The effects of the method used to present a complex item on the face of a financial statement on nonprofessional investors' judgments

Our study is motivated by standard setters' (FASB, 2010; IASB, 2010a) interest in better understanding the effects of item complexity and disaggregation of financial information on users' decision processes. We examine whether the method used to present a complex item on a financial statement influences nonprofessional investors' judgments. We also examine whether disaggregation influences how different levels of item complexity are associated with judgments. Using a 2 × 2 between-subjects experiment, we manipulate variables representing presentation method (disaggregation versus aggregation) and level of item complexity (which is defined pension cost with high versus low volatility). With a sample of 114 nonprofessional investors, we find that when the complex item defined pension cost is disaggregated into its component parts and displayed in different sections of the statement of comprehensive income, nonprofessional investors acquire more information about the item and are able to more accurately understand the function of the item. This, in turn, helps the nonprofessional investors decide whether the information is useful in certain judgments. Additionally, we find that when a complex item is disaggregated, nonprofessional investors place even greater weight on their perceptions of level of item complexity in certain judgments. The results of this study are of value to managers, standard setters, and investors. For instance, results suggest that disaggregating a complex item across a financial statement can help nonprofessional investors learn how the component(s) driving a complex item relates to different economic events, improving their ability to understand and process the information in their judgments.     

An analysis of the implications of discontinued operations for continuing income

We examine the extent to which changes in the accounting for discontinued operations affects the usefulness of disaggregated income components in predicting an entity’s future continuing income. Our study is motivated by the joint FASB/IASB convergence project which seeks to define the scope of transactions reported in discontinued operations. To examine our question, we compare the properties of continuing income and discontinued operations reported under SFAS 144 and APB 30, where APB 30 closely parallels IFRS 5. We find that the broader scope of the rule under SFAS 144 results in more persistent continuing income among firms reporting discontinued operations, and that this is concentrated among single-segment firms, which previously were less likely to fall within the scope of APB 30. Because we find no evidence of increased opportunism, we conclude that the broader scope of the rule results in a finer partitioning of recurring and nonrecurring income. Overall, our results support the broader scope of discontinued operations.     

How Disaggregation Enhances the Credibility of Management Earnings Forecasts

An important problem facing managers is how to enhance the credibility, or believability, of their earnings forecasts. In this paper, we experimentally test whether a characteristic of a management earnings forecast—namely, whether it is disaggregated—can affect its credibility. We also test whether disaggregation moderates the relation between managerial incentives and forecast credibility. Disaggregated forecasts include an earnings forecast as well as forecasts of other key line items comprising that earnings forecast. Our results indicate that disaggregated forecasts are judged to be more credible than aggregated ones and that disaggregation works to counteract the effect of high incentives. We also develop and test an original model that explains how disaggregation positively impacts three factors that, in turn, influence forecast credibility: perceived precision of management's beliefs, perceived clarity of the forecast, and perceived financial reporting quality. We show that forecast disaggregation works to remedy incentive problems only via its effect on perceived financial reporting quality. Overall, our study adds to our understanding of how managers can credibly communicate their expectations about the future to market participants.     

The relation between aggressive financial reporting and aggressive tax reporting: Evidence from ex-Arthur Andersen clients

We investigate the economic trade-offs managers face due to conflicting incentives to report high financial statement book income and, at the same time, report low taxable income. Our setting involves Houston clients of Arthur Andersen (AA), who have been shown to exhibit a culture of aggressive financial reporting. Using our sample of AA Houston clients, we test two competing theories: (1) firms which have a culture of aggressive financial reporting are also aggressive in their tax reporting, versus (2) firms which are willing to pay real dollars (taxes) to report higher financial statement earnings. We do not find support for either theory. Instead, our findings suggest a middle-ground: firms may exhibit a culture of aggressive financial reporting without impacting their relative tax reporting. Our findings not only shed light on the intersection of financial and tax reporting, but they also add to the extant literature involving the culture of AA. To the best of our knowledge, this is the first paper to investigate the tax ramifications of AA’s culture of aggressive financial reporting.     

Discontinued operations and analyst forecast accuracy

Review of Quantitative Finance and Accounting - The Financial Accounting Standards Board requires separate reporting of discontinued operations within the income statement to provide better...     

Management earnings forecast and financial statement complexity

We investigate the manager’s earnings forecasting strategy when financial statement complexity becomes a significant issue in capital markets. We suppose that complexity in financial statements arises from complexity of firm’s business transactions (business complexity) or complexity of associated reporting standards (reporting complexity) as mentioned in Guay et al. (2016). We find that a manager’s forecasting strategy depends on whether financial statement complexity stems from business or reporting complexity. Specifically, we indicate, among other observations, that managers who initially announced optimistic earnings forecasts will revise and release pessimistic earnings forecasts when financial statement complexity stems from reporting complexity.     

Value‐Added Per Share (VAPS): A Value‐Relevant Corporate Performance Metric

The authors introduce Value Added Per Share (VAPS) as a value‐relevant metric that is intended to complement earnings per share (EPS) in helping corporate managers and analysts understand and overcome the limitations of GAAP‐based reporting. VAPS discounts a firm's past and projected cash flows at its “cost of capital,” allowing companies to avoid the subjective accounting accrual process and other practices that often make EPS misleading. A company's VAPS is calculated in three main steps: (1) estimate the change in the capitalized value of after‐tax operating cash flow by taking the net change (plus or minus) of the firm's operating cash flow after taxes and dividing that number by the firm's cost of capital; (2) subtract total investment expenditures; and (3) divide by the number of shares outstanding. By capitalizing the change in after‐tax operating cash flow, one finds the net change in a firm's current operations value. By subtracting investment expenditures from that change in current operations value, the analyst gets a clearer picture of the benefit to shareholders net of the funds used to create that benefit. Consistent with basic theory, VAPS is positive when a company earns a return at least equal to its cost of capital and negative otherwise. Because of their fundamental differences, EPS and VAPS are likely to send different signals, and VAPS is expected to provide greater insight into stock price changes. The authors provide the findings of statistical tests showing the superior explanatory power of VAPS and recommend that companies publish statements of VAPS along with standard GAAP results, especially since the former can be readily calculated using the available income statement, balance sheet, and cash flow statement data.     

Disclosure of GAAP line items in earnings announcements

We provide new evidence on the disclosure in earnings announcements of financial statement line items prepared under Generally Accepted Accounting Principles (GAAP). First, we investigate the circumstances that might provide disincentives generally for GAAP line item disclosures. We find that managers who regularly intervene in the earnings reporting process limit disclosures at the aggregate level and in each of the financial statements so as to more effectively guide investor attention to summary financial information. Specifically, this disclosure behavior obtains when managers habitually cater to market expectations, engage in income smoothing, or use discretionary accruals to improve earnings informativeness. Second, we predict and find that the specific GAAP line items that firms choose to disclose are determined by the differential informational demands of their economic environment, consistent with incentives to facilitate investor valuation. However, these valuation-related disclosure incentives are muted when managers habitually intervene in the earnings reporting process.     

S&P 500 Membership and Managers’ Supply of Conservative Financial Reports

Our study is motivated by economic theory and the debate among practitioners, standard setters, and academics on the role of conditional conservatism in financial reporting. We find that managers provide less conditionally conservative financial reports after their firms are added to the Standard and Poor's (S&P) 500 index. S&P 500 membership is expected to reduce information asymmetry between managers and outside stakeholders due to an increased flow of public and private information. As a result, the contracting benefits of conservative accounting choices are reduced, and managers are less willing to provide conditionally conservative reports. In contrast, we find that managers provide more conditionally conservative financial reports after their firms are deleted from the index. Firms being deleted from the S&P 500 index probably incur an increase in information asymmetry. Overall, our results provide evidence consistent with conditional conservatism being a response by managers to the information needs of financial statements users.     

Restatement costs and reporting bias

Financial restatements are costly, but frequent, events and many firms restate several times. We explore why rational managers engage in misreporting despite the costly consequences. To guide our analysis, we build a parsimonious model of reporting bias and the cost of restating. In our model, the observed cost of a restatement conveys information about the true cost of biasing financial statements, which the manager incorporates into the optimal choice of bias. A restatement hence offers managers an opportunity to learn about the true cost of reporting bias, which allows them to update their biasing strategy if the observed cost differs from the expected. We test the model's predictions by analyzing how firms' accruals quality changes after observing the costs attached to restating, which we measure as the market loss following a restatement scaled by the restatement's net income effect. We find that future accruals quality is increasing in the cost of restating and the change in the cost of restating. Consistent with our stylized model, our results indicate that rational managers use the insights from prior restatements to improve their future bias strategy.     

To What Extent Does the Financial Reporting Process Curb Earnings Surprise Games?

Managers play earnings surprise games to avoid negative earnings surprises by managing earnings upward or by managing analysts' earnings expectations downward. We investigate the effectiveness of the financial reporting process at restraining earnings surprise games. Because the annual reporting process is subject to an independent audit and more rigorous expense recognition rules than interim reporting, it provides managers with fewer opportunities to manage earnings upward. We document that, relative to interim reporting, annual reporting reduces the likelihood of income‐increasing earnings management and, to a lesser extent, of negative surprise avoidance, but increases the magnitude of downward expectations management. Our findings suggest that regulatory attempts to monitor corporations' internal checks and balances are likely to be more effective at curbing upward earnings management than at mitigating negative surprise avoidance.     

An analysis of the impact of adopting IFRS 8 on the segment disclosures of European blue chip companies

Amidst the IASB's post-implementation review of IFRS 8, we examine how the standard's adoption changed the reporting of segments by European blue chips (i.e. companies comprising the top tier index of 14 European stock exchanges). We focus on anticipated benefits articulated in the IASB's Basis for Conclusions and concerns expressed by IFRS 8 opponents.In addition to convergence with U.S. GAAP, IFRS 8 results in the reporting of significantly more operating segments on average. However, most companies report the same number or fewer segments. Refuting claims regarding the loss of geographic data at the entity-wide level, we identify an improvement in the fineness of disclosures and a significant increase in the disclosure of geographic groupings. We do not identify an improvement in consistency of segment disclosures with other sections of the annual report, which is due to the consistency already achieved under IAS 14R.IFRS 8 results in a significant decline in the number of reportable segment information items (notably liabilities) and a significant decline in the reporting of capital expenditures at the entity-wide level. Furthermore, adoption of the standard produces a lack of comparability in segment profitability measures and extensive reporting of non-IFRS measures. However, almost all companies report a measure of segment profitability tied to a number on the consolidated income statement or reconciled to the income statement.     

Tick Size and Financial Reporting Quality in Small-Cap Firms: Evidence from a Natural Experiment

Using a natural experiment (the SEC's 2016 Tick Size Pilot Program), we investigate the effects of an increase in tick size on financial reporting quality. The tick size pilot program reduces algorithmic trading (AT) and increases fundamental investors’ information acquisition and trading activities. This in turn increases the scrutiny of managers’ financial reporting choices and reduces their incentives to engage in misreporting. Using a difference-in-differences research design, we find a significant decrease in the magnitude of discretionary accruals, a significant reduction in the likelihood of just meeting or beating analysts’ forecasts, and a marginally significant decrease in restatements for the treated firms in the pilot program. Furthermore, we find that the change in financial reporting quality is concentrated in treated firms experiencing decreases in AT and increases in information acquisition activities. We also find that the mispricing of accruals is significantly lower for treated firms. Taken together, our results suggest that an increase in tick size has a causal effect on firms’ financial reporting quality.     

EARNINGS MANAGEMENT AND CORPORATE OWNERSHIP STRUCTURE: AN EXAMINATION OF EXTRAORDINARY ITEM REPORTING

This study examines the empirical relation between a three-way classification of corporate ownership structure and earnings management through the use of extraordinary item (EI) reporting. The EI reporting decisions examined are those made during 1960-1966, a time period when US reporting standards allowed considerable management discretion with respect to both the classification of EIs and their placement in the financial statements (i.e., income. versus retained earnings statement). Overall, the results provide strong support for income-increasing behavior by non-owner managers. Importantly, the results also suggest that the three-way ownership classification scheme used in this study is superior to the dichotomous owner-controlled/managercontrolled classification typically used in accounting studies.     

Fair value accounting for liabilities: The role of disclosures in unraveling the counterintuitive income statement effect from credit risk changes

When liabilities are accounted for at fair value, a deterioration of a company’s credit risk results in the reporting of an income statement gain; an improvement in a company’s credit risk results in a loss. Many argue that these income statement effects are counterintuitive and that financial statement-users are likely to misinterpret fair value gains as positive signals and fair value losses as negative signals. Utilizing an experiment with CPAs as participants, we find that these arguments are indeed valid. Specifically, we find that over 70% of the participants incorrectly assess a company’s credit risk as improving (deteriorating) when a fair value gain (loss) is recognized. We also find that disclosures that explicitly specify the relation between the direction of the credit risk change and the income statement effect significantly reduce participants’ misinterpretations, and are more beneficial when fair value gains versus losses are recognized. These findings provide empirical evidence in the debate over the recognition of company-specific credit risk changes and offer direction for improving disclosures in the area of fair value accounting.     

Recognition versus Disclosure of Stock Option Compensation: An Analysis of Judgements and Decisions of Nonprofessional Investors*/CONSTATER OU PRÉSENTER PAR VOIE DE NOTE LA RÉMUNÉRATION SOUS FORME D'OPTIONS D'ACHAT D'ACTIONS: UNE ANALYSE DES JUGEMENTS ET DES DÉCISIONS DES INVESTISSEURS NON PROFESSIONNELS

Given the importance of stock options in the aggregate compensation of chief executive officers and other firm employees in the 1990s and early 2000s, the International Accounting Standards Board issued an International Financial Reporting Standard on stock‐based payments on February 19, 2004, requiring that all share‐based payment transactions be recognized at fair value in entities' financial statements. The Canadian Institute of Chartered Accountants' Accounting Standards Board had already agreed to this principle and amended section 3870 of the CICA Handbook (stock‐based compensation) for financial periods beginning on or after January 1, 2004, making Canada the first major jurisdiction to require all public companies to expense employee stock‐based compensation awards. The revised section eliminated the possibility of disclosing pro forma net income and earnings per share only by way of a note. This research, conducted as a between‐subjects experiment with executive MBA students as nonprofessional investors, examines whether changes in the way stock option compensation is reported (recognition as an expense in the income statement or note disclosure of pro forma net income and earnings per share) affect financial statement users' judgements and investment decisions. Our results indicate that, consistent with the functional fixation hypothesis, the reporting method does indeed significantly influence subjects' judgement of the expected stock price direction, but has no material influence on their investment decisions.     

Barriers to Interpretation—A Case Study of Philips Electronics NV

Philips Electronics NV, a very large European company, went through considerable upheaval in the period 1980 to 1994. Accounting disclosures did not seem to be very helpful to statement readers who wanted to evaluate Philips' progress and position. The company's financial condition and income results deteriorated significantly during most of the period, and large losses were shown in 1990 and 1992. Prior to the huge loss recorded in 1990, there were few indications in the annual reports that troubles were mounting. In earlier periods a series of accounting changes were made, the effect of which typically was to increase income. The most significant change came in 1992, when Philips abandoned current cost accounting. We investigated financial analysts' reactions to company disclosures and found that they had problems interpreting the effects of Philips' accounting changes. In addition to accounting changes, Philips also used a somewhat arbitrary restructuring charge (or credit) to adjust income amounts. Finally, the absence of full explanations from the directors at some points could have resulted in users of the annual report being misled. Over the period studied, Philips lost a significant portion of its stockholders' equity. The effect of its reporting practices was to obscure the impact of the unfavorable economic events that affected the company. Financial reporting, at least for this company, fell short of providing disclosures that told a clear story of what was taking place. In the periods before large losses were recorded, few hints were provided of impending disasters. Overall, the results of this study are disturbing. Although the study is restricted to one company, the results deserve the thoughtful consideration of both academics and practising accountants.     

An empirical examination of the impact of the Sarbanes Oxley Act in the reduction of pension expense manipulation

Since the Sarbanes Oxley Act of 2002 (SOX) attempts to make managers more accountable for the fair presentation of reported earnings in their financial statements, we expect managers to manipulate pension expense less during the three years after the passage of SOX than during the three years preceding the passage of SOX. Our results reveal that for smoothing firms the magnitude of pension expense manipulation during the three years after the passage of SOX on average increases instead of decreases. On the other hand, for benchmark firms the magnitude of pension expense manipulation during the three years after the passage of SOX on average decreases as expected. This research provides mixed evidence concerning the effectiveness of SOX in making financial statement reporting more transparent and representative of actual financial position, in the area of pension expense.     

Consequences and Institutional Determinants of Unregulated Corporate Financial Statements: Evidence from Embedded Value Reporting

I analyze Embedded Value (EV) reporting by firms with life insurance operations to assess the impact of unregulated financial reporting on transparency and to examine the institutional characteristics that promote unregulated reporting. Under EV accounting, the present value of future cash flows from in‐force contracts is included in shareholders’ equity, and profit is calculated as the change in equity between two periods. In contrast to Generally Accepted Accounting Principles (GAAP), this approach produces higher shareholder's equity and recognizes income at contract inception. I find firms that adopt EV reporting exhibit a decline in information asymmetry, with the decline increasing as EV reporting evolves to address methodological deficiencies and to permit more comparability across firms. The decrease in information asymmetry is contingent on providing an audit certification, and larger for firms that commit to providing EV reports. Moreover, I document that EV reporting is more widespread in countries with more hostile takeovers, managers that do not avoid volatile income measures, regulators that are less likely to intervene in the product market, and analysts that believe EV disclosure increases the value of their information intermediation function.     

On the Segment Identification Issue

Disclosure of financial data disaggregated by business and/or geographic segment is currently being considered by the Accounting Standards Committee. This paper reports the views of a group of preparers and users of segment reports on the segmental reporting issue. Identifying reportable segments is of primary importance if the disaggregated financial data are to have any meaning or value. Yet, the imposition of a rigid and arbitrary set of rules suggesting a single form of presentation is unlikely to gain universal approval. Based on the criteria of the preparers and users interviewed alternative forms of presentation are proposed.