Does Fair Value Accounting Contribute to Systemic Risk in the Banking Industry?

I investigate whether fair value accounting can contribute to the banking industry's systemic risk. I focus on the adoption of Statement of Financial Accounting Standard No. 115 (SFAS No. 115), which required available‐for‐sale (AFS) securities to be recognized at fair value with unrealized gains and losses included in equity through accumulated other comprehensive income. SFAS No. 115 increased banks' regulatory risk because, at the time, calculation of regulatory capital closely conformed with GAAP equity. I find that systemic risk increased following the adoption of SFAS No. 115. Furthermore, following a subsequent regulatory amendment—which excluded unrealized gains and losses on AFS securities from regulatory capital but did not change their GAAP treatment—systemic risk decreased. Taken together, the evidence suggests that fair value accounting has the potential to increase systemic risk through the explicit inclusion of volatile fair value estimates in regulatory bank capital adequacy assessments. I do not, however, find evidence of fair value accounting impacting systemic risk in its information role; that is, by providing information to a bank's external stakeholders about its financial position and performance. I also show that higher fair value volatility of investment securities, lower bank capital, and larger AFS security holdings increase banks' marginal contribution to systemic risk. My findings should interest regulators and policymakers, as recent regulatory changes in light of Basel III recommendations require unrealized gains and losses on AFS securities to be included in regulatory capital for advanced approaches banks.     

Enterprise Risk Management Program Quality: Determinants,Value Relevance,and the Financial Crisis

This paper investigates factors associated with high‐quality Enterprise Risk Management (ERM) programs in financial services firms, and whether ERM quality enhances performance and signals credibility to the financial markets. ERM, developed with the assistance of the accounting profession, provides a framework and plan to integrate management of all sources of risk. Challenged by measurement difficulties common to research on management control systems, prior ERM studies present mixed findings. Using ERM quality ratings of financial companies by Standard & Poor's, we find that higher ERM quality is associated with greater complexity, less resource constraint, and better corporate governance. Controlling for such characteristics, we find that higher ERM quality is associated with improved accounting performance. Results show a market reaction to signals of enhanced management control from initial ERM quality ratings and rating revisions, and a stronger response to earnings surprises for firms with higher ERM quality. Focusing on the recent global financial crisis, our analysis suggests that there is no relation between ERM quality and market performance prior to and during the market collapse. However, returns of higher ERM quality companies are higher during the market rebound. Overall, results reveal that firm performance and value are enhanced by high‐quality controls that integrate risk management efforts across the firm, enabling better oversight of managers' risk‐taking behavior and aligning that behavior with the strategic direction of the company.     

Earnings Manipulation in Failing Firms

Prior literature and anecdotal evidence, most recently provided by allegations relative to Enron, Global Crossing, and WorldCom, suggest that failing firms (defined here as prebankruptcy firms) may be motivated to engage in fraudulent financial reporting to conceal their distress. I examine two research questions: (1) Are failing firms' prebankruptcy financial statements more likely to exhibit signs of material income increasing earnings manipulation than those of nonfailing firms? (2) Do auditors detect the overstatements in firms that they perceive to be failing? I predict and find that as (ex post) bankrupt firms that do not (ex ante) appear to be distressed approach bankruptcy, their financial statements reflect significantly greater material income‐increasing accrual magnitudes in nongoing‐concern years than do control firms. The accrual behavior of these firms resembles that of bankrupt firms that the Securities and Exchange Commission (SEC) has sanctioned for fraud. Like sanctioned firms, the nonstressed bankrupt firms display significantly greater (material) increases in receivables; inventory; property, plant, and equipment; sales; net working capital, current, and discretionary accruals in prebankruptcy nongoing‐concern years than do control firms. They also display significantly more negative changes in cash flows from operations and net cash and a greater disparity between accrual‐based net income and operating cash flows than do control firms, consistent with Lee, Ingram, and Howard 1999. Finally, I predict and find that these firms' going‐concern years reflect evidence consistent with auditor‐prompted reversal of previous overstatements. These results are based on parametric and nonparametric tests for various subsample combinations drawn from a sample of 293 bankrupt firms representing approximately 2,500 observations.     

Strategic Tax and Financial Reporting Decisions: Theory and Evidence*

This paper examines the effect of book‐tax differences on the probability that a transaction is audited and the probability that additional taxes are collected. It constructs a stylized model in which the taxpayer reports both financial accounting income and taxable income. The government observes both reports before deciding whether to conduct an audit. The analysis of the equilibrium yields two hypotheses. First, the probability that the government will audit a transaction is higher if the transaction generates a positive book‐tax difference (e.g., an expenditure that is deducted for tax purposes but capitalized for financial reporting purposes) than if the transaction generates no book‐tax difference. Second, conditional on being selected for audit, transactions with and without book‐tax differences are equally likely to have detected understatements of tax liability. These hypotheses are tested using Internal Revenue Service (IRS) data from the Coordinated Examination Program. The empirical tests are consistent with the predictions of the strategic tax compliance model.     

The Shielding of CEO Compensation from the Effects of Strategic Expenditures*

This study investigates whether and why compensation committees shield CEO compensation from income‐decreasing effects of strategic expenditures. We document that firms do shield recurring strategic expenditures such as research and development and advertising expenditures. We also find that firms shield research and development expenditures more than advertising expenditures. Our results are consistent with prior findings that suggest that compensation committees shield CEOs from nonroutine transactions such as restructuring charges and extraordinary losses. Using a two‐task principal‐agent framework, we show that such shielding improves the efficiency of the contract by making the shielded income measure more congruent with the principal's objectives.     

Big Five Audits and Accounting Fraud*

We examine the association between Big Five audits and the incidence of accounting frauds allegedly committed by U.S. public companies between 1981 and 2001. Many commentators argue that the prominent financial reporting failures that led to major corporate governance reforms cast serious doubt on whether the large public accounting firms continue to supply relatively high‐quality audits, especially in recent years. However, in unmatched and matched samples, we provide strong, robust evidence that fraudulent financial reporting becomes less likely with the presence of a Big Five auditor. Importantly, time‐series tests suggest that the Big Five are consistently associated with a lower incidence of fraudulent accounting, including in the last five years of our sample period when the number of frauds soared. Moreover, we find evidence implying that these relations are causal rather than an artifact of endogeneity in auditor choice.     

House Price Dynamics with Household Debt: The Korean Case*

This paper revisits the long‐run determinants of house prices, and analyzes the house price dynamics using Korean data taking into account the close relationship between house prices and household debt. The results of cointegrating regression indicate that the major portion of the rise in house prices in Korea over the last 15 years can be explained by changes in macro variables such as household income, the demographic structure, the user cost of home ownership and the housing stock supply. The results also confirm that house prices are, indeed, closely linked to the steep increase in household debt seen over this period. Estimation of an error correction model shows that the extent of convergence of actual house prices to their long‐run equilibrium path has weakened somewhat since the global financial crisis while the speed of convergence has slowed, indicating structural changes in the Korean housing market. Finally, a forecast for house prices over the next several years suggests that they are unlikely to rise as sharply as they did in the 2000s, given the likely changes in the macro‐financial environment, and that their future path will be closely associated with that of the household debt‐to‐income ratio.     

Mandatory IFRS Adoption and the Role of Accounting Earnings in CEO Turnover

We study whether mandatory adoption of International Financial Reporting Standards (IFRS) is associated with changes in the sensitivity of CEO turnover to accounting earnings and how the impact of IFRS adoption varies with country‐level institutions and firm‐level incentives. We find that CEO turnover responds more to a firm's accounting performance after adoption. This increase in turnover‐to‐earnings sensitivity is concentrated in countries with stronger enforcement of financial reporting and is more prominent for mandatory adopters that have strong firm‐level compliance incentives. In addition, we link the change in turnover‐to‐earnings sensitivity directly to accounting changes due to IFRS adoption and find a stronger adoption effect when firms report large overall accounting changes and large de‐recognition of loss provisions upon adoption. Some of the above findings are sensitive to the exclusion of UK firms, which account for more than half of our sample.     

Disclosure Overload? A Professional User Perspective on the Usefulness of General Purpose Financial Statements

We survey a broad group of professionals who use financial statements as part of their job to assess the extent to which they believe financial reports suffer from disclosure overload. Consistent with the claims made by regulators, auditors, and preparers, we find that a significant portion of professional financial statement users believe disclosure overload is a problem. However, this group is in the minority, with about twice as many professional users believing that overload is not a problem and that more information should be disclosed in financial statements. This dichotomy presents a difficult challenge to standard setters aiming to improve financial reporting by altering the amount of information provided in financial reports. To that end, we complement existing research on the informativeness of accounting information by measuring perceptions of the usefulness of the various financial statements and their footnotes across a variety of tasks. Finally, we develop a framework that could be useful in developing a theory of disclosure overload.     

Accounting Discretion and Managerial Conservatism: An Intertemporal Analysis*

Accounting discretion and the principle of conservatism are two salient features embedded in financial reporting systems. Arguably, the practice of conservative accounting choices can never be well understood without incorporating their effect on future periods (the intertemporal effect). This paper provides one explanation for managerial conservatism in a two‐period agency model with hidden information (a binary project type) and hidden actions (the agent's efforts). A piece‐wise linear incentive scheme with accounting earnings as the performance measure is employed. The agent's discretion is the choice of a depreciation method. Discretion is valuable if and only if the agent's marginal productivity of a “bad” project is greater than that of a “good” project, but not to an extreme degree. A conservative depreciation method decreases current compensation in exchange for a “bet” on future compensation and, hence, serves as a commitment device for the agent to signal that the prospect is indeed good. The accounting mechanism replicates the performance of the optimal direct mechanism.     

Financial Statement Comparability and the Efficiency of Acquisition Decisions

This study examines whether acquirers make better acquisition decisions when target firms’ financial statements exhibit greater comparability with industry peer firms. We predict and find that acquirers make more profitable acquisition decisions when target firms’ financial statements are more comparable—as evidenced by higher merger announcement returns, higher acquisition synergies, and better future operating performance. We also find that post‐acquisition goodwill impairments and post‐acquisition divestitures are less likely when target firms’ financial statements are more comparable. Finally, we find that acquirers benefit most from comparability when acquirers’ ex ante information asymmetry is higher, acquirers operate in volatile operating environments, and management knows relatively less about the target. In total, our evidence suggests targets’ financial statement comparability helps acquirers make better acquisition‐investment decisions and fosters more efficient capital allocation.     

Investment Experience,Financial Literacy,and Investment‐Related Judgments

This research examines how investment experience and financial literacy impact investment‐related judgments. Financial literacy refers to a person's knowledge of fundamental financial concepts. I begin by documenting investors' demographic characteristics and financial literacy using a relatively large sample of participants (n > 2,000) recruited from Amazon's Mechanical Turk under different categories of investment experience, which I benchmark against national samples of financial capability skills in the United States. I then replicate a sample of three accounting research experiments, varying the type and depth of the underlying accounting issue. Across the three experiments, the data show two main results: First, investment experience strengthens the influence of financial accounting disclosures on participants' investment‐related judgments. Second, financial literacy further strengthens the influence of financial accounting disclosures on investors' (but not noninvestors') judgments. Collectively, these findings suggest that investment experience and financial literacy can help to identify individuals who are more likely to be able and willing to study financial reporting information with reasonable diligence as they form their investment‐related judgments.     

The Effects of Financial Statement Information Proximity and Feedback on Cash Flow Forecasts*

The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB), in their joint Financial Statement Presentation project, are reconsidering the basic format of financial statements. The Boards’ preliminary discussions related to this joint project indicate that they intend to modify the required financial statements to increase the proximity of performance‐related information for each reported period. We provide evidence related to this potential change by investigating the effects of financial statement information proximity on investors’ ability to learn the forecast‐relevant time series properties of reported cash flows and accruals. We also examine the role feedback plays in this relationship. Our experimental results suggest that nonprofessional investors are able to more quickly learn the relation between current period cash flows and accruals and future cash flow realizations when financial statement information is presented in a single statement rather than separated into two statements. In addition, we find that nonprofessional investors exhibit lower levels of absolute forecast errors and less forecast dispersion when financial statement information is unified into a single statement. Finally, we provide evidence that nonprofessional investors who receive extensive outcome feedback on a single page initially learn more quickly and later, after learning has leveled off, accurately forecast more consistently than do investors who receive extensive or limited feedback spread across two pages. Overall, our results provide evidence on the effectiveness of alternate financial statement presentation formats and the potential usefulness of receiving more extensive feedback.     

Does Mandatory Adoption of IFRS Improve Accounting Quality? Preliminary Evidence

We provide evidence on the preliminary effects of mandatory adoption of International Financial Reporting Standards (IFRS) on accounting quality for a relatively broad set of firms from 20 countries that adopted IFRS in 2005 relative to a benchmark group of firms from countries that did not adopt IFRS matched on the strength of legal enforcement, industry, size, book‐to‐market, and accounting performance. Relative to these benchmark firms, we find that IFRS firms exhibit significant increases in income smoothing and aggressive reporting of accruals, and a significant decrease in timeliness of loss recognition; however we do not find significant differences across IFRS and benchmark firms in meeting or beating earnings targets. Our findings contrast with findings in earlier studies which suggest that IFRS adoption leads to increased accounting quality. Our findings primarily hold for firms in strong enforcement countries, which suggests that enforcement mechanisms in these countries were not able to counter the initial effects of greater flexibility in IFRS relative to domestic GAAP.     

How Can China Avoid the Middle Income Trap?

Many middle income economies have been unable to advance to become high income economies over a period of 50 years or longer, not due to the existence of middle income traps, but because of the overly broad income range in the definition of middle income economies. The middle income trap is, in essence, a growth trap, and refers to the situation in which a middle income economy experiences growth stagnation or a growth rate that is lower than that of high income economies. Nonetheless, it is hard to fully comprehend the formation of the trap solely based on growth theories. Historical data indicate that the middle income economies do not lack growth potential, and the real problem is that although their long‐term average growth rates are higher than those of the high income economies, their average growth rates over a business cycle or an even longer period of time often fall below those of the high income economies. The cause of this phenomenon is neither short‐term macroeconomic fluctuations nor long‐term growth potential, but the frequent occurrence of financial crises in middle income economies. As a middle income economy, China is also facing the risk of a financial crisis, and the key to avoiding the middle income trap is to guard against future financial crises, preventing unsound financial liberalization and mismanagement of the corporate debt ratio.     

Rethinking the impact of GDP on financial development: Evidence from heterogeneous panels

This paper examines the nonlinear impact of real GDP per capita on financial development in a panel of 125 countries. It also determines the moderating effect of inflation on the impact of GDP on financial development. It employs the dynamic panel system generalized method of moments (GMM) and the dynamic common correlated effects (CCE) to do both panel and country‐specific analysis, as well as control for cross‐sectional dependence, heterogeneity and endogeneity. This study shows that GDP has a positive impact on financial development in the entire panel. However, when we split the panel into different income groups, we find a positive impact in the high‐ and middle‐income groups while the impact is insignificant in the low income group. Although we find no evidence of a nonlinear impact of GDP on financial development in the panel, the country‐specific analysis reveals a significant nonlinear relationship between GDP and financial development in 73 countries. We also show that inflation adversely moderates the positive impact of GDP on financial development in middle‐income countries. This study implies that the relationship between GDP and financial development depends on the levels of GDP and inflation rate. We recommend some policy options based on the findings.     

Financial Statement Comparability and the Informativeness of Stock Prices About Future Earnings

We find that financial statement comparability enhances the ability of current period returns to reflect future earnings, as measured by the future earnings response coefficient (FERC). This suggests that comparability improves the informativeness of stock prices and allows investors to better anticipate future firm performance. In addition, using both the FERC and stock price synchronicity tests, we find that comparability increases the amount of firm‐specific information (rather than market/industry‐level information) reflected in stock prices. Analysts play an important role in improving stock price informativeness by producing more firm‐specific information when comparability is high. These findings suggest that comparability lowers the costs of gathering and processing firm‐specific information.     

Accounting Comparability and Economic Outcomes of Mandatory IFRS Adoption

This study examines the associations between four economic outcomes of the 2005 mandatory adoption of International Financial Reporting Standards (IFRS) and concurrent changes in two important accounting constructs, accounting comparability and reporting quality. My primary purpose is to evaluate the relative importance of cross‐country accounting comparability and firm‐specific reporting quality in explaining previously documented increases in Tobin's Q, stock liquidity, analyst forecast accuracy, and analyst forecast agreement following IFRS adoption. Given that improvements in both comparability and reporting quality are primary stated objectives of the International Accounting Standards Board (IASB), it is important to understand their relative roles in shaping the information environment of financial statement users following IFRS adoption. Using 1,861 first‐time adopters in 23 countries, I find that firms with a larger improvement in comparability have larger increases in Q, liquidity, forecast accuracy, and forecast agreement following adoption, relative to other adopters. In contrast, improvements in reporting quality around adoption appear to have only a second‐order effect that is generally limited to Q effects among those adopters with concurrent improvements in comparability. These results are robust to alternative design and variable specifications. Finally, I continue to find these results for samples restricted to countries with weaker pre‐adoption institutional environments and countries that did not initiate proactive financial statement reviews, indicating that strong institutions and regulatory improvements are not driving the results. Overall, my results suggest that improvements in cross‐country accounting comparability played an important role in the previously documented economic benefits that accrued to 2005 mandatory IFRS adopters.     

Financial development and top income shares in OECD countries

We examine the causal impact of financial development (FD) on top income shares for a panel of 14 OECD countries—five Anglo‐Saxon countries, eight continental European countries, and Japan—over a 110‐year period. In our main General Method of Moments estimates, we find that a 1‐percentage‐point change in FD increases the top 1% income share by 0.2%. In distribution terms, a 1‐SD incr=ease in FD increases the top 1% income share by around 0.4 of an SD. The effects are robust to various measures of top income shares and FD and alternative estimation techniques, including nonparametric estimation. FD is typically viewed in positive terms in that it makes it easier to access credit and facilitates economic growth. Our results are important because they contribute to understanding of the potential negative effects of FD.     

The Relation between Market Values,Earnings Forecasts,and Reported Earnings*

Recently, much of the research into the relation between market values and accounting numbers has used, or at least made reference to, the residual income model (RIM). Two basic types of empirical research have developed. The “historical” type explores the relation between market values and reported accounting numbers, often using the linear dynamics in Ohlson 1995 and Feltham and Ohlson 1995 and 1996. The “forecast” type explores the relation between market value and the present value of the book value of equity, a truncated sequence of residual income forecasts, and an estimate of the terminal value at the truncation date. The analysis in this paper integrates these two approaches. We expand the Feltham and Ohlson 1996 model by including one‐ and two‐period‐ahead residual income forecasts to infer “other” information regarding future revenues from past investments and future growth opportunities. This approach results in a model in which the difference between market value and book value of equity is a function of current residual income, one‐ and two‐period‐ahead residual income, current capital investment, and start‐of‐period operating assets. The existence of both persistence in revenues from current and prior investments and growth in future positive net present value investment opportunities leads us to hypothesize a negative coefficient on the one‐period‐ahead residual income forecast and a positive coefficient on the two‐period‐ahead residual income forecast. Our empirical results strongly support our hypotheses with respect to the forecast coefficients.