Corporate portfolio management

Summary We solve the optimal portfolio problem in continuous time from the point of view of a corporation, acting on behalf of risk neutral shareholders. Our model fits for example the case of a commercial bank. Risk aversion is generated endogenously by financial frictions, and increases when the value of the firm’s assets decrease. We find a remarkably simple investment policy: invest a multiple of the firm’s equity into the risky asset, keep the rest as cash reserves, and distribute dividends when the value of the firm exceeds some threshold. As a consequence, the firm locally behaves as a Von Neumann-Morgenstern investor with constant relative risk aversion.We thank three anonymous referees for their comments.     

Corporate Financial Control Mechanisms and Firm Performance: The Case of Value-Based Management Systems

Abstract:  We examine the performance of 84 firms that adopt value-based management (VBM) systems during the period 1984-1997. The typical firm significantly improves matched-firm-adjusted residual income after adopting VBM. This improvement persists for the five post-adoption years studied. After controlling for possible sample bias, we find that large firms show less improvement than small firms. We find a negative relation between tying compensation to VBM and post-adoption performance. We also find that firms reduce capital expenditures following VBM adoption, but that the reductions in spending do not differ based on the firms' growth opportunities. Overall, the evidence suggests that VBM improves economic performance and the efficient use of capital.     

Use of loan loss provisions for capital, earnings management and signalling by Australian banks

This study examines whether and to what extent Australian banks use loan loss provisions (LLPs) for capital, earnings management and signalling. We examine if there were changes in the use of LLPs as a result of the implementation of banking regulations consistent with the Basel Accord of 1988, which made loan loss reserves no longer part of Tier I capital in the numerator of the capital adequacy ratio. We find some evidence to indicate that Australian banks use LLPs for capital management, but we find no evidence of a change in this behaviour after the implementation of the Basel Accord. Our results indicate that banks in Australia use LLPs to manage earnings. Furthermore, listed commercial banks engage more aggressively in earnings management using LLPs than unlisted commercial banks. We also find that earnings management behaviour is more pronounced in the post‐Basel period. Overall, we find a significant understating of LLPs in the post‐Basel period relative to the pre‐Basel period. This indicates that reported earnings might not reflect the true economic reality underlying those numbers. Finally, Australian banks do not appear to use LLPs for signalling future intentions of higher earnings to investors.     

The impact of enterprise risk management on the marginal cost of reducing risk: Evidence from the insurance industry

We test the hypothesis that practicing enterprise risk management (ERM) reduces firms’ cost of reducing risk. Adoption of ERM represents a radical paradigm shift from the traditional method of managing risks individually to managing risks collectively allowing ERM-adopting firms to better recognize natural hedges, prioritize hedging activities towards the risks that contribute most to the total risk of the firm, and optimize the evaluation and selection of available hedging instruments. We hypothesize that these advantages allow ERM-adopting firms to produce greater risk reduction per dollar spent. Our hypothesis further predicts that, after implementing ERM, firms experience profit maximizing incentives to lower risk. Consistent with this hypothesis, we find that firms adopting ERM experience a reduction in stock return volatility. We also find that the reduction in return volatility for ERM-adopting firms becomes stronger over time. Further, we find that operating profits per unit of risk (ROA/return volatility) increase post ERM adoption.     

Using Real Activities to Avoid Goodwill Impairment Losses: Evidence and Effect on Future Performance

We examine whether managers postpone the recognition of goodwill impairment by manipulating cash flows and the consequences of such a strategy on future performance. According to SFAS 142, an impairment loss must be recognized if the reporting unit's total fair value to which goodwill has been allocated is less than its book value. A growing body of empirical evidence shows that managers delay the recognition of goodwill impairment in accounting books. However, past literature is silent on how managers convince various gatekeepers (e.g., auditors, financial analysts) that recognizing an impairment loss is unnecessary although it seems economically justified. SFAS 142 requires managers to forecast future cash flows to justify the decision to recognize, or not, an impairment loss. Therefore, we predict that managers manipulate upward current cash flows to support their choice to avoid reporting an impairment loss. We also test whether or not this real earnings management is detrimental to future performance. Based on a sample of US firms over the period 2003–2011, we document that firms suspected of postponing goodwill impairment losses exhibit significantly positive discretionary cash flows compared to various control groups. We also find that this real activities manipulation is detrimental to future performance.     

Quarterly earnings guidance and real earnings management

We examine if quarterly earnings guidance induces real earnings management. Quarterly guidance may cause myopia and inefficient decision-making, if managers become overly concerned with setting and beating short-term earnings targets. We test these associations on a large sample of US firms. Our evidence suggests that quarterly guidance is informative and lowers myopic incentives. However, our analyses also reveal endogenous associations exist between guidance and real earnings management. In contrast with existing concerns over frequent guiders, we find that guidance appears problematic in infrequent guiders, and in firms that issue good news earnings guidance and that operate in settings where earnings pressures are high.     

Forecasts in IPO Prospectuses: The Effect of Corporate Governance on Earnings Management

Prior research suggests that managers may use earnings management to meet voluntary earnings forecasts. We document the extent of earnings management undertaken within Canadian Initial Public Offerings (IPOs) and study the extent to which companies with better corporate governance systems are less likely to use earnings management to achieve their earnings forecasts. In addition, we test other factors that differentiate forecasting from non‐forecasting firms, and assess the impact of forecasting and corporate governance on future cash flow prediction. We find that firms with better corporate governance are less likely to include a voluntary earnings forecast in their IPO prospectus. In addition, we find that while IPO firms use accruals management to meet forecasts; the informativeness of the discretionary accruals depends on whether or not the firm would have missed its forecast without the use of discretionary accruals.     

Earnings Management Constraints and Classification Shifting

Prior literature has investigated three forms of earnings management: real earnings management (REM), accruals earnings management (AEM) and classification shifting. Managers make trade‐off decisions among these methods based on the costs, constraints and timing of each strategy. This study investigates whether managers use classification shifting when their ability to use other forms of earnings management is constrained. We find that when REM is constrained by poor financial condition, high levels of institutional ownership and low industry market share, managers are more likely to use classification shifting. Further, we find that when AEM is constrained by low accounting system flexibility and the provision of a cash flow forecast, managers are more likely to use classification shifting. In addition, when we limit our sample to firms that are most likely to have manipulated earnings, we continue to find support for constraints of both REM and AEM leading to higher levels of classification shifting. We also find support for the hypothesis that the timing of each earnings management strategy influences managers’ trade‐off decision. Our results indicate that managers use classification shifting as substitute form of earnings management for both AEM and REM.     

Regulation Fair Disclosure and the timeliness of long-horizon management forecasts

We examine the effect of Regulation Fair Disclosure (hereafter Reg FD) on the timeliness of long-horizon management forecasts of annual earnings, especially those conveying bad news. We expect that managers are less timely in issuing bad news forecasts than good news forecasts prior to Reg FD when they can disclose bad news to selected analysts and institutional investors privately. As Reg FD prohibits private disclosures of material information, managers are expected to accelerate the issuance of long-horizon bad news forecasts after Reg FD due to concerns of litigation risk from institutional investors and loss of analyst coverage, leading to a decrease in timeliness asymmetry between bad news and good news forecasts. We also expect that the effect of Reg FD is stronger among firms with lower ex-ante litigation risk or higher information asymmetry as they are more likely to withhold bad news prior to Reg FD. In addition, we expect that investors and analysts react more to bad news forecasts than to good news forecasts prior to Reg FD, and this asymmetry decreases after Reg FD. Our results are consistent with our predictions and suggest that managers provide long-horizon forecasts conveying bad news more timely after Reg FD.     

Do accounting standards matter? An exploratory analysis of earnings management before and after IFRS adoption

In this paper, we analyze the effect of the mandatory introduction of IFRS standards on earnings quality, and more precisely on earnings management. We concentrate on three IFRS first-time adopter countries, namely Australia, France, and the UK. We find that the pervasiveness of earnings management did not decline after the introduction of IFRS, and in fact increased in France. Our findings confirm that sharing rules is not a sufficient condition to create a common business language, and that management incentives and national institutional factors play an important role in framing financial reporting characteristics. We suggest that the IASB, the SEC and the European Commission should now devote their efforts to harmonizing incentives and institutional factors rather than harmonizing accounting standards.     

An analysis of earnings management by European private firms

This paper addresses the questions of whether private firms in eight European countries engage in earnings management, and if so, whether tax incentives affect such practices. To measure earnings management, we analyze the earnings distributions of private firms and compare these distributions with those of public firms in the same countries. The empirical evidence suggests that in absence of capital market pressures, firms still have incentives to manage earnings, as we find that private firms avoid reporting small losses. We further find that private firms in some countries where tax regulation strongly influences financial accounting do not avoid reporting small losses. We attribute this finding to tax incentives reducing firms’ benefits of (upward) earnings management. Finally, our results suggest that some types of earnings management are due to capital market pressures and are specific to public firms since we do not find evidence that private firms avoid earnings decreases.     

"新公共管理"与完善我国税务机构的内部管理

"新公共管理"给西方税务机构改革带来的变化为我国加强税务机构内部管理提供了经验。借鉴发达和新兴工业化国家改善税务机构的内部管理的经验,完善我国税务机构的内部管理可从组织机构、人力资源管理机制和绩效评估机制三方面着手。     

Why firms purchase property insurance

We investigate whether corporate finance incentives affect the extent of corporate hedging with property insurance. Using a database that contains detailed insurance information, we document a positive relation between the expected costs of distress and property insurance coverage. We also show that the dividend payout ratio is negatively associated with property insurance coverage, consistent with the view that firms with high payout ratios insure a smaller fraction of properties due to cash flows in excess of investment needs, easy access to capital markets, or both. Different incentives are important for the insurance deductible and limit of coverage, and the deductible and limit of coverage are substitutes.     

Credit portfolios: What defines risk horizons and risk measurement?

The strong autocorrelation between economic cycles demands that we analyze credit portfolio risk in a multiperiod setup. We embed a standard one-factor model in such a setup. We discuss the calibration of the model to Standard & Poor’s ratings data in detail. But because single-period risk measures cannot capture the cumulative effects of systematic shocks over several periods, we define an alternative risk measure, which we call the time-conditional expected shortfall (TES), to quantify credit portfolio risk over a multiperiod horizon.     

保险资金运用全面风险管理——基于机制建设的角度

保险资金运用对保险公司稳健经营具有支柱性作用。为保障实现保险公司经营目标,应充分研究保险资金特性,分析投资资产风险和内部管理风险,建立有效的总体风险管理制度、实施有力的风险具体控制措施。在当前风险管理现实条件下,科学投资决策和运作架构,强化交易流程控制和风险防范监测,完善激励约束机制,以持续推进保险资金运用全面风险管理具有较强的实践意义。     

Executive compensation and corporate risk management

We provide the first evidence on the effects of executive compensation on corporate risk management for insurers. Our unique data set allows the construction of a new, more complete measure of corporate risk management behavior. Specifically, we include hedging-driven usage of not only derivatives but also insurance. To address potential endogeneity, we utilize a difference-in-differences approach, based on the implementation of FAS 123R that required firms to expense stock-based compensation at fair value. We find that the decline in the convexity of executive compensation following FAS 123R led firms to significantly increase corporate risk management, primarily through increased demand for insurance.     

Firm Accrual Quality Following Restatements: A Signaling View

We consider whether and how firms improve their financial reporting credibility following a restatement by comparing two alternative views. The compliance view predicts that firms simply correct errors to comply with regulations; the signaling view predicts that improvements are broader to allow firms to signal higher reporting quality and thereby reduce information uncertainty. We find that accrual quality improves significantly following the restatement and that this improvement is observed for both earnings and non‐earnings error restatements. We also find that the extent of real earnings’ management decreases significantly. Further, we find that improvements in accrual quality are higher for firms with CEO turnover and higher incentives to improve, but lower for firms switching to an auditor of lower quality. Collectively, our findings suggest that firms signal improved reporting credibility following a restatement through higher accruals quality and lower real earnings management.     

Visible Reserves in Banks – Determinants of Initial Creation,Usage and Contribution to Bank Stability

The opportunity of building up visible “Reserves for General Banking Risks” by the bank management represents a peculiarity in the German financial accounting framework for banks. We investigate German banks' motives for the creation and usage of these reserves and assess their role in financial stability. We find that banks primarily create and use GBR reserves to build up Tier 1 capital for regulatory capital management and earnings management purposes. Most importantly, however, we also reveal that banks using these reserves are less likely to experience a future distress or a bank default event. We therefore conclude that the existence of GBR reserves within the financial accounting framework represents both a convenient capital and earnings management tool for bank managers and a beneficial regulatory instrument to enhance bank stability.     

The effect of financial leverage on real and accrual-based earnings management

Past research has documented a substitution effect between real earnings management (RM) and accrual-based earnings management (AM), depending on relative costs. This study contributes to this research by examining whether levels of (and changes in) financial leverage have an impact on this empirically documented trade-off. We hypothesise that in the presence of high leverage, firms that engage in earnings manipulation tactics will exhibit a preference for RM due to a lower possibility – and subsequent costs – of getting caught. We show that leverage levels and increases positively and significantly affect upward RM, with no significant effect on income-increasing AM, while our findings point towards a complementarity effect between unexpected levels of RM and AM for firms with very high leverage levels and changes. This is interpreted as an indication that high leverage could attract heavy outsider scrutiny, making it necessary for firms to use both forms of earnings management in order to achieve earnings targets. Furthermore, we document that equity investors exhibit a significantly stronger penalising reaction to AM vs. RM, indicating that leverage-induced RM is not as easily detectable by market participants as debt-induced AM, despite the fact that the former could imply deviation from optimal business practices.     

Asset Disposal as a Method of Real Earnings Management: Evidence from the UK

We examine asset sales as a method of real earnings management around the benchmarks of loss avoidance and last year's earnings. Evidence is reported of asset sales to boost or reduce earnings near the benchmark of last year's earnings. For the zero earnings benchmark our results are moderated by the opening balance of accruals: only firms with high levels of accruals use asset sales to boost earnings to avoid a loss and only firms with low levels of accruals use asset sales as part of a big bath. We suggest that firms with high accrual balances find it difficult to use additional income-increasing accruals but find it more convenient to write off accruals rather than sell assets to artificially reduce earnings. International Financial Reporting Standards (IFRS) are associated with reduced use of asset sales for gains and especially with reduced asset sales for losses. We ascribe this to IFRS introducing additional judgement and estimation in relation to the valuation of both long-lived and current assets on a recurring basis.