken together, these results suggest that standardization of fair value measurement matters for effectively improving comparability through expanded use of fair value estimates.
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    Employee Stock Options: The Importance of Differentiating Between Proceeds and Compensation
    ( 2017-08-31) Hill, Mary ; Ruch, George
    Prior research finds a negative association between outstanding employee stock options (ESOs) and common equity risk, suggesting that outstanding ESOs possess economic characteristics of equity rather than liabilities. We examine whether this association is attributable to (1) the expected value of the cash proceeds to be received upon ESO exercise (“ESO-Proceeds”), or (2) the expected value of compensation to be paid to ESO holders for services provided (“ESO-Compensation”). This distinction is important because the question of whether outstanding ESOs possess characteristics of liabilities or equity inherently pertains to ESO-Compensation, not ESO-Proceeds. Our findings indicate that the negative association observed in prior research is attributable to ESO-Proceeds rather than ESO-Compensation. Additionally, we find that ESO-Compensation is positively associated with common equity risk, which suggests that outstanding ESOs possess characteristics of liabilities rather than equity. Overall, our evidence illustrates the importance of differentiating between ESO-Compensation and ESO-Proceeds when addressing financial reporting questions related to outstanding ESOs.
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    Myopia and earnings management strategies
    ( 2017-08-30) Haga, Jesper ; Huhtamaki, Fredrik ; Sundvik, Dennis
    In this study, we investigate how country-level myopia affects managers’ willingness to engage in earnings management and choice of earnings management strategy. Using a comprehensive dataset of 47 countries for the time period from 2003 to 2015, we find that firms in short-term oriented cultures engage in more real earnings management, while firms in long-term oriented cultures rely on earnings management through accruals manipulation. Furthermore, we find a larger discontinuity around earnings benchmarks in long-term oriented cultures suggesting that utilization of AM enables benchmark beating with high precision.
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    Do Smoothing Activities Indicate Higher or Lower Financial Reporting Quality? Evidence from Effective Tax Rates
    ( 2017-08-29) Demere, Paul ; Li, Laura ; Lisowsky, Petro ; Snyder, R. William
    Prior literature is mixed as to whether smoothing through accruals indicates higher or lower financial reporting quality (Tucker and Zarowin 2006; Jayaraman 2008; Dechow et al. 2010). Motivated by the unique inter-temporal features and reporting incentives of tax expense, we provide new evidence on this debate by examining the link between smoothing of GAAP effective tax rates (ETRs) and the likelihood of financial restatements. Different from earnings smoothing’s insignificant relation with restatements, we find that ETR smoothing through tax accruals is associated with a lower likelihood of financial restatement and lower likelihood of tax-related financial reporting fraud. Further investigation reveals that such negative associations are stronger in firms with a higher level of discretion in tax reporting and when the demand and monitoring for transparent reporting is higher. We also document corroborating evidence that smoothing through tax accruals increases the informativeness of GAAP ETRs for predicting future cash ETRs. Collectively, our results contribute to the financial reporting and tax literatures by providing evidence that smoothing activities pertaining to tax accruals are consistent with higher financial reporting quality.
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    Does the Threat of Takeover Discipline Managers? New Evidence from the Foreign Investment and National Security Act
    ( 2017-08-25) Godsell, David
    Competing theories and mixed results describe the effect of the takeover market on managers’ earnings management incentives. I use the passage of the Foreign Investment and National Security Act (FINSA), which suppressed foreign investment in a subset of U.S. industries, to re-examine this relationship. I find that, after FINSA implementation, FINSA-affected firms record more income-increasing discretionary accruals. Firms that were more likely to be subject to takeover before FINSA drive this effect. This inference is robust to a wide variety of empirical specifications and discretionary accrual measures as well as to the use of firm fixed effects, model-free measures of earnings management and multiple placebo tests. Overall, these results suggest that a weaker market for corporate control accentuates earnings management.