Contagion of accounting methods: evidence from stock option expensing

I examine how a firm’s accounting methods can be influenced by the choices of other firms, which I label contagion. I model accounting method choice as a combination of intrinsic propensities to adopt a method and contagion effects. I predict contagion of accounting methods occurs for two reasons: (1) adoption decisions of other firms are informative for the adoption decision, and (2) prior adoptions change the net benefits of the decision. I test these predictions in the stock option expensing setting where firms had the choice to use the intrinsic or fair value method. Using a firm-level diffusion model, I document evidence consistent with my predictions.     

Political Cost Incentives for Managing the Property-Liability Insurer Loss Reserve

This paper examines the effect of rate regulation on the management of the property-liability insurer loss reserve. The political cost hypothesis predicts that managers make accounting choices to reduce wealth transfers resulting from the regulatory process. Managers may under-state reserves to justify lower rates to regulators. Alternatively, managers may have an incentive to report loss inflating discretionary reserves to reduce the cost of regulatory rate suppression. We find insurers over-state reserves in the presence of stringent rate regulation. Investigating the impact along the conditional reserve error distribution, we discover that a majority of the response occurs from under-reserving firms under-reserving less because of stringent rate regulation.     

Market and Political/Regulatory Perspectives on the Recent Accounting Scandals

Not surprisingly, the recent accounting scandals look different when viewed from the perspectives of the political/regulatory process and of the market for corporate governance and financial reporting. We do not have the opportunity to observe a world in which either market or political/regulatory processes operate independently, and the events are recent and not well researched, so untangling their separate effects is somewhat conjectural. This paper offers conjectures on issues such as: What caused the scandalous behavior? Why was there such a rash of accounting scandals at one time? Who killed Arthur Andersen—the Securities and Exchange Commission, or the market? Did fraudulent accounting kill Enron, or just keep it alive for too long? What is the social cost of financial reporting fraud? Does the United States in fact operate a “principles‐based” or a “rules‐based” accounting system? Was there market failure? Or was there regulatory failure? Or both? Was the Sarbanes‐Oxley Act a political and regulatory overreaction? Does the United States follow an ineffective regulatory model?     

Political corruption and accounting choices

We examine how political corruption affects firms’ accounting choices. We hypothesize and find that firms headquartered in corrupt districts manipulate earnings downwards, relative to firms headquartered elsewhere. Our finding is robust to alternative corruption measures, alternative discretionary accrual measures, alternative model specifications, the instrumental variable approach and difference-in-differences analyses based on firm relocation and high profile cases. We find that firms headquartered in corrupt districts prefer income-decreasing accounting choices and exhibit higher conservatism. Finally, we find that the effect of corruption on earnings management is more pronounced for geographically concentrated firms, for firms without political connections, for firms in politically sensitive industries, for firms with lower transient institutional investor ownership and for firms with less analyst coverage. In sum, our findings suggest that firms respond to corruption by lowering their accounting earnings.     

Determinants of intramethod choice in the oil and gas industry

Procedural flexibility can have a substantial impact on reported costs, revenues, expenses, and balance sheet valuations. Until 1978 oil and gas companies had considerable flexibility in applying full cost and successful efforts. A unique opportunity to measure the income effect of firms' procedural choices occurred when the SEC specified the exact procedures that must be followed by oil and gas producers when they account for exploratory and development costs under both the full cost and successful efforts methods. In complying with the new rules firms were required to adjust retained earnings retroactively to reflect what it would have been if the new procedures had been in effect all along. These retained earnings adjustments provide a measure of the income effect of procedural choices.This study shows that economic incentives influence the procedural accounting choices which were made by oil and gas producers. The same economic incentives also influence the choice of full cost or successful efforts. Finally, the discriminatory ability of firms' economci incentives is most powerful when firms' reporting strategies are defined in terms of both choice of accounting methods and procedural applications within those methods.     

The effects of cross-border cooperation on disclosure enforcement,earnings attributes,and transparency

This study tests for changes in U.S.-listed foreign firms’ financial reporting properties and transparency when their home market regulators enter an arrangement that facilitates enforcement cooperation with the Securities and Exchange Commission. This arrangement—the International Organization of Securities Commissions’ Multilateral Memorandum of Understanding Concerning Consultation and Cooperation and the Exchange of Information (MMoU)—has explicit disclosure-related provisions. I show that the MMoU is associated with improvements across various measures of accounting properties and transparency. Collectively, the findings help resolve enduring questions about why the earnings quality of U.S.-listed foreign firms diverged from that of U.S. firms during pre-MMoU periods.     

Discussion of “The implications of unverifiable fair-value accounting: Evidence from the political economy of goodwill accounting”

Ramanna [2007. The implications of unverifiable fair-value accounting: evidence from the political economy of goodwill accounting, Journal of Accounting and Economics] provides interesting and novel evidence on how firms use contributions from their political action committees (PACs) to members of Congress as a means of lobbying for preferred positions on the two exposure drafts that led to SFAS-141 and SFAS-142. My discussion raises some concerns about his main conclusion: that pooling firms lobbied the FASB to obtain a “fair-value”-based impairment rule to facilitate their ability to manipulate financial statements. I offer a more benign explanation and make some other observations about how this line of research could proceed in the future.     

Liquid asset sheltering,or cost of capital? The effect of political corruption on corporate cash holdings

I posit that political corruption affects firms through an entrenchment between entrepreneurs and politicians instead of coercive extortion. Based on this postulate, I refute the claim that firms in a more corrupt environment hold less cash due to liquid assets sheltering from political extraction. Instead, I propose that firms in a more corrupt environment hold less cash because of the high cost of capital. In fact, I find that firms in more corrupt countries hold cash beyond their optimum for the given cost of carry due to severe financial constraints. This excess cash results in value destruction. I call this phenomenon the financial effect of corruption. Thus, I challenge the conventional wisdom and argue that the effects of political corruption on corporate cash holdings are primarily indirect through financial mechanisms.     

Does fair value accounting for non-financial assets pass the market test?

The choice between fair value and historical cost accounting is the subject of long-standing controversy among accounting academics and regulators. Nevertheless, the market-based evidence on this subject is limited. We study the choice of fair value versus historical cost accounting for non-financial assets in a setting where market forces rather than regulators determine the outcome. In general, we find a very limited use of fair value accounting. However, the observed variation is consistent with market forces determining the choice. Fair value accounting is used when reliable fair value estimates are available at a lower cost and when they convey information about operating performance. For example, with very few exceptions, firms’ managers commit to historical cost accounting for plant and equipment. Our findings contribute to the policy debate by documenting the market solution to one of the central questions in the accounting literature. Our findings indicate that, despite its conceptual merits, fair value is unlikely to become the primary valuation method for illiquid non-financial assets on a voluntary basis.     

Political spending,related voluntary disclosure,and the cost of public debt

Following the Supreme Court decision in the Citizens United v. Federal Election Commission case of 2010, which removed restrictions in relation to firms’ political spending, and building on the growing debate over whether voluntary political spending disclosure (VPSD) provides valuable information, we examine the effect of political spending on the cost of public debt and the role of VPSD on this effect. Based on a measure of VPSD that became available in 2012 and a large dataset on US firms’ actual political spending, manually extracted from different filings, we provide novel evidence that, in the post-Supreme Court decision period, political spending increases the cost of public debt. This is consistent with the uncertainty associated with political spending. Moreover, we find that the level of voluntary disclosure weakens the positive association between political spending and the cost of public debt. These results hold across multiple specifications as well as when we use a sudden release of firms’ political spending as an exogenous shock to political spending.     

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.     

Auditing standards,increased accounting disclosure,and information asymmetry: Evidence from an emerging market

The interest in accounting disclosure and audit quality by academics, practitioners, and regulators heightened following the various financial reporting scandals, and subsequent legislative and professional response to these scandals. An important question is whether the implementation of stricter auditing standards such as those mandated by the US Sarbanes-Oxley Act would improve the information environment of firms whose shares are publicly traded. In this paper, I investigate the link between information asymmetry, measured by bid-ask spread, and increased accounting disclosures following the adoption of new auditing standards in China—an environment in which disclosure hitherto was relatively low. I report the following primary results of the statistical analyses. First, information asymmetry cost is substantial in the Chinese order-driven emerging markets. Second, the firms in the sample experienced significant reductions in their bid-ask spreads subsequent to the adoption of the new auditing standards. Third, the reductions in the bid-ask spreads were abrupt and permanent. However, no significant result is found for firms in the control group with foreign ownership, whose financial statements were prepared in accordance with international accounting standards and were audited with international auditing standards. The results have implications for policy makers and regulators in general, and those in emerging markets in particular.     

Enforceable Accounting Rules and Income Measurement by Early 20th Century Railroads

We investigate the extent to which income measurement by major early 20th‐century U.S. railroads shows evidence of lower income smoothness and increased conservatism following new fixed asset accounting rules issued by the Interstate Commerce Commission (ICC) in 1907 and 1908 and concurrent rate regulation regime shifts. Accounting rules promulgated by the ICC after the Hepburn Act of 1906 are the first accounting rules in U.S. history in which regulators could enforce such rules under federal law to increase compliance. Our samplewide results are more consistent with increased conservatism than with income smoothing. Additional tests indicate these effects are more pronounced for firms subject to more intense rate regulation by the ICC, which suggests that the tie‐in between accounting regulation and product/service market regulation influences how managers respond to new accounting rules.     

Does the market dole out collective punishment? An empirical analysis of industry,geography, and Arthur Andersen’s reputation

Arthur Andersen’s reputation was tarnished following news that its Houston office had shredded documents related to the auditing of energy giant Enron. Earlier studies documented widespread spillover of the reputation effect, suggesting a strong commonality in Big 5 audit practices. We examine whether the market is more discriminating in its assessments. We focus on the roles industry specialization of auditors and the geography of clients’ audit offices play in accounting for the contagion. Our results are supportive of investors who differentiate audit practices by industry and who account for the location of the specific office where the audit work is done. We find that losses suffered by energy firms or firms located close to Houston are equivalent to approximately 90% of the aggregate abnormal losses suffered by Big 5 clients. Our evidence suggests the possibility of more localized impact of accounting scandals and supports accounting regulations targeted at individual industries.     

Accounting for Changing Prices: The Value Relevance of Historical Cost, Price Level, and Replacement Cost Accounting in Mexico

This paper investigates the value relevance of historical cost, price level and replacement cost accounting using a sample of Mexican firms from 1989 to 1995. It contributes to prior research by distinguishing between two distinct aspects of changing prices:(1) the change in the general price level, and (2) the change in the value of specific non-monetary assets. I select Mexico to examine because it is unique in requiring and disclosing separately price level and replacement cost adjustments. A sample of Mexican firms also addresses a key reason cited for mixed results in previous assessments of the usefulness of price level and replacement cost accounting using United States data: the effects of inflation are too weak to detect. High rates of inflation in Mexico, ranging between 7% and 52% during the sample period, mitigate that potential problem. Results indicate that replacement cost adjustments are relatively and incrementally relevant beyond historical cost and price level measures while price level adjustments are incrementally value relevant beyond historical measures.     

Further Evidence on Accounting Choices: The South of Scotland Electricity Board, 1978–1988

This study augments Mclnnes (1990) by investigating the effects of a small number of accounting procedures which were chosen by the management of a state-owned enterprise. It focuses on those accounting choices in the South of Scotland Electricity Board's (SSEB) set of accounting choices which were subject to criticism in a Price Commission report published in 1978. In spite of this criticism SSEB management continued to use these accounting procedures in their main set of financial statements, although in recent years some of these procedures have been changed. Estimates are provided of the multi-period and cumulative decreasing effects of the accounting procedures criticised by the Commission on the net income reported by the SSEB. The possible incentives that SSEB management may have had for continuing to use these accounting procedures in their main set of financial statements after they had been subject to criticism are identified and explored.     

Mitigating political uncertainty

This study examines whether firms that establish political connections gain differential access to relevant information over legislative developments, thereby mitigating the negative consequences of uncertainty. I find that political connections (partially) offset the negative relation between investment and political uncertainty documented in prior research. My results do not appear to be driven by connected firms pursuing investments that are insensitive to uncertainty. I perform additional tests to address concerns over correlated omitted variables. First, I identify a setting around a tax policy development designed to provide new investment incentives to firms. In this setting, I predict and find that reduced information asymmetry for connected firms results in delaying investment in anticipation of future lucrative tax incentives. Second, I perform a falsification test and document that political connections do not mitigate the effects of general economic uncertainty. Finally, I continue to find support for my hypothesis within a propensity matched sample.     

Critical thinking about creative accounting in the face of a recent scandal in the Turkish banking sector

In the last two decades, serious accounting scandals occurred in large companies (e.g. WorldCom and Enron) and in the banking sector (e.g. BCCI, Barings, Allied Irish Bank and Baninter). Then the problem of creative accounting with its legal and illegal aspects has come into agendas of business firms and governments. In this paper, a certain type of creative accounting practices (i.e. fraud) has been examined in the light of a Turkish case (i.e. the Imarbank Scandal). It has been found that deficiencies in the legal frameworks for banking and accounting, inadequacies in the autonomy of governmental regulation and supervision bodies, practical difficulties in enforcing legal and ethical rules due to the slow functioning of the judicial system are significant reasons for creative accounting practices in addition to the personal greed of both owners&top management of Imarbank and its customers. However, the intention and capability of political power in combating such kind of corruption are also crucial.