Managerial discretion and the comparability of fair value estimates

We explore how discretion over fair value measurement affects the comparability of fair value estimates in the financial industry. We find that greater exposure to Level 2 (Level 3) measurement enhances (diminishes) the comparability of fair value estimates across firms. These contrasting results reflect a nuanced relation between discretion over fair value measurement and comparability and suggest that managers convey useful information through Level 2 estimates, whereas Level 3 measurement is subject to error and managerial opportunism. Cross-sectional analyses show that fair value estimates are less comparable when managers have stronger incentives to introduce discretion and more comparable when investor monitoring is stronger. Additional analyses demonstrate that the comparability of fair value estimates is negatively associated with non-agency mortgage backed security holdings, the asset class most likely to be held at Level 3 by our sample firms, and that our primary results hold for alternative measures of comparability. Taken together, our results highlight the critical role of discretion in shaping the comparability of fair value estimates.     

Understanding accounting discretion in China: An analysis of fair value reporting for investment property

This study sheds light on the discretionary accounting practices in China, the largest emerging market in the world. In particular, we focus on whether Chinese firms use discretion in investment property fair values to manage reported performance. We examine whether firms’ ex ante needs for accounting discretion affect their decisions to adopt fair value reporting for investment property and the ex post performance management by these fair value adopters. Our findings show that the voluntary adoption of fair value reporting for investment property in China remains low. However, the fair value option for investment property is significantly more likely to be chosen by firms with greater needs for accounting discretion. Consistent with the conjecture that firms choose the fair value model to manipulate reported earnings, we show that fair value adopters use the unrealized gains and losses associated with investment properties to smooth earnings and that these firms are also more likely to meet or beat earnings benchmarks after adoption. Overall, our findings indicate that the use of fair value reporting for investment property in the emerging Chinese market is driven by managerial opportunism.     

The association between fair value measurements and banks' discretionary accounting choices

This study examines the association between fair value measurements and banks' discretionary loan loss provisions using regulatory financial data from 2009 to 2016 for a sample of U.S. public bank holding companies. I find that banks recognizing larger proportions of fair value assets and liabilities based on level 2 and level 3 inputs are associated with lower discretionary loan loss provisions. However, there is no significant association between level 1 fair value assets and liabilities and discretionary loan loss provisions. When pre-managed earnings are lower, banks with larger proportions of level 2 and level 3 fair value assets and liabilities report smaller discretionary loan loss provisions to inflate earnings. Banks reporting larger proportions of level 2 and level 3 fair value assets and liabilities are more likely to use discretionary loan loss provisions to beat earnings benchmarks and manage tier one capital ratios. Overall, the results support the proposition that fair value assets and liabilities based on level 2 and level 3 inputs are less transparent and are subject to more discretion regarding loan loss provisions.     

Financial instruments in non-financial firms: what do we know?

Accounting for financial instruments is one of the most controversial standard setting issues. Attempts by standard setters to expand the scope of fair value measurement provoked fierce opposition from preparers, in particular from the financial industry but also, albeit less frequently and less scathingly, from non-financial firms. Academic research could help to bring the discussion onto a more objective level. Most of the existing research focuses on the financial industry and uses US disclosure data from the 1990s. More recent papers use recognition and measurement data from IFRS financial statements, again primarily from the financial industry. This paper provides novel evidence on the relevance of financial instruments for non-financial firms of the STOXX Europe 600 Index. The results in particular refute the myths that fair value measurement of financial instruments is pervasive and that many fair value measurements are of the problematic ‘level 3’ quality. The empirical evidence forms the background for a survey of the small body of existing research on the effects of accounting standards relating to financial instruments on non-financial firms. This survey covers research on the effects on risk management, on the volatility of cash flows and earnings, on earnings management and on the effects on user decisions. Both in the empirical sections and in the survey sections, I identify a number of areas for further research to overcome the poor current state of knowledge.     

Usefulness of fair values for predicting banks’ future earnings: evidence from other comprehensive income and its components

This paper examines whether fair value adjustments included in other comprehensive income (OCI) predict future bank performance. It also examines whether the reliability of these estimates affects their predictive value. Using a sample of bank holding companies, we find that fair value adjustments included in OCI can predict earnings both 1 and 2 years ahead. However, not all fair value-related unrealized gains and losses included in OCI have similar implications. While net unrealized gains and losses on available-for-sale securities are positively associated with future earnings, net unrealized gains and losses on derivative contracts classified as cash flow hedges are negatively associated with future earnings. We also find that reliable measurement of fair values enhances predictive value. Finally, we show that fair value adjustments recorded in OCI during the 2007–2009 financial crisis predicted future profitability, contradicting criticism that fair value accounting forced banks to record excessive downward adjustments.     

The effect of SFAS 142 on the ability of goodwill to predict future cash flows

This study examines the effect of Statement of Financial Accounting Standards No. 142 (SFAS 142) on the ability of goodwill to predict future cash flows. SFAS 142 allows substantial managerial discretion and leads to a significant magnitude of economic impact on financial statements, resulting in critical debates over the consequence of its adoption. I find that the ability of goodwill to predict future cash flows has improved since the Financial Accounting Standards Board (FASB) adopted SFAS 142. Furthermore, sub-sample analyses fail to reveal compelling evidence that reporting discretion induced by SFAS 142 is used opportunistically or informatively, contrasting with the pervasive view based on the opportunistic reporting hypothesis. Overall, contrary to the position of critics of SFAS 142, the results support the view taken by the FASB and proponents of SFAS 142: eliminating systematic amortization and adopting fair value estimates improve representational faithfulness of goodwill reporting.     

Asset value management in the Portuguese real estate sector

This paper analyzes whether real estate investment fund managers use asset valuation discretion strategically to achieve financial reporting objectives. Portuguese real estate investment funds represent a unique opportunity to investigate executive behavior regarding accounting choice, as fund managers may choose to use historical cost, fair value or a mixed system (historical cost with internal revaluations) to value fund properties. We also investigate the factors that influence this strategic behavior. Empirical results confirm that fund managers manage asset valuations in order to avoid net asset value declines, particularly in a period of financial distress. We also observe that funds with a higher level of past unconditional conservatism are more likely to manage asset values. With respect to corporate governance issues, we conclude that audit quality reduces managerial discretion and that the conflicts that may arise between fund management company shareholders and fund participants due to management fees do not seem to have impact on fund managers’ opportunistic behavior.     

Management Perceptions of Fair-Value Accounting for all Financial Instruments

Accounting for all financial instruments at fair value is a controversial issue currently under review by standard-setters. Banking industry associations have typically opposed the use of fair-value accounting for financial instruments. This study examines perceptions of managers at financial institutions regarding support for recording all financial instruments at fair value. Managers at financial institutions do not uniformly oppose the use of fair-value accounting for all instruments. Considerable variation is found, ranging from strong support to strong opposition. Support for fair-value accounting is negatively associated with concern about excess volatility in reported earnings. There is less concern that the fair value of assets and liabilities cannot be reliably measured.     

The usefulness of accounting estimates for predicting cash flows and earnings

Accounting estimates and projections potentially improve the relevance of financial information by providing managers a venue to convey to investors forward-looking, inside information. The quality of financial information is, however, compromised by the increasing difficulty of making reliable estimates and forecasts and the frequent managerial misuse of estimates. Given the ever-increasing prevalence of estimates in accounting data, particularly due to the move to fair value accounting, whether these opposing forces result in an improvement in the quality of financial information is among the most fundamental issues in accounting. We examine the contribution of accounting estimates embedded in accruals to the quality of financial information, as reflected by their usefulness in the prediction of enterprise cash flows and earnings. Our out-of-sample prediction tests indicate that accounting estimates beyond those in working capital items (excluding inventory) do not improve the prediction of cash flows. Estimates do, however, improve the prediction of next year’s earnings, though not of subsequent years’ earnings. We conclude that the usefulness of accounting estimates to investors is limited and provide suggestions for improving the usefulness of estimates.     

正确认识财务报表的计量

本文试图探讨如何恰当地选择资产的计量属性。文章提出了三点可作为恰当选择计量属性的标准,同时也评论了IASB工作人员起草稿中的"计量因素",分析了把它作为计量标准的选择的恰当性。本文的写作受到IASB staffpaper的"财务报表计量"稿(2009年6月)的启发,并反映了该稿的若干观点。     

公允价值的价值相关性:B股公司的证据

本文研究了B股公司按国际会计准则第39号(IAS39)披露公允价值的股价反映,以及公允价值揭示对会计信息价值相关性的影响。本研究发现,公允价值披露显著地增加了会计盈余的价值相关性。按公允价值计量的投资持有利得(损失)具有较弱的增量解释能力。而投资的公允价值调整没有显示出价值相关性。公允价值调整及持有利得(损失)对股价的影响存在差异,原因可能在于我国投资者对盈余的关注程度要高于对账面净值的关注程度。公允价值调整及持有利得(损失)缺乏很强的价值相关性的原因在于,公允价值存在计量误差,而投资者也看穿了这一计量误差。     

The perceived credibility of forward-looking performance disclosures

We investigate the credibility of forward-looking performance disclosures (FLPDs) in the narrative sections of annual reports, as perceived by investors. Our proxy for these disclosures is an index of statements about future performance. We find that companies issue more FLPDs when raising debt or conveying bad news in the financial statements. In the presence of these managerial incentives, investor reliance on FLPDs increases with the quality of earnings reported in the audited financial statements. Our results suggest that firms derive a benefit in terms of higher credibility for their narrative disclosures from having a reputation for high quality earnings.     

Fair Value‐related Information in Analysts’ Decision Processes: Evidence from the Financial Crisis

We use a sample of conference calls and analyst research reports from international banks to examine how financial analysts request and communicate fair value‐related information in their valuation process. We find that analysts devote considerable attention to fair value‐related topics. Most of the conference call questions and references in research reports pertain to fair value reclassifications and fair value changes of liabilities resulting from banks’ own credit risk. The accounting impact of these one‐time effects during the financial crisis and a lack of corresponding firm disclosures help to explain the prevalence of these two topics. The content of the questions and references suggests that analysts have different motives for their interest in fair value‐related information. While some analysts adjust reported earnings for unrecognised fair value changes of reclassified assets, most of the observed analysts exclude banks’ own credit risk effects from reported earnings. Thus, the use of fair value‐related information varies substantially across analysts and across instruments.     

The Effect of Fair Value Adjustments on Dividend Policy Under Mandatory International Financial Reporting Standards Adoption: Australian Evidence

Using a sample of firms from the financial sector of the Australian Securities Exchange, we examine the effect of the fair value adjustments of financial instruments on firms’ dividend distributions in the context of mandatory International Financial Reporting Standards (IFRS) adoption. We find a positive relationship between the fair value adjustments of financial instruments and firms’ dividend payouts, suggesting that the frequent use of fair value adjustments of financial instruments by financial firms following mandatory IFRS adoption has the potential to increase the proportion of transitory earnings in reported earnings and cause changes in dividend policies. Our results add to the ongoing debate on the unintended economic consequences of fair value accounting (FVA) and provide empirical support for regulators’ concerns that unrealized FVA gains from asset revaluation during booms may encourage the distribution of those unrealized gains.     

Convertible security design and contract innovation

This paper studies convertible security design for a sample of 814 issuers over the years 2000 through 2007. Using a nested logit model, we examine how firms choose fixed income claims and the method of payment. We find that fixed income claims are chosen to reduce corporate income taxes, minimize refinancing costs, and help mitigate managerial discretion costs. The method of payment choice frequently includes cash settlement features because they increase reported diluted earnings per share. Some of the cash settlement issuers also adopt other innovative financial strategies (share repurchase programs and call spread overlays) that inflate reported earnings per share. We find that firms needing debt capacity include mandatory conversion features.     

Equity Financial Assets: A Tool for Earnings Management—A Case Study of a Chinese Corporation

With China’s adoption of principles-based international accounting standards and its convergence with International Accounting Standard 39 (IAS 39), Chinese companies have discretion under the original Accounting Standards for Enterprises 22 (CAS 22) as to how they account for the initial measurement, sale, and subsequent reclassification of financial assets. We use a Chinese company (‘Company A’) as a case study to illustrate how earnings are managed to exploit this discretion. We document that the company re-classifies its available for sale equity investments as long-term equity investments to decrease the volatility of the company’s apparent profits. We also make some predictions regarding how the company will handle its financial assets under the new standard, which is the same as IFRS 9. Our research contributes to the continuous improvement of China’s accounting standards and has implications for regulators of the capital market.     

Economic Consequences of the Cancellation of Inner Reserves for Hong Kong Banks

Inner reserves, which allow banks to report a higher or lower earnings at managerial discretion, bring into focus the ability of the market to make an informed judgment of banks' performance. This study examines the market response to the disclosure and elimination of inner reserves by Hong Kong banks resulting from a change in the regulatory reporting system. Test results show that despite a significant increase in the variability of bank earnings in the post-compared to the pre-disclosure period, there is no evidence of a significant increase in banks' systematic risk in the post-disclosure period. Earnings-returns association is significantly stronger in the post- than in the pre-disclosure period, indicating an improvement in the value relevance of reported earnings. Disclosure of inner reserve transfer is found to provide incremental information over reported earnings over a short disclosure window. These results suggest that the increased value relevance of earnings outweighs the costs of inner reserve cancellation, thus supporting greater reporting transparency for Hong Kong banks.     

The Future of Financial Reporting: Insights from Research

Research offers insights that, if heeded and built upon, could improve financial reporting, thereby contributing to a more prosperous society. In particular, research suggests improvement could stem from greater use of fair value; a performance statement designed to reveal the information embedded in changes in fair value; better information to help investors assess the value of intangible assets; more specific information about risk and uncertainty; information that is unbiased, rather than conservative; acceptance of a degree of earnings management together with a determination of how much earnings management is acceptable; and a financial reporting package designed to convey information users need, which presumably is broader than today's financial statements.     

公允价值会计涉及的三个层次基本理论问题

本文认为公允价值计量模式是与财务报告的决策有用性目标相一致的,如果财务报告决策有用性的目标不能被推翻,则公允价值计量模式不会被取消。但是公允价值计量模式在短期内不会成为唯一的计量模式,21世纪将是混合计量模式的时代。既然混合计量模式将是未来相当长时期内的主要会计计量模式,那么各财务报表项目采用何种计量属性应以财务报表需达到的质量要求为判断依据,采用公允价值计量的项目应提高其信息质量。     

Discretion in accounting for pensions under IAS 19: using the ‘magic telescope’?

We use a panel data set of UK-listed companies over the period 2005–2009 to analyse the actuarial assumptions used to value pension plan liabilities under IAS 19. The valuation process requires companies to make assumptions about financial and demographic variables, notably discount rate, price inflation, salary inflation and mortality/life expectancy of plan members/beneficiaries. We use regression analysis to analyse the relationships between these key assumptions (except mortality, where disclosures are limited) and company-specific factors such as the pension plan funding position and duration of pension liabilities. We find evidence of selective ‘management’ of the three assumptions investigated, although the nature of this appears to differ from the findings of US authors. We conclude that IAS 19 does not prevent the use of managerial discretion, particularly by companies whose pension plan funding positions are weak, thereby reducing the representational faithfulness of the reported pension figures. We also highlight that the degree of discretion used reflects the extent to which IAS 19 defines how the assumptions are to be determined. We therefore suggest that companies should be encouraged to justify more explicitly their choice of assumptions.