Financial instruments,financial reporting,and financial stability

I review new empirical evidence from the recent financial crisis on the relation between financial reporting and financial stability. I draw the following conclusions: First, there is still no evidence that fair value accounting caused widespread fire sales of asset or contagion. Second, the empirical evidence suggests that accounting and regulation might have contributed to the crisis by allowing several banks to delay actions. Third, even if share prices reacted positively to the relaxation of fair value accounting rules during the crisis, the origin of the problem might be lax rules that allowed banks to run into financial and regulatory problems. Fourth, fair values can be relevant for assets that a bank intends to hold until maturity if that bank strongly relies on short-term financing. Fifth, the recognition of fair values is no substitute for information that allows investors to judge a bank's risk exposure and the validity of reported fair values.     

Enhancing bank transparency: Financial reporting quality,fraudulent peers and social capital

This study examines the role of social norms in financial markets by relating bank transparency to social capital. Using comprehensive data on commercial banks, we provide empirical evidence that high social capital contributes to more transparent financial reporting, thereby enabling more precise risk assessments and promoting financial stability. We find that the effect of social capital is more pronounced when commercial banks are more complex and disclosure incentives of bank managers are strong. Our results suggest that more opaque reporting by peers explains lower transparency but financial misreporting is less contagious when social capital is high. Our study suggests that social capital can effectively improve reporting transparency when other mechanisms are not effective, thus securing financial system stability.     

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.     

Accounting Information in Financial Contracting: The Incomplete Contract Theory Perspective

This paper reviews theoretical and empirical work on financial contracting that is relevant to accounting researchers. Its primary objective is to discuss how the use of accounting information in contracts enhances contracting efficiency and to suggest avenues for future research. We argue that incomplete contract theory broadens our understanding of both the role accounting information plays in contracting and the mechanisms through which efficiency gains are achieved. By discussing its rich theoretical implications, we expect incomplete contract theory to prove useful in motivating future research and in offering directions to advance our knowledge of how accounting information affects contract efficiency.     

Income smoothing among European systemic and non-systemic banks

There is scant research on the financial reporting behaviour of global systemically-important banks (G-SIBs) and non-global systemically-important banks (non-G-SIBs). We examine the link between financial reporting and financial system stability given the understanding that income smoothing is a stability mechanism for banks. We empirically examine whether the way G-SIBs use loan loss provisions (LLPs) to smooth income differ compared to non-G-SIBs and the incentive to do so. We examine 231 European banks and find that income smoothing is pronounced among G-SIBs in the post-crisis period and pronounced among non-G-SIBs in the pre-crisis period. Also, G-SIBs exhibit greater income smoothing when they: (i) have substantial non-performing loans, (ii) are more profitable and meet/exceed minimum regulatory capital ratios (iii) engage in forward-looking loan-loss provisioning and during recessionary periods. The implication of our findings is that capital regulation and abnormal economic fluctuations create incentives for systemic banks to use accounting numbers (loan loss provisions) to smooth income, which also align with the financial system stability objective of bank regulators. Our findings are useful to accounting standard setters in their evaluation of the role of reported accounting numbers for financial system stability, given the current regulatory environment in Europe which focuses on systemic banks.     

Financial derivatives and bank risk: evidence from eighteen developed markets

We examine the relationship between equity risk and the use of financial derivatives with a sample of 555 banks from eighteen developed markets from 2006 to 2015. Our main findings suggest that banks’ use of financial derivatives increased their risk. This increase in risk can be driven by banks’ use of derivatives for speculative purposes, by suboptimal hedging to obtain hedge accounting status, or from accounting mismatches that generate volatility in earnings. We also show that this relationship is nonlinear. Too-Big-To-Fail banks and those that employ a traditional retail banking business model are subject to lower idiosyncratic risk. We address endogeneity concerns using instrumental variables capturing the use of derivatives with portfolio ranking. Overall, our study contributes to understanding the impact of derivatives use on bank risk and the risk consequences of a bank’s business model choice.     

Effects of Increasing Enforcement on Financial Reporting Quality and Audit Quality

A widely held assumption in policy making and empirical research is that increasing the strength of public enforcement improves financial reporting quality and audit quality. This paper provides a more nuanced view. In a model with a manager who can manage earnings, a strategic auditor, and an enforcement institution, we show that enforcement and auditing are complements in a weak enforcement regime but can be substitutes in a strong regime. Although stronger enforcement always mitigates earnings management, the effects of different instruments of strengthening enforcement are ambiguous. We show that they can improve or impair financial reporting quality and audit quality, depending on production risk, accounting system characteristics, and the scope of auditing relative to enforcement.     

Taxes and Financial Constraints: Evidence from Linguistic Cues

Using a new measure of financial constraints based on firms’ qualitative disclosures, we find that financially constrained firms—firms that use more negative words in their annual reports—pursue more aggressive tax planning strategies as evidenced by: (1) higher current and future unrecognized tax benefits, (2) lower short‐ and long‐run current and future effective tax rates, (3) increase in tax haven usage for their material operations, and (4) higher proposed audit adjustments from the Internal Revenue Service. We exploit the unexpected closures of local banks as exogenous liquidity shocks to show that firms’ external financial constraints affect their tax avoidance strategies. Overall, the linguistic cues in firms’ qualitative disclosures provide incremental information beyond traditional accounting variables or commonly used effective tax rates to reveal and predict tax aggressiveness, both contemporaneously and in the future.     

Financial Statements as Monitoring Mechanisms: Evidence from Small Commercial Loans

Using a data set that records banks’ ongoing requests of information from small commercial borrowers, we examine when banks use financial statements to monitor borrowers after loan origination. We find that banks request financial statements for half the loans and this variation is related to borrower credit risk, relationship length, collateral, and the provision of business tax returns, but in complex ways. The relation between borrower risk and financial statement requests has an inverted U‐shape; and tax returns can be both substitutes and complements to financial statements, conditional on borrower characteristics and the degree of bank–borrower information asymmetry. Frequent financial reporting is used to monitor collateral, but only for non–real estate loans and only when the collateral is easily accessible to lenders. Collectively, our results provide novel evidence of a fundamental information demand for financial reporting in monitoring small commercial borrowers and a specific channel through which banks fulfill their role as delegated monitors.     

Accounting disclosure and firms' financial attributes: Evidence from the UK stock market

This paper focuses on the disclosure of accounting information in the financial statements of UK firms. The primary objective of the study is to analyse the financial characteristics of firms that provide extensive disclosures, and assess the financial impact of their motives, such as for example the need to raise equity finance. The study examines the financial attributes of firms that disclose information about key accounting issues including risk exposure, changes in accounting policies, use of international financial reporting standards and hedging practices. Firms are inclined to disclose accounting information in order to assure the market participants that their accounting policies are consistent with the accounting regulation and meet the information needs of their stakeholders. The study shows that in order to raise finance in the capital and debt markets, firms tend to provide extensive accounting disclosures. Firms that provide informative accounting disclosures appear to display higher size, growth and leverage measures. The findings also show that the disclosure of sensitive accounting information has not adversely affected firms' profitability. In fact, firms that provide detailed accounting disclosures tend to exhibit higher profitability. The implementation of international financial reporting standards enhances the quality and the comparability of financial statements; hence it promotes consistency and reliability in financial reporting and facilitates companies in raising capital internationally.     

Financial statement comparability and accounting fraud

We examine the association between financial statement comparability and the likelihood of accounting fraud. Prior research documents a negative association between the quality of a firm's reporting environment and accounting fraud. We build on this literature and show that poor financial statement comparability is associated with a greater likelihood of accounting fraud. We also find that accounting comparability declines over time as the year of fraud detection approaches and that the association between comparability and fraud becomes more negative over this time. In addition, we find that financial statement comparability improves after fraud detection, consistent with the notion that managers improve their financial reporting quality after fraud.     

A Real Effects Perspective to Accounting Measurement and Disclosure: Implications and Insights for Future Research

Accounting measurement and disclosure rules have a significant impact on the real decisions that firms make. In this essay, we provide an analytical framework to illustrate how such real effects arise. Using this framework, we examine three specific measurement issues that remain controversial: (1) How does the measurement of investments affect a firm's investment efficiency? (2) How does the measurement and disclosure of a firm's derivative transactions affect a firm's choice of intrinsic risk exposures, risk management strategy, and the incentive to speculate? (3) How could marking‐to‐market the asset portfolios of financial institutions generate procyclical real effects? We draw upon these real effects studies to generate sharper and novel insights that we believe are useful not only for the development of accounting standards, but also for guiding future empirical research.     

Financial and external reporting research: the broadening corporate governance challenge

This study provides a critical examination of contemporary financial and external reporting research from a corporate governance perspective. Adopting Hines' social constructionist approach to financial reporting, the study investigates research into accounting publishing patterns, published reviews of major subject areas within financial and external reporting research, and interviews a sample of accounting professors in British universities. The findings reveal a strong North American economics and finance-based positivist influence, a largely uncritical acceptance of accounting's subservience to the demands of the market, a reluctance to engage major policy questions and broader reporting constituencies. These appear to be conditioned to a large degree by internal features and pressures within the academic research community. Evidence is presented for greater attention to major environmental shifts impacting accounting and communities globally, a reinvigoration of researchers' direct engagement with reporting constituents in the field, a revisiting of major accounting, business, social and environmental policy questions, and a preparedness to address today's major corporate governance concerns of communities and governments.     

Business-model (intent)-based accounting

We discuss how basing financial reporting on an entity's business model is, in effect, basing financial reporting on management's intent with respect to the use, transfer or other disposition of an asset or liability. We provide several examples of existing International Financial Reporting Standards and US Generally Accepted Accounting Principles that permit or require intent-based accounting. We describe the meaning and consequences of basing the accounting for financial assets on management's intentions for realising value from those assets. We analyse the positive and negative features of intent-based accounting in the context of the Financial Accounting Standards Board's and International Accounting Standards Board's conceptual frameworks, specifically, the qualitative characteristics relevance and comparability and the objective of financial reporting, and apply that analysis to existing and proposed guidance for measuring financial assets. We also discuss evidence from academic research on the measurement of financial assets.     

A half-century of Accounting and Business Research: the impact on the study of international financial reporting

This paper celebrates the contribution of this journal, over its first 50 years, to research on international financial reporting, defined as comprising writings on comparative or harmonisation topics. The paper examines the journal’s output in that field and how it contributed to the field’s development. Even though the journal was sympathetic to international financial reporting, less than 1% of output in its first decade (the 1970s) related to it. In its first 35 years, a large proportion of the journal’s limited output in the field was produced by two small groups of researchers. However, during its fourth decade, the field gradually became dominant as the accounting world changed. By then, the journal had already published the seminal papers on several central topics in international financial reporting, including measuring harmonisation, using reconciliations to measure international accounting differences, assessing international differences in the influence of tax on financial reporting, and measuring international difference in the application of international standards. These topics were later taken up by many researchers in several other journals.     

Procyclicality of U.S. Bank Leverage

In light of the current debate about the link between accounting and financial stability, we investigate the determinants of procyclical book leverage for U.S. commercial and savings banks. We find that total asset growth and GDP growth are both positively related to book leverage growth. Our evidence is not consistent with the notion that fair value accounting contributes to procyclical leverage or that historical cost accounting reduces procyclicality. Overall, the business model of banks is more important for procyclical leverage than accounting or regulatory risk weights.     

Risk reporting quality: implications of academic research for financial reporting policy

In this paper, I survey empirical research on the relevance of firms’ financial report information for the evaluation of their risk. I recommend that financial reporting policymakers require or encourage firms to enhance their risk reporting quality in four ways. First, firms should report comprehensive income statements that: (1) use fair value or a similarly information-rich accounting measurement attribute and (2) separate the components of comprehensive income that are primarily driven by variation in cash flows from those that are primarily driven by variation in costs of capital. Such comprehensive income statements would provide users of financial reports with the flexibility to calculate alternative summary accounting numbers and to perform different types of risk assessment analyses. Second, firms should conduct and disclose the results of back-tests of prior significant accrual estimates, indicating any identified trends in and drivers of revisions to those estimates, and describing the effects of those revisions on current or future summary accounting numbers. Third, firms should aggregate and present risk disclosures in tabular or other well-structured formats that promote the usability of the information. Identifying existing best disclosure practices and encouraging new best practices are the most natural way to do this. Fourth, for model-dependent risk disclosures, firms should disclose the primary historical and forward-looking attributes of the models and their implementation in practice, sensitivity of the model outputs, and benchmarking of the models to standard portfolios of exposures.     

Do Strict Regulators Increase the Transparency of Banks?

We investigate the role that regulatory strictness plays on the enforcement of financial reporting transparency in the U.S. banking industry. Using a novel measure of regulatory strictness in the enforcement of capital adequacy, we show that strict regulators are more likely to enforce restatements of banks' call reports. Further, we find that the effect of regulatory strictness on accounting enforcement is strongest in periods leading up to economic downturns and for banks with riskier asset portfolios. Overall, the results from our study indicate that regulatory oversight plays an important role in enforcing financial reporting transparency, particularly in periods leading up to economic crises. We interpret this evidence as inconsistent with the idea that strict bank regulators put significant weight on concerns about the potential destabilizing effects of accounting transparency.     

Contractibility and Transparency of Financial Statement Information Prepared Under IFRS: Evidence from Debt Contracts Around IFRS Adoption

We outline several properties of IFRS that potentially affect the contractibility or the transparency of financial statement information, and hence the use of that information in debt contracts. Those properties include the increased choice among accounting rules IFRS gives to managers, enhanced rule‐making uncertainty, and increased emphasis on fair value accounting. Consistent with reduced contractibility of IFRS financial statement information, we find a significant reduction in accounting‐based debt covenants following mandatory IFRS adoption. The reduction in accounting covenant use is associated with measures of the difference between prior domestic standards and IFRS. Because IFRS adoption changed financial reporting in many ways simultaneously, it is difficult to trace the decline in accounting covenant use to individual IFRS properties, though we report larger declines in accounting covenant use in banks, which have a higher proportion of assets and liabilities that are fair‐valued. Our findings are better explained by reduced contractibility than by increased transparency, which would predict reduced nonaccounting covenant use as well, whereas we observe increases. Overall, we conclude that IFRS rules sacrifice debt contracting usefulness to achieve other objectives, such as provision of accounting information relevant to valuation.     

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.