Accounting restatements and information risk

We examine the association between accounting restatements and the pricing of information risk. Using the Fama and French three-factor model augmented with discretionary and innate information risk factors, we find a significant increase in the factor loadings on the discretionary information risk factor for restatement firms after a restatement announcement. The increase in factor loadings results in an increase in the estimated cost of capital, which is cross-sectionally associated with the short-window price reaction to restatements. We study several potential determinants of the change in information risk pricing and find evidence consistent with the restatement initiator (auditor vs. firm management) and the number of times a firm restates affecting the change in the pricing of discretionary information risk. We also find an increase, of smaller magnitude, in the pricing of discretionary information risk for non-restatement firms in the same industries as the restatement firms, consistent with an information transfer effect.     

Private Information and the Exercise of Executive Stock Options

This paper finds strong evidence that executives use private information when exercising their stock options. The most informed executives tend to exercise early, do not exercise on the vest date, do not exercise to capture dividends, exercise a high percentage of their options, and exercise when the option is the least in‐the‐money. We also find that exercises around resignation and retirement are followed by significant negative abnormal returns. Furthermore, the operating performance of firms following exercises motivated by private information is significantly worse than that of firms in which the exercises are not motivated by private information.     

Imperfect Accounting and Reporting Bias

Errors and bias are both inherent features of accounting. In theory, while errors discourage bias by lowering the value relevance of accounting, they can also facilitate bias by providing camouflage. Consistent with theory, we find a hump‐shaped relation between a firm's propensity to engage in intentional misstatement and the prevalence of unintentional misstatements in the firm's industry for the whole economy and a majority of the industries. The result is robust to using firms’ number of items in financial statements and exposure to complex accounting rules as alternative proxies for errors and to using the restatement amount in net income to quantify the magnitude of bias and errors. To directly test for the two effects of errors, we show that when errors are more prevalent, the market reacts less to firms’ earnings surprises and bias is more difficult to detect. Our results highlight the imperfectness of accounting, advance understanding of firms’ reporting incentives, and shed light on accounting standard setting.     

Nonrecurring Accounting Transactions and Stock Option Grants

Abstract:  We examine the effect of nonrecurring accounting transactions on stock option grants for a sample of US companies. After controlling for both the economic and corporate governance-related determinants of option grants, we find that the aggregate value of stock option grants is more positively related to nonrecurring gains than to nonrecurring losses. We also examine whether the asymmetric treatment of nonrecurring gains and losses arises because (1) information contained in the nonrecurring transactions is related to firms' long-term prospects, (2) weak corporate governance fails to curb more favorable executive pay arrangements, (3) executives possess superior bargaining power in the labor marketplace, and (4) firms have significant growth opportunities. While we find no support for the first explanation and some support for the third, we find more consistent support for the growth explanation and two factors related to the corporate governance explanation: director-executive duality and the frequency of board meetings.     

What drives the dating game of executive options exercise? Evidence from Taiwan

Examining Taiwanese firms from 2002 to 2008, this paper investigates the motivations behind backdating the exercising of executive stock options. The probability of suspect exercises (backdating) is positively related to the firm’s stock return, the value of the option, tax savings, institutional ownership and the extent of CEO equity ownership and negatively related to firm‐specific risk and the use of Big Four accounting firms. Tax incentives motivate executives to backdate the exercise date, implying that the greater the potential for larger tax savings, the greater the likelihood of backdating. Backdating usually occurs in firms that have heavy ownership by the CEO, have more claims to executive stock options and are not family‐run, confirming the presence of the agency cost problem.     

Discretionary accounting choices and the predictive ability of accruals with respect to future cash flows

Using a sample of restatement firms and a meet-or-beat model to classify firms as making discretionary accounting choices for opportunistic meet-or-beat (OP-MB) reasons, we show that originally reported earnings and accrual components are less predictive of future cash flows relative to the restated numbers. We find the opposite is true for firms classified as making discretionary accounting choices for non-OP-MB reasons. We consider a number of competing explanations for these latter results. Our findings are most consistent with the informational hypothesis, weakly consistent with conservative-motivated efficient contracting hypotheses, but inconsistent with opportunistic contracting and misapplication/errors of GAAP explanations.     

Corporate misreporting and bank loan contracting

This paper is the first to study the effect of financial restatement on bank loan contracting. Compared with loans initiated before restatement, loans initiated after restatement have significantly higher spreads, shorter maturities, higher likelihood of being secured, and more covenant restrictions. The increase in loan spread is significantly larger for fraudulent restating firms than other restating firms. We also find that after restatement, the number of lenders per loan declines and firms pay higher upfront and annual fees. These results are consistent with banks using tighter loan contract terms to overcome risk and information problems arising from financial restatements.     

DO INSIDERS PRACTICE WHAT THEY PREACH? INFORMED OPTION EXERCISES AROUND MERGERS AND ACQUISITIONS

We examine executive stock option exercises around a sample of merger and acquisition announcements between 1996 and 2006, focusing on a subset we identify as potentially informed. For stock‐financed acquisitions, we find a surge in informed exercises by acquirer insiders in the year leading up to the acquisition announcement, but target insiders display no similar increase. We find the market reaction upon the announcement for acquirers is negatively related to extreme early exercises and find some evidence of long‐run underperformance. Overall, our evidence indicates that insiders knowingly bid for firms when they personally believe their own firm is overvalued.     

Executive stock options and IPO underpricing

In about one-third of US IPOs between 1996 and 2000, executives received stock options with an exercise price equal to the IPO offer price rather than a market-determined price. Among firms with such “IPO options”, 58% of top executives realize a net benefit from underpricing: the gain from the options exceeds the loss from the dilution of their pre-IPO shareholdings. If executives can influence either the IPO offer price or the timing and terms of their stock option grants, there should be a positive relation between IPO option grants and underpricing. We find no evidence of such a relation. Our results contrast sharply with the emerging literature on managerial self-dealing at shareholder expense.     

Resolution of restatement-induced lawsuits after the Private Securities Litigation Reform Act

Using a sample of 185 restating firms that were sued between 1997 and 2005, we examine the role of accounting irregularity, other restatement characteristics and the Sarbanes Oxley Act in the resolution of litigation after the Private Securities Litigation Reform Act (PSLRA). The empirical results indicate that restatement due to an accounting irregularity and investigation of accounting misstatement by the Securities and Exchange Commission (SEC) are associated with a higher probability of settlement. Furthermore, the more negative the investor reaction to a restatement, the higher the probability that a lawsuit will be settled. Finally, we do not find any evidence that the Sarbanes Oxley Act is associated with the probability of a settled lawsuit. Our findings suggest that restatement-induced lawsuits with strong inference of fraud are settled in the period after the PSLRA. The results also highlight the importance of making a distinction between dismissed and settled restatement-induced lawsuits.     

The efficacy of regulatory intervention: Evidence from the distribution of informed option trading

A substantive body of equity-market academic research documents an extensive range of costs arising from the SEC’s October 2000 adoption of strictures on selective disclosure and insider trading; suggesting an unusual outcome, specifically, an increase in informed trading. We investigate the efficacy of the SEC’s regulations by examining informed trading in an attractive setting for exploiting private information; the options market. Using data on the S&P 1500 industrial firms, our analysis indicates that about 38% of firms exhibited symptoms of informed option trading prior to regulatory intervention. After regulatory intervention, we observe that only 19% of firms show symptoms of informed trading. In additional testing of ADR firms – explicitly exempt from complying with Reg FD, we find no evidence of a change in informed option trading from pre- to post-regulation; suggesting that the SEC’s strictures on US firms led a to a significant reduction in informed option trading. Notably, our proxies for large shareholder and financial analyst access are associated with the largest decreases in informed option trading. In developing a unique measure of informed trading based on option market data, we provide evidence on the efficacy of security regulation in limiting informed trading.     

Hedging,speculation, and shareholder value

We document that gold mining firms have consistently realized economically significant cash flow gains from their derivatives transactions. We conclude that these cash flows have increased shareholder value since there is no evidence of an offsetting adjustment in firms’ systematic risk. This finding contradicts a central assumption in the risk management literature that derivatives transactions have zero net present value, and highlights an important motive for firms to use derivatives that the literature has hitherto ignored. Although we find considerable evidence of selective hedging in our sample, the cash flow gains from selective hedging appear to be small at best.     

Effective board monitoring over earnings reports and forecasts: Evidence from CFO outside director appointments

Prior evidence that firms adjust their board structure following accounting restatements suggests that firms expect the board to effectively monitor the firm’s financial accounting system. However, little is known about signals firms use to identify monitoring weaknesses or the types of individuals firms appoint to improve the quality of monitoring. We expand on Ghannam, Bujega, Matolcsy, and Spiropolous (2019)’s evidence that firms appoint directors with accounting experience after financial fraud by investigating whether firms that file restatements or issue highly inaccurate earnings forecasts appoint individuals with CFO experience (i.e., a subset of accounting experts) to their audit committee. We find that firms are more likely to appoint an outside director with CFO experience to the audit committee when they have recently restated earnings and when they have higher prior management forecast error. We also find that the appointment of a CFO outside director to the audit committee is followed by a lower likelihood of restatement and more accurate management forecast. Together, our results suggest that firms respond to accounting failures by appointing outside directors with CFO experience. Thus, we provide insight into the signals firms use to identify weaknesses in the monitoring of the accounting function and the types of expertise firms value in addressing those weaknesses.     

The effects of accounting restatements on firm growth

Do restatements result in lower firm growth? One argument in support of this contention is that accounting restatements hurt contracting relations between the firm and outside parties such as a firm’s customers and suppliers, negatively impacting firm cash flows. The negative impact on cash flow reduces the level of internal cash holdings available for investment. Another argument is that restatements dampen firm growth by increasing the firm’s cost of external financing. We empirically evaluate these arguments by using the standard sales growth based financial planning model. In carrying out our analysis, we distinguish the effects of restatement on overall firm growth as well as its components of internally and externally financed growth. Our findings suggest that overall firm growth rates decline following a restatement. Furthermore, we find that accounting restatements have a greater adverse impact on externally financed growth rates. We also find that not all restatements yield identical effects: the impact of restatements is more pronounced for the subsample of firms identified to have undertaken the more egregious fraudulent reporting than the subsample of firms that reported restatements to correct previous accounting errors. We also find that firms with severe restatements, measured based on announcement period market reactions, have lower externally financed growth. Overall, our evidence highlights the adverse impact of restatement on firm growth, particularly through external financing.     

Family values: Ownership structure,performance and capital structure of Canadian firms

This study examines how family ownership affects the performance and capital structure of 613 Canadian firms from 1998 to 2005. In particular, we distinguish the effect of family ownership from the use of control-enhancing mechanisms. We find that freestanding family owned firms with a single share class have similar market performance than other firms based on Tobin’s q ratios, superior accounting performance based on ROA, and higher financial leverage based on debt-to-total assets. By contrast, family owned firms that use dual-class shares have valuations that are lower by 17% on average relative to widely held firms, despite having similar ROA and financial leverage.     

Directors' and officers' liability insurance and loan spreads

We analyze the effect of directors' and officers' liability insurance (D&O insurance) on the spreads charged on bank loans. We find that higher levels of D&O insurance coverage are associated with higher loan spreads and that this relation depends on loan characteristics in economically sensible ways and is attenuated by monitoring mechanisms. This association between loan spreads and D&O insurance coverage is robust to controlling for endogeneity (because both could be related to firm risk). Our evidence suggests that lenders view D&O insurance coverage as increasing credit risk (potentially via moral hazard or information asymmetry). Further analyses show that higher levels of D&O insurance coverage are associated with greater risk taking and higher probabilities of financial restatement due to aggressive financial reporting. While greater use of D&O insurance increases the cost of debt, we find some evidence that D&O insurance coverage appears to improve the value of large increases in capital expenditure for firms with better internal and external governance.     

The investment opportunity set,director ownership,and corporate policies: evidence from an emerging market

This paper provides evidence of the association between a firm's investment opportunity set (IOS), director ownership, and corporate policy choices. Using a sample of growth and non-growth firms in an emerging Asian market, we find that the IOS theory has significant explanatory power in the financing, dividend, executive compensation, and leasing aspects of corporate policies. Growth firms have lower debt-to-equity ratios and dividend yields, pay higher cash compensation and bonus amounts to their top executives, and finance a higher proportion of their asset acquisitions through operating leases. We also find that director ownership moderates and counteracts the association between IOS and corporate policies. Our results are consistent with contracting theory predictions that high director ownership mitigates the need for incentive or bonus compensation plans in growth firms.     

Financial integration and emerging markets capital structure

This paper investigates the impact of country-level financial integration on corporate financing choices in emerging economies. Examining 4477 public firms from 24 countries, we find that corporate leverage is positively related to credit market integration and negatively related to equity market integration. As integration proceeds to higher levels, high-growth firms seem to obtain more debt than low-growth firms; large firms seem to obtain more debt - especially long-term debt - and issue more equity than small firms. Also, there is evidence that firms are able to borrow more funds in countries with more efficient legal systems during integration process.     

Intra-Industry Effects of Earnings Restatements Due to Accounting Irregularities

Abstract:  This paper investigates the intra-industry effects of earnings restatements due to accounting irregularities. We detect a significant contagion effect for rival firms whose cash flow characteristics are similar to those of the restating firm. The restatement doesn't seem to influence all the firms in the industry or firms that have a high probability of involving the same type of accounting irregularity as the restating firm does. We do not detect any competitive effect; nor do we find a significant change in the implied cost of equity capital of the rival firms, suggesting that the contagion effect is due to the revision in the expected short-run future earnings of the rival firms.     

The effects of executive share options and investment opportunities on firms’ accounting performance: Some Australian evidence

This paper provides evidence that firms with high investment opportunities and share options are associated with lower agency costs measured in terms of better accounting performance. The results of this study of 753 observations of 251 Australian firms over the three years 1998–2000 show that firms with high growth and executive share option plans are associated with better firm performance. In addition, this study shows that executives have greater risk-bearing preferences at higher option levels. That is, it is the combination of both high growth opportunities and high levels of options that is associated with higher financial performance. The results of this study suggest that it is economically irrational for low growth firms to use options as a means to motivate executives to increase firm performance. Further analysis revealed that these associations are not endogenously determined.