Are incentives for earnings management reflected in the ERC: Large sample evidence

In this study, I examine the effect of exposure to earnings management (EM) incentives on the earnings response coefficient (ERC). Drawing from several anecdotes and normative arguments about the implications of managers' incentives for investor perception, I predict and test that exposure to EM incentives is negatively associated with the ERC. I find that ERC is reliably lower for firms with elevated exposure to EM incentives, holding constant the effects of actual EM and other factors that affect the returns–earnings relation. Furthermore, the effect of the incentive exposure on cash flows as well as on total accruals is reliably negative. These results are robust across alternative price– and returns–earnings specifications, and are insensitive to the inclusion of other measures of earnings quality. Additional analysis shows that the effect of such incentives on the ERC is more pronounced at higher levels of institutional stock ownership. However, a certain class of institutional owners – transient institutions – are less sensitive to the implications of such incentives for earnings quality.     

Adjustment Process of the Price to Book Ratio for Regulated Utilities

This study tests whether shifts in the price to book ratio (PB) of electric utilities follow a partial adjustment rather than the pure adjustment process implied by the cost-plus pricing policy of regulation. The results for utilities are compared to benchmark results for manufacturing firms to highlight the similarity/dissimilarity in the time-series behavior of PB for regulated and non-regulated firms. It is shown that shifts in PB follow a partial adjustment process. The adjustment period is longer for utilities than for manufacturing firms and extends well beyond the average regulatory lag. Moreover, shifts in PB are associated with changes in future profits and investments.     

Deregulation of the Electric Power Industry: The Earnings,Risk, and Return Effects

This study tests whether recent reforms of the electric power industry reverse the predicted effects of regulation on profits, risk, and return for electric utilities. The analysis also considers potential variation in the effects of the reforms across utility sizes. The empirical predictions are derived from theories of economic regulation which argue that regulation reduces earnings variability and risk, and enhances share value by buffering the regulated firms against the profit effects of cost and demand shocks and by shifting the burden of inefficiencies to consumers. These views motivate an opposite argument that reductions of regulation would reverse the predicted effects of regulation. The results reveal (1) a reversal of the buffering effects of regulation, (2) the existence of subsidies attributable to regulation, and (3) a redistribution of shareholder wealth during the reforms.     

Earnings management in the electric utility industry: profit incentives

Electric utilities face profit regulation tied explicitly to accounting data. Under existing rate structure, the utilities are required to provide periodic and specialized accounting reports for use in rate decisions. Consumer groups and opponents often criticize the rate structure alleging possible alteration of accounting reports by utilities to gain favorable regulation. Nonetheless, there is little empirical evidence supporting the allegation. This study investigates profit incentives for earnings management by utilities seeking rate increases. Specifically, this study investigates whether electric utilities proactively adopt profit-reducing actions before and during rate requests. The results are consistent with strategic use of accounting methods to reduce reported profits immediately before and during rate requests. The evidence supports the notion that utilities reduce profits just before and during rate reviews to relax regulatory constraints and improve profit opportunities.     

Valuation Relevance of Allowance for Funds Used During Construction and Operating Income: The Effects of Regulatory Climates and Deregulation

This study considers the valuation relevance allowance for funds used during construction (AFUDC), operating income (OI), and their innovations across regulatory climates and regulatory reforms. Valuation relevance is assessed by examining the coefficients and R ²s from the regressions of returns on AFUDC, OI, and their innovations. Regulatory climate is predicted to affect valuation relevance of earnings components on the premise that different regulatory regimes enact and enforce policies that differently affect (1) the uncertainty of future earnings, (2) the recovery of deferred assets, and (3) the sustainability of earnings innovations. In an extended analysis, indicators of rate-base valuation method and leverage are added as control variables to isolate their mediating effects on returns for electric utilities. Additional analysis considers the effects of the Energy Policy Act (EPAct) of 1992 on the valuation of earnings components. The results reveal that AFUDC and OI are valued differently relative to each other and across regulatory climates. The results also show a significant decline in the explanatory power of earnings components after the passage of the EPAct in 1992. Rate-base valuation method has no discernible effects on returns for the utilities. On the other hand, the effect of leverage on returns for the utilities is reliably negative.     

Sarbanes–Oxley Act and the quality of earnings and accruals: Market-based evidence

In this paper we study the impact of the Sarbanes-Oxley Act (SOX) on the valuation weights of earnings and earnings components. The analysis seeks evidence that SOX is associated with changes in investors’ perception of earnings and accruals quality. Of particular interest in the analysis is the effect of SOX on the valuation weight of discretionary accruals that are perceived to be most vulnerable to manipulation prior to SOX. We find reliable increases in the valuation weights of earnings and earnings components after the passage of SOX. Nonetheless, we also find that the post-SOX shifts in the valuation weights of earnings and earnings components are indistinguishable from zero among firms in which the percentage equity shares held by institutional investors is 15% or greater.     

Accounting Information and CEO Compensation: The Role of Cash Flow from Operations in the Presence of Earnings*

We examine the role of cash flow from operations (CFO) in chief executive officer (CEO) cash compensation. We predict that CFO is contract‐relevant in the presence of earnings, and more so when (1) the quality of earnings relative to the quality of CFO as a measure of performance is low and (2) the need for CFO as a financing source is high. Our analysis is motivated principally by normative arguments and anecdotes from financial disclosures linking CFO to managerial effort and contracts, notwithstanding the traditional role of earnings in performance measurement. We find that the weight of CFO in the compensation model is positive and significant in the presence of earnings and stock returns. We also find that the relative quality of CFO compared with that of earnings has a positive (negative) impact on the weight of CFO (earnings). We further find that the relative weight of CFO is enhanced substantially when enterprise activities crucially depend on internally generated cash flow. These findings are unaltered when we include CEO age, firm size, and risk in the model and allow the coefficients to vary across industries.     

The implications of TARP: Evidence from bank performance and CEO pension benefits

This study examines the effect of compensation restrictions introduced by the Troubled Assets Relief Program (TARP) of 2008 on the performance of banks and their compensation structures. It documents significant performance improvement among TARP banks that experienced Chief Executive Officer (CEO) resignations after their banks accepted TARP funds. The improvement is most significant in the year following CEO resignation. In addition, TARP banks that kept their CEOs show a significant increase in CEO pensions post-TARP. TARP banks that did not experience CEO resignations, thus, appear to substitute pension increases for their CEOs to mitigate the TARP-induced decrease in conventional forms of compensation. Further analysis on all banks without CEO resignations shows that TARP banks have significantly higher increase in pension benefits post 2009 than banks that chose to decline TARP funds. The evidence shows that increased pension arrangements play a significant role in CEOs’ decisions to remain in their roles despite the constraints imposed by TARP.     

The Adjustment Process of Accruals: Empirical Evidence and Implication for Accrual Research

This study analyzes the intertemporal behavior of accruals and uses the results to offer some perspectives on models of accruals. Separate adjustment rates are estimated for total and managed accruals and further compared to assess the influence of managers on accrual adjustment. Analysis is further performed to test whether there is an industry-specific adjustment rate for either total or managed accruals. The results show that both the total and managed accruals follow a partial adjustment process rather than a pure-adjustment or random-walk process. Nonetheless, managed accruals exhibit longer adjustment length than total accruals in each industry sample. In addition, total and managed accruals appear to follow certain adjustment patterns that are industry-specific, consistent with the view that common industry practices and norms lead to benchmark adjustment rates to which industry firms conform. Based on the results showing that accruals exhibit lagged and industry-specific adjustments, an extension of the modified Jones model is proposed. The extended model incorporates lagged accruals and an industry accrual index in an attempt to exploit the lagged-adjustment and industry effects and, in that context, improve the temporal classification of accrual innovations. Simple tests show that the extended model achieves substantial improvements in specification over the modified Jones model.