Do firms understate stock option-based compensation expense disclosed under SFAS 123?

Focusing on the four key option pricing model inputs—expected option life, expected stock price volatility, expected dividend yield, and the risk-free interest rate for the expected life of the option—this study finds that firms understate option value estimates and, thus, stock-based compensation expense disclosed under SFAS 123. As predicted based on incentives and opportunities for management to understate SFAS 123 expense, the understatement of option value estimates is increasing in proxies for the magnitude of the expense, is greater for firms with weaker corporate governance, and, to a lesser extent, is increasing in the excessiveness of executive pay. The findings are strongest for the expected option life and expected stock price volatility input assumptions, consistent with firms’ greater latitude in determining these inputs. We find weaker evidence of understatement associated with the expected dividend yield assumption, and none for the interest rate assumption, consistent with these inputs being less amenable to discretion. Taken together, our findings raise some concern that the exercise of management discretion adversely affects the overall reliability of SFAS 123 expense.

Executive stock-based compensation and firms’ cash payout: the role of shareholders’ tax-related payout preferences

We hypothesize that the structure of executive stock-based compensation helps to align managers’ payout choices with shareholders’ tax-related payout preferences. Specifically, stock options, which are not dividend-protected, can deter self-interested executives from using dividends as a form of payout. In contrast, restricted stock, which is dividend-protected, is more likely to induce the use of dividends. Relatedly, shareholders’ preferences for dividends, which are taxed as ordinary income, can depend on the income tax consequences of dividends relative to those of long-term capital gains. To test our hypothesis, we investigate whether the exogenous changes in shareholders’ tax-related payout preferences following the 2003 dividend tax rate reduction result in predictable shifts in executive stock-based compensation and in managers’ payout choices. Consistent with our prediction, we find a positive relation between the increased use of dividends in firms’ payouts and the increased (decreased) use of restricted stock (stock options) in executive compensation, particularly for firms with a greater percentage ownership by individual investors and with lower costs associated with modifying the structure of their compensation plans. Our investigation of the role of shareholders’ tax-related payout preferences in the design of executive stock-based compensation extends the prior literature that has largely focused on the role of incentive contracts in inducing managerial effort, risk taking, and retention.     

Shareholder Wealth Effects of the Private Securities Litigation Reform Act of 1995

This paper investigates the reaction ofstock prices to enactment of the Private Securities LitigationReform Act of 1995 (PSLRA). Based on a sample of 489 high-technologyfirms, we find that the PSLRA was wealth-increasing, on average,and that the market reaction is more positive for firms at greatestrisk of being sued in a securities class action. However, wealso show that the PSLRA was less beneficial for firms likelyto be the subject of a meritorious lawsuit. Collectively, ourevidence implies that shareholders generally benefit from restrictionson private securities litigation, although these benefits aremitigated when other mechanisms for curbing fraudulent activityare inadequate.     

Does Meeting Earnings Expectations Matter? Evidence from Analyst Forecast Revisions and Share Prices

This paper investigates whether the market rewards firms meeting current period earnings expectations, and whether any such reward reflects the implications of meeting expectations in the current period for future earnings or reflects a distinct market premium. We document that abnormal annual returns are significantly greater for firms meeting expectations, controlling for the information in the current year's earnings. We then test whether firms meeting expectations experience higher returns simply because their expected future earnings are also higher. We find firms meeting expectations have significantly higher earnings forecasts and realized earnings than firms that do not. We find that controlling for these higher future earnings, firms meeting expectations in one or two years do not receive a greater valuation than their fundamentals would suggest. We find, however, that the market assigns a higher value to firms that meet expectations consistently, controlling for an estimate of the firm's fundamental value.     

Brand Values and Capital Market Valuation

Brand value estimates are significantly positively related to prices and returns, incremental to accounting variables. Questionable brand value estimate reliability underlies lack of financial statement recognition for brands. Findings suggest estimates are relevant and sufficiently reliable to be reflected in share prices. Simultaneous equations estimation reveals inferences are unaffected by potential bias resulting from simultaneity between brand value estimates and equity market value. Brand value estimates are positively associated with advertising expense, operating margin, and market share. Yet, brand value estimates provide significant explanatory power for prices incremental to these variables, and to recognized brand assets and analysts earnings forecasts.     

Analyst Coverage and Intangible Assets

This study examines the relation between analysts' incentives to cover firms and the extent of their intangible assets. Because intangible assets typically are unrecognized and estimates of their fair values are not disclosed, absent analyst coverage firms with more intangible assets likely have less informative prices. Accordingly, we expect analysts have greater incentives to cover firms with more intangible assets and, thus, predict they have higher analyst coverage. As predicted, we find that analyst coverage is significantly greater for firms with larger research and development and advertising expenses relative to their industry, and for firms in industries with larger research and development expense. We also predict and find that analyst coverage is increasing in firm size, growth, trading volume, equity issuance, and perceived mispricing, and is decreasing in the size of the firm's analysts' brokerage houses and the effort analysts expend to follow the firm. These findings indicate that analyst coverage depends on private benefits and costs of covering a firm. We also test hypotheses related to analyst effort. We predict and find that analysts expend greater effort to follow firms with more intangible assets, after controlling for other factors associated with analyst effort. Our evidence indicates that intangible assets, most of which are not recognized in firms' financial statements, are associated with greater incentives for analysts to cover such firms, and greater costs of coverage. An open question is whether financial statement recognition of intangible assets could more efficiently provide information about such assets to investors.     

Discussion of “The Effect of Accounting Restatements on Earnings Revisions and the Estimated Cost of Capital”

The Hribar and Jenkins study (2004, this issue) investigates the effect of accounting restatements on firms' cost of equity capital. The authors document that the loss of market value associated with restatement announcements is attributable not only to a downward revision in expected future earnings but also to an increase in implied cost of capital. This finding is consistent with the conjecture that restatements lead to increased investors' uncertainty about management credibility and competence, as well as to concerns about overall earnings quality. My discussion evaluates the motivation for the research question, addresses a number of key research design issues, particularly the estimation of implied cost of capital, and offers some suggestions for future research.     

International equity valuation: the relative importance of country and industry factors versus company‐specific financial reporting information

The relative importance of country‐ and industry‐specified factors vis‐à‐vis company‐specific financial statement–based information in explaining equity valuation multiples in an international setting is examined. Both country‐specific effects via previously identified variables and an indicator variable approach are analysed. While company‐specific factors are predominant in explaining cross‐sectional differences in valuation, country and industry factors have sizable incremental explanatory power over them; the latter are not independent, so their relative importance is influenced by how we adjust for this commonality. Using country indicators provides larger incremental explanatory power than using country‐specific factors, suggesting that previously identified factors may be measured with sizeable error or omitted factors are important.     

The Impact of Securities Litigation Reform on the Disclosure of Forward-Looking Information By High Technology Firms

This study evaluates corporate voluntary disclosure of forward-looking information under the safe harbor provision of the Private Securities Litigation Reform Act of 1995. Using a sample of 523 computer hardware, computer software, and pharmaceutical firms, we find a significant increase in both the frequency of firms issuing earnings and sales forecasts and the mean number of forecasts issued following the Act's passage. To provide more direct evidence that our findings are attributable to the Act reducing firms' legal exposure, we develop a proxy for litigation risk and examine whether the increase in disclosure is more pronounced for firms at greatest risk of a lawsuit. As expected, we find that the change in disclosure is increasing in firms' ex ante risk of litigation. Finally, we report that the safe harbor had no adverse impact on the quality of forward-looking information. Forecast errors, whether directional or non-directional, were not significantly affected by the Act's passage.     

Bank earnings and regulatory capital management using available for sale securities

Based on a large sample of publicly listed and non-listed US commercial banks from 1996 to 2011, we find robust evidence consistent with banks using realized available for sale (AFS) securities gains and losses to smooth earnings and increase low regulatory capital. We also find that (i) banks with positive earnings smooth earnings, and banks with negative earnings generally take big baths; (ii) regulatory capital constrains big baths; (iii) banks with more negative earnings and more unrealized beginning-of-quarter losses (gains) take big baths (smooth earnings); and (iv) banks with low regulatory capital and more unrealized gains realize more gains. Also, banks with negative earnings take big baths (avoid or reduce the earnings loss) if their unrealized gains are insufficient (sufficient) to offset the negative earnings. Our inferences apply to listed and non-listed banks, which indicates that the earnings management incentives do not derive solely from public capital markets. Our findings reveal that the accounting for AFS securities gains and losses enables banks to manage regulatory capital and earnings in a variety of ways.