Valuation-based accounting research: Implications for financial reporting and opportunities for future research

This paper discusses the relation between financial reporting research and practice, particularly standard setters. Many studies addressing financial reporting issues use a valuation approach. The paper describes alternative approaches to valuation research and summarises the findings relating to four major current issues: fair value accounting for financial, tangible, and intangible assets, cash flows versus accruals, recognition versus disclosure, and international harmonisation of accounting standards. The summaries include identifying what standard setters and others would like to learn from research, what we have learned, and what is left to learn. The paper concludes with observations about future financial reporting academic research.     

Accounting for Intangible Assets: Thinking It Through

With the modern corporation investing more in intangible assets, the issue of appropriate accounting for these assets is very much at the fore and formally on the agendas of accounting standards boards. Some commentators advocate that internally generated intangible assets should be booked to the balance sheet, just like tangible assets. This paper explains that this apparently straightforward solution is not so simple. There are subtleties that, when recognised, indicate that such accounting would often make both balance sheets and income statements less informative. In response, the paper outlines an accounting for intangible assets that preserves, indeed enhances, the information conveyed by both the balance sheet and the income statement and satisfies the financial reporting objective of providing information to investors about ‘the amount, timing, and uncertainty of future cash flows’.     

Are Entrenched Managers’ Accounting Choices More Predictive of Future Cash Flows?

We examine the role manager entrenchment has on firms’ financial reporting quality. More specifically, we test whether entrenched managers’ reported accruals deviate from industry norms and whether entrenched managers’ abnormal accruals are more (or less) predictive of future cash flows. Consistent with implications from prior research, we find that firms with entrenched managers generally report lower levels of abnormal accruals (in an absolute sense), but the abnormal accruals utilized by entrenched managers are more predictive of future cash flows. Contrary to a more traditional view of manager entrenchment, our evidence suggests that entrenched managers report higher quality abnormal accruals. While prior research provides evidence that manager entrenchment is associated with negative economic outcomes, we argue that attempts to limit entrenchment are unlikely to improve financial reporting quality and may actually lower quality. Future corporate governance research should consider not only the level but also the quality of the association between accounting choices and manager entrenchment.     

What Are Assets and Liabilities? Where Is True North? (Accounting That my Sister Would Understand)

This is an article about what I think financial accounting and reporting ought to look like—about my vision that the singular focus of financial accounting and reporting should be on cash, that is, cash itself, contractual claims to cash, things (assets) that can be converted into cash, and obligations to pay cash, and that assets and liabilities should be stated at fair value in corporate balance sheets. I call this formulationTrue North. I previously have written about how we should keep financial accounting and reporting simple (‘Keep It Simple’, Accounting Horizons, June 1991, pp. 113–17). I also have written about how assets should be defined for accounting purposes (‘What Is an Asset?’, Accounting Horizons, Septem‐ber 1993, pp. 66–70). This article builds on those two earlier ones. It deals with definitions of assets and liabilities that should be recognized (that is, displayed, shown, or reported) in corporate balance sheets and how the recognized assets and liabilities should be measured when reported in those balance sheets.     

CEO's Operating Ability and the Association between Accruals and Future Cash Flows

This study investigates whether an individual CEO's operating ability, operationalized as the extent to which an individual CEO utilizes the company's assets efficiently to generate profits, explains the association between accruals and future cash flows. While this mapping can be driven by both the quality of accounting measurement and CEO operating ability, there is little empirical evidence on the latter link. After controlling for the CEO's accounting estimation ability, we find that the association between current period accruals and future cash flows is stronger when the CEO demonstrates superior operating ability. This suggests that a CEO's operating ability is an important determinant of the informativeness of current accruals for future cash flows.     

Gaps in the IFRS Conceptual Framework

Abstract

The stated purpose of the IFRS Conceptual Framework is to assist the IASB to develop Standards that are based on consistent concepts, and also to assist preparers to develop consistent accounting policies when Standards either do not apply or allow a choice of accounting policy. Yet, the Framework actually does surprisingly little to help the IASB (or preparers) determine which assets, liabilities, income and expenses should be recognised, and how they should be measured. The Framework’s focus on assets and liabilities implies that the accounting can, and should, be determined from the balance sheet. Yet, many current financial reporting requirements focus initially on the income statement, and so they are not so much derived from the Framework as instead in need of being reconciled back to it. At its heart, the problem here is that, while the Framework states that accrual accounting provides a better basis for assessing past and future performance than cash-based information, it does not explain why. To do so would require a conceptualisation of how entities’ business models are employed to create value, and of the strengths and limitations of accounting data in enhancing investors’ understanding of that value-creation. The lack of explanation of the purpose and informational objectives of accruals, how they relate to business models and how they cause the income statement and the balance sheet to interact are gaps in the Framework. Filling those gaps would provide a more robust, and natural, way for the IASB to develop recognition and measurement requirements in its Standards.     

从净收益视角看公允价值和历史成本计量属性的作用

论文在决策有用性的会计目标框架下,以权益投资者的企业价值评估为视角,探讨了会计计量属性的选择和应用问题。在资产负债会计体系下,即便采用公允价值计量也无法反映企业的整体经济价值。企业价值需要借助金融模型估计,传统收入费用会计体系下的净收益指标是模型中的关键变量,但资产负债表中公允价值的引入使净收益的计量失去了逻辑一致性。这对权益估价模型的应用造成了干扰,从而损害了财务报告对投资者的有用性。论文认为对投资者提供公允价值信息的最佳方式是单独披露,而不是表内确认。最近FASB为应对金融危机对有关会计准则的修订反映了计量方法多样化的趋势,但计量方法的优势并不取决于该计量方法是否符合计量对象的具体特点,而是是否符合会计系统的整体目标。     

Accounting Quality in Private Firms During the Transition Towards International Standards

We study the historical development of Slovenian Accounting Standards (SAS) and their association with accounting quality (AQ). We focus on private firms where the financial reporting process is characterised by low demand for high-quality reporting. We investigate three distinct editions of SAS since 1994 and test how their development towards international standards is related to AQ. Aggregate earnings management measures indicate that the use of accounting discretion decreases with less earnings smoothing over time. The main features of AQ have been consistent throughout historical development. Asymmetric timeliness of earnings, the ability of earnings to predict future cash flows, and the ability of accruals to mitigate mismatching are all present throughout. We also document typical departures from properties of high AQ. For example, accruals do not (always) facilitate timely recognition of losses. However, these can be attributed to the overwhelming influence of reporting incentives (e.g. taxation, debt, size) rather than to the (lower) quality of accounting standards.     

Accruals: An overview

The paper provides a broad discussion of the topic "accruals". Though much of what is said is familiar from the literature on accruals, the paper tries to develop concepts and show how theses forge tight links across a variety of themes. The starting point of the analysis concerns the construct of an accrual.The case is made that it should rest solely on consecutive balance sheets and the splitting of assets/liabilities into(i) cash and approximate cash,assets/liabilities and(ii) all other kinds of assets/liabilities. Given this divide of assets/liabilities one can measure the components in the foundation equation: cash earnings + net accrual = comprehensive earnings. The paper then proceeds to discuss how the net accrual relates to growth in a firm's operating activities and the extent to which it can be informative or misleading.This topic in turn integrates with the issue of a firm's quality of earnings and the role of accounting conservatism. Among the remaining topics, the paper discusses how one conceptualizes diagnostics to assess whether or not a period's accrual is likely to be biased upwards or downwards. It gives rise to a consideration of how one constructs accruals that may be more informative than GAAP accruals and the role of value-relevance studies to assess the information content of accrual constructs. The paper ends with a list of suggestions how future research may be modified in light of the discussions in this paper.     

What Do FAS 157 “Fair Values” Really Measure: Value Or Risk?

FAS 157, the U.S. accounting standard that prescribes how fair values of assets and liabilities are to be measured when other U.S. GAAP standards require fair valuation, stipulates that fair values be measured as the exit values of assets and liabilities—the proceeds for assets hypothetically sold on the date of the financial report, and, correspondingly, the amount required to settle liabilities on the date of the financial report. This conceptual article argues that exit values do not reflect the value of the net assets of the firm to shareholders, which is best reflected by discounted cash flows to maturity. Moreover, exit values—biasing fair values downward when markets are illiquid—have a pernicious, systemic risk effect; specifically, they give rise to write‐downs that in turn cause contagion: prices of equities and other financial instruments of peers react negatively, leading to further write‐downs by those peers. This may have aggravated the recent financial crisis. However, while exit values are not proper measures of value to shareholders, they are useful measures of downside risk when prospects turn sour for a firm. Thus, both exit values and discounted cash flows should be presented in financial statements.     

The Predictive Ability of Direct Method Cash Flow Information

This research examines the predictive ability of direct method cash flow information for firms that use the direct method in their cash flow statements. We use cross sectional and pooled time series regressions to predict operating cash flow data and assess relative predictive ability. Principal findings are: (1) past period direct method cash flow data predict future operating cash flow better than indirect method cash flow data; (2) past period direct method gross operating cash flows predict future net operating cash flow better than past period net operating cash flow; (3) measurement error exists in estimates of direct method operating cash flows from other financial statement data; (4) past operating cash flows predict future operating cash flows better than earnings and accruals.     

Do firms follow GAAP when they record share repurchases?

This paper examines U.S. firms' accounting for share repurchases and the accounting choice provided to Delaware-incorporated firms between the treasury and retirement methods. This accounting choice does not affect income, cash flows, or net assets, but it nevertheless affects financial reporting transparency and the allocation of equity between retained earnings and contributed capital. According to Generally Accepted Accounting Principles (GAAP), the accounting choice to record share repurchases should reflect management's intended disposition of the repurchased shares. We compare characteristics of Delaware-incorporated treasury and retirement firms and find that the choice between the two accounting methods is not always consistent with GAAP, but neither is it random; rather, this choice is related to a number of firm characteristics including firm growth, industry membership, trading exchange, and price–earnings ratio. We also find that a firm's accounting method for share repurchases is associated with a firm's propensity to make future share repurchases.     

Financial Performance Adjustment in English Local Governments

This paper analyses financial performance adjustment in English local governments and the specific accruals used to achieve it. Based on statistical approaches used in previous literature, our results indicate the use of abnormal accruals in English local governments in order to report surpluses/deficits close to zero as well as to avoid reporting big deficits. We find that depreciation and impairment expense of fixed assets is the item most significantly related to abnormal accruals. Consistent with the conservatism theory, local governments with higher leverage use more income‐decreasing accounting policies.     

Accruals quality and the incentive contracting role of earnings

This paper investigates the association between accruals quality and the usefulness of accounting earnings in incentive contracting. Accruals quality, which measures the precision with which accruals predict future cash flows, has two potential opposing effects on the noise in earnings as a measure of managerial performance. Specifically, higher quality accruals should decrease the deviations of earnings from future cash flows and increase the sensitivity of earnings to cash flows that are not attributable to managerial actions. My evidence indicates that better accruals quality is associated with a higher weight on earnings in compensation contracts, which suggests that accruals quality overall reduces the noise in earnings. I also find that the positive association between accruals quality and the weight on earnings is mainly driven by innate accruals quality rather than discretionary accruals quality. Therefore, accrual errors resulting from the volatility of the operating environment are a primary source of noise in earnings considered by compensation committees.     

Measuring income tax accrual quality

We develop and validate a measure of tax accrual quality. Tax accrual quality captures variation in the extent to which the income tax accrual maps into income tax-related cash flows, with lower variation indicating a higher quality tax accrual. Low tax accrual quality arises from (1) management estimation error and (2) financial reporting standards that lead to differences between income tax expense and income tax cash flows not captured by deferred tax assets and liabilities. We validate our tax accrual quality measure by showing it is associated with firm characteristics that capture both constructs and by demonstrating it predicts future tax-related restatements and internal control material weaknesses. We illustrate the importance of our measure by showing that investors view tax expense as more informative in firms with better tax accrual quality. Future researchers can use tax accrual quality to address questions related to estimation error in the income tax account.     

Accounting Choices: Variation in Managerial Opportunism

This study focuses on variation in managers' accounting choices given motivations to use accounting accruals opportunistically. Prior research identifies a number of motivations arising from accounting–based contracts that encourage opportunistic reporting by managers. However, prior research implicitly assumes all managers respond identically to the same contractual motivations. This study identifies variation in managers' responses to contractual motivations involving accruals that is related to managers' stewardship of corporate assets. Evidence shows that modeling how managers use corporate assets enhances the explanation of their accounting choices given motivations to (a) use accruals opportunistically, and (b) to smooth income via accruals. Managers with high ratings on judicious use of corporate assets are less responsive to motivations to use accruals opportunistically, and to smooth income via accruals, than managers with low ratings. This evidence suggests that not all managers are equally opportunistic, and that modeling this factor helps explain cross–sectional differences in managers' accounting choices.     

Cash Flow Accounting and Liquidity: Cash Flow Potential and Wealth

The persistence of a minority interest in ‘cash flow accounting’ alongside the dominant financial reporting pattern that gives cash flow statements a distinctly secondary role in the line-up of flow statements suggests that something is missing from the analyses of the interested parties. The major theme of this paper is that users rely on historical cash flow reporting for information relevant to projecting enterprise liquidity in the short run, and on financial statements based on accrual-deferral accounting for information relevant to their interest in wealth and income. An explicit distinction between the two accounting objectives (providing information for use in assessing future enterprise liquidity and providing information for use in assessing enterprise wealth and income and performance against investors' augmentation-of-wealth objective) is recommended as a basis for clarifying the issues. That distinction suggests the value of two quite different, but related, sets of data: historical cash flows and stocks and flows of cash potentials.     

Impact of an accounting environment on cash flow prediction

This study investigates the impact of an accounting environment on the performance of cash flow prediction models. It is hypothesized that the cash flow model by Barth, Cram, and Nelson [Acc. Rev. 76 (2001) 27] performs well in countries where the accruals are used mainly to correct cash flows to better reflect current profitability of the firm, i.e., in countries with high information content of accruals. The results suggest that the model performs consistently across countries, except in Germany. As hypothesized, the impacts of the explanatory variables are similar in market-oriented countries with separated financial accounting and taxation, with strong shareholder protection and legislation based on common-law origin, i.e., in countries with high quality of accruals. By contrast, the impacts are different in countries with low quality of accruals. The results imply that the cash flow prediction model by Barth et al. [Acc. Rev. 76 (2001) 27] can be used in different kinds of accounting environments. However, the exact parameter values are dependent on the accounting environment.     

The Role of Accruals in Asymmetrically Timely Gain and Loss Recognition

We investigate the role of accrual accounting in the asymmetrically timely recognition (incorporation in reported earnings) of gains and losses. Timely recognition requires accruals when it precedes complete realization of the gains and losses in cash. We show that nonlinear accruals models incorporating the asymmetry in gain and loss recognition (timelier loss recognition, or conditional conservatism) offer a substantial specification improvement, explaining substantially more variation in accruals than equivalent linear specifications. Conversely, conventional linear accruals models, by omitting the loss recognition asymmetry, exhibit substantial attenuation bias and offer a comparatively poor specification of the accounting accrual process. Linear specifications also understate the ability of current earnings to predict future cash flows. These findings have implications for our understanding of accrual accounting and conservatism, as well as for researchers estimating discretionary accruals, earnings management, and earnings quality.     

Dissecting and connecting the growth and accounting distortion components of accruals

This study refines the accrual decomposition approach in Richardson et al. (Account Rev 81:713–743, 2006) and introduces a growth measure that is free from accounting distortions. My evidence indicates that the lower persistence of accruals extends to accruals that are unrelated to accounting distortions. I, however, find that the growth and accounting distortion components of accruals are not isolated. Growth may provide a context where firms have more incentives to manipulate earnings. I provide evidence that the persistence of both the growth and accounting distortion components of accruals is affected by firm growth and agency cost factors, such as free cash flows, leverage, and overvalued equity. I also document high accounting distortions for relatively high-growth firms that are close to reporting positive earnings, and negative accounting distortions for relatively low-growth firms that are far from the potential to report positive earnings.