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The study examines whether consolidating qualified special-purpose entities (QSPEs) under Statement of Financial Accounting Standards Nos. 166 and 167 (FAS 166/167) improves the market reaction to earnings disclosures. We use a difference-in-difference design to compare the change sample, which is defined as banks that consolidate QSPEs after FAS 166/167, with the no-effect sample, which is defined as financial institutions with no QSPEs or banks that do not consolidate QSPEs after FAS 166/167. The results show that, during a short window around earnings announcements, the change sample experiences higher market reaction to earnings surprises than the no-effect sample after the implementation of FAS 166/167. We also find that the effect is more pronounced in banks that engage in securitization and in financial institutions whose securitized loans originate primarily from consumer loans rather than mortgages. Additional analysis also finds that adopting FAS 166/167 enhances the ability of earnings to predict future earnings and future cash flows in banks. The important implication of the study for regulators is that FAS 166/167 improves bank transparency. [ABSTRACT FROM AUTHOR]

The Current Expected Credit Loss (CECL) Financial Accounting Standards Board (FASB) standard that goes into effect for major banks in 2020 contains a serious conceptual error. Using the contractual rate rather than the hurdle rate (the competitive rate on a loan for which there is no expected loss) as the rate to discount expected cash collections gives rise to accounting losses where no economic losses exist. This can have a profound effect on required capital and hence lending, especially in economically depressed episodes. [ABSTRACT FROM AUTHOR]

This article examines the use of annual earnings guidance as a mechanism used by managers to reduce the volatility of analyst earnings forecasts and allow them to report smooth earnings without missing quarterly analyst forecasts. Facing the pressure to meet or beat analyst forecasts and driven by the perceived capital market benefits of reporting a smooth earnings path, managers attempting to influence investors' earnings expectations over a longer horizon can issue annual guidance to smooth the time-series path of analyst forecasts, a strategy we term as "expectation smoothing." Our empirical results suggest that annual guidance reduces the volatility of analysts' multi-period forecasts, which in turn contributes to a smoother actual earnings and higher likelihood of meeting analysts' quarterly forecasts. We also find that issuing quarterly guidance does not affect the smoothness of analysts' earnings expectations and that managers with longer horizons are more likely to issue annual guidance, consistent with the unique long-term effects of annual earnings guidance. [ABSTRACT FROM AUTHOR]

In a recent paper, Hui, Matsunaga, and Morse have argued that managers may prefer using accounting conservatism instead of issuing management earnings forecasts (MFs) that may reduce information asymmetry and may lower firms' potential legal liability. We argue in this article that accounting conservatism serves as a substitute only for informative forecasts, which are classified as cost of capital (COC) MFs, and it does not serve as a substitute for opportunistic (OPP) MFs and disclose or abstain (DOA) MFs that are required under 1933 Securities Exchange Act because both these types of MFs are used to achieve different objectives. Our findings confirm our claim that conservatism serves as a substitute for informative MFs only. [ABSTRACT FROM AUTHOR]

The most prevalent forecasts of firms' long-term earnings issued by analysts are 2-yearahead earnings per share (EPS) estimates. When introduced by analysts, 2-year-ahead EPS estimates set market expectations for firms' future earnings. Subsequent revisions to these estimates are highly correlated with contemporaneous changes in stock prices. We examine whether such revisions are sufficiently predictable to enable investors to earn abnormal returns on hedged portfolios. We find that analyst forecast revisions are predictable and document an implementable strategy for investors. Consistent with investors' fixation on unscaled EPS, the strategy earns positive abnormal returns using unscaled EPS revisions but not when revisions are scaled by the level of the EPS estimate or the stock price. Abnormal returns are found for firms with low analyst coverage, consistent with a greater initial mispricing from analyst optimism for firms with poorer information environments. [ABSTRACT FROM AUTHOR]

The vast majority of reports written by sell-side equity analysts conclude with a reiteration of the analyst’s existing recommendation on a firm’s stock. Yet there is a disproportionate amount of research that focuses on the market reactions of changes in recommendations and a prevailing sense that reiterations do not matter. In this article, we test the hypothesis that reiterations of recommendations serve to resolve information uncertainty since the original recommendation was published and that they give rise to market reactions in the direction of the original recommendation, which we call a confirmation effect. Using a sample of analyst reports that do not contain any changes in recommendations, earnings forecasts, or price targets, we focus solely on reiterations and show that they are associated with proxies for information content, reductions in information uncertainty, and return reactions consistent with a confirmation effect. [ABSTRACT FROM AUTHOR]

This study investigates the role of Chinese auditors in preventing aggressive management financial reporting. We conduct two experiments to investigate auditors’ behaviors. The first experiment examines auditors’ awareness of earnings management (EM) attempts induced by the delisting rule. One hundred seventy-four Chinese auditors participated in the study. The evidence shows that auditors believe the use of the classification of investment transactions to avoid losses is appropriate. The second experiment investigates whether the bond (Guanxi) between managers and auditors may have contributed to auditors’ reluctance to mitigate delisting-motivated EM and whether increased regulatory enforcement may moderate this behavior. We find that Guanxi undermines auditors’ ability to correct EM. Specifically, when auditors have close bond (Guanxi) with managers, they are less likely to recommend adjustments; however, we find that increased penalty has a positive effect on auditors’ performance, as harsh penalties/sanctions enhance their willingness to challenge managers’ decisions. [ABSTRACT FROM AUTHOR]

In this article, the authors revisit the role of the cash and accrual components of accounting earnings in predicting future cash flows using out-of-sample predictions and market value of equity as a proxy for all future cash flows. They find that, on average, accruals improve upon current cash flow from operations (CFO) in predicting future cash flows. In the cross-section, accruals’ contribution is positively associated with proxies for quality of accruals and governance. Next, the authors investigate the implications of accruals’ predictive value for accrual-based market anomalies. They find that portfolios formed on stock return predictions using information from current CFO and accruals yield significantly positive returns on average, as opposed to CFO alone. They also find that Sloan’s accrual anomaly is related to our accrual contribution anomaly. Indeed, when accruals’ contribution to future cash flow prediction is the highest, the accrual anomaly vanishes. Collectively, the results suggest that the predictive value of accruals and market participants’ ability to process it are a significant driver of accrual-based anomalies. [ABSTRACT FROM PUBLISHER]

The framers of the Sarbanes–Oxley Act (SOX) presume that nonaudit services (NASs) lower the quality of financial statements, so they have prohibited auditors from offering most NASs. In addition, regulators believe that NASs may cause the auditor to be perceived as “dependent” in appearance, thus increasing information risk, even if they have no impact on the quality of financial statements. The authors investigate two hypotheses using pre-SOX data. First, they ask whether the proportion of NASs fees to total fees has a positive or negative association with the ability of financial statements to predict a firm’s future cash flows, which can be considered a measure of the quality of the statements. Second, they ask whether the proportion has a negative or positive association with the cost of capital (COC) and the bid/ask spread, controlling for the predictability. The COC and the bid/ask spread serve as proxies for information risk. Contrary to the proponents of prohibiting NAS, the authors find that the proportion of NASs fees to total fees has a positive association with predictability. Controlling for the quality of financial statements, NASs still have a negative association with the COC and the bid/ask spread as proxies for information risk. These findings suggest that NASs improve the quality of financial statements and reduce information risk. [ABSTRACT FROM PUBLISHER]

On December 16, 2004, the Financial Accounting Standards Board published FASB Statement No. 123 (revised 2004), which significantly changes the accounting for employee stock options. Under the new standard, equity-based compensation results in a cost to the issuing enterprise and should be measured at its fair value on the grant date, based on the estimated number of awards that are expected to vest. I contend that expensing stock or option grants is not responsive to either the needs of a corporation's creditors, or to the needs of equity investors since the cost of the share-based payments is borne only by the preexisting shareholders; the corporation itself suffers no sacrifice in assets or other resources (unless its own shares are considered an asset, which is not the case under the present Conceptual Framework and Generally Accepted Accounting Practices [GAAP]). Hence, I suggest the use of three separate statements instead of the single income statement now provided. Specifically, I propose that the first statement— the ''Corporation Income Statement''—not include share-based payments as an expense. Rather, a ''Statement of Costs and Benefits to Pre-existing Shareholders'' would show the dilution cost to the pre-existing shareholders; this dilution cost would be determined as the amounts that, if accrued during each year throughout the vesting period and until exercise, would cumulatively sum to the intrinsic value at exercise (the price of the optioned share minus the exercise price). A combined ''Statement of Enterprise Income'' would then show the totals of the amounts reported in the other two statements. The combined statement would reflect the net income from operations with regard to both the corporation and its preexisting shareholders; that is, it would reflect the cost of manufacturing products or rendering services. This paper discusses the implications of this proposal for the debate on the distinctions between liabilities and equities and for the treatment of inseparable compound securities such as convertible bonds. [ABSTRACT FROM AUTHOR]

This paper presents a proposal for reform of the public auditor-client relationship. We suggest the creation of incentives to permit public auditors to form, as an optional matter, audit risk insurers (ARIs) to assume the risk of a deficient public audit. We discuss the following in turn: (1) the need for this radical structural change, (2) why the change will produce benefits justifying the cost and dislocation resulting from implementing it, (3) how it will work, (4) the incentives necessary to bring it about, including limitations on liability, (5) the need for a transition period, and (6) the resulting benefit to not only the audit process but also the promotion of efficiency in the securities markets. An increasingly complex financial world demands better and more transparent signaling to investors. In our view, the ARI, powered by its risk assumption attributes, will function as a more efficient intermediary for transmitting financial information to investors. [ABSTRACT FROM AUTHOR]

In the aftermath of one of the worst financial and accounting scandals, the SEC and other regulatory bodies have initiated a flurry of reforms designed to improve corporate governance and to hopefully deter future abuses. The Sarbanes-Oxley Act of 2002 (SOA) has imposed harsher penalties on errant directors and officers and significantly enhanced the role and responsibility of audit committees and independent directors. But the suggested reforms so far have failed to address the major problem that still besets corporate America today. Namely, the agency costs of managing corporations: CEOs, CFOs, and other directors and officers serve their entrenched-insular interest to the detriment of shareholders. In this article, we intend to survey the landscape of the recent suggested reforms, especially as they relate to accounting and audit failures, and evaluate their effectiveness in terms of their ability to alleviate the agency cost of conducting business. We will also offer a proposed reform which we believe can be an effective deterrent to financial and auditing failures. [ABSTRACT FROM AUTHOR]

We study analytically the effect of preliminary voluntary disclosure and preemptive preannouncement on the slope of the regression of returns on earnings surprise—the earnings response coefficient (ERC). When firms do not manage earnings, additional disclosure has no effect, and the ERC is proportional to price/permanent earnings ratio. If they manage earnings by attempting to inflate them, the response to (100% credible) negative earnings surprise is stronger than the response to (less than 100% credible) positive surprise. To avert litigation, firms that manage earnings adopt a partial voluntary disclosure strategy—either public revelation of good news and withholding bad news, or public revelation of bad news and withholding good news. Voluntary disclosure affects ERC on positive earnings surprise only, depending on what the firm reveals: the good news revealing ERC (GRC) is higher than the bad-news revealing ERC (BRC), because good news enhances the credibility of the positive earnings surprise, even though the market discounts good news. Furthermore, preemptive pre-announcements improve ERC accuracy by narrowing the scope of earnings management. [ABSTRACT FROM AUTHOR]

A model is developed to study managerial strategies vis-à-vis choice of accounting alternatives and earnings reports where the manager is better informed than the market about firm prospects. How corporate taxation affects these strategies is a focal aspect of this study. In the information equilibrium identified, managers of firms with higher future cash flows choose income-increasing accounting alternatives and report higher earnings in spite of the potential corporate tax consequences. The optimal earnings reports are shown to involve some intertemporal smoothing. The announcement effects and the comparative statics properties derived provide a rich menu of testable implications. [ABSTRACT FROM AUTHOR]

This paper investigates the time-series properties and adjustment processes of a group of financial ratios for the purpose of finding accurate forecasting models. The ratios selected represent profitability, liquidity, cash position, turnover, and capital structure. Our investigation of financial ratios included two deflated earning measures that have been the subject of considerable research. These are the return on assets and return on owner's equity ratios. Past research has focused on describing the movement of the income series over time, primarily to develop earnings forecasting accuracy, and hence equity pricing. Methods were sought to identify and disentangle the permanent and transitory components of income in an effort to improve forecasting accuracy, and hence equity pricing. To achieve this, researchers used models such as ARIMA, which removed a portion of transitory error from past earnings changes.

This study examines information disclosures about non-announcing firms' following the earnings release by another firm in the same industry. It provides indirect evidence (through stock price changes) that the information disclosed about non-announcing firms is significant only when announcing firms convey bad news through their earnings releases and when non-announcing firms are large. This finding provides support to Verrecchia's (1983) theory which predicts that in the presence of disclosure related costs, full revelation of managers' private information (as shown in the Grossman [1981]-Milgrom [1981] world) does not obtain. Instead, managers use discretion in disclosing their private information. [ABSTRACT FROM AUTHOR]

In this paper, we provide a theory that links optimal contracting with structures of information, such as measures of profit and productivity, which in turn, are determined by the nature of the underlying technologies that a firm employs. The general thesis of this paper is that the nature of the business venture contemplated gives rise simultaneously to an optimal information structure and optimal financial contracts that are paired with the information structure chosen. An information structure refers here to a specification of who has what information and when. Thus, it specifies the kind of information available to that could be acquires or discovered, the locus of information, that is, whether it is private information to some agents or common knowledge, and the temporal sequence of information discovery and transmission. A brief discussion of related works is presented in the second section of this paper. Following that is an illustration of the arguments cited. Section three lays down the framework in which stylized cases are analyzed. Analysis of individual cases is presented in section 4 and section 5 generalizes the notation to integrate the cases analyzed within a more encompassing model.

Introduces a series of articles regarding the off-balance sheet activities of banks.

This article documents the history of the creation of finance subsidiaries and the incidence of relatively high debt-equity ratios for companies that have created subsidiaries. The creation of finance subsidiaries has become an important business strategy of many nonfinancial companies. Capital funds of finance subsidiaries have grown by 35 percent during the past three years. Wholly owned finance subsidiaries have been used to provide a wide array of financial services to their parents' customers and dealers. Some subsidiaries are captives in that at least 70 percent of their operations are dedicated to financing parent sales to customers and dealers. Other finance subsidiaries have developed into major financial intermediaries providing financial services beyond the requirements of their parents' manufacturing or retailing activities. They may finance the sales of other companies, engage in substantial leasing activities, and provide venture capital and leveraged buyout financing. Along with the increase in finance subsidiaries, there was also a substantial increase in borrowing levels of the consolidated units that include finance subsidiaries relative to nonfinancial companies that have not created such subsidiaries.

This article comments on an article on the Financial Accounting Standards Board's (FASB) conceptual framework for accounting and auditing. In the authors' view, the conceptual framework got off to a good start with the first concepts Statement about the objectives of financial reporting after a great deal of effort, research, and time. After initially not accepting the Trueblood report, but insisting on their own study to formulate objectives, the FASB subsequently enunciated objectives consistent with the Trueblood objectives. This provides a confirmation of the validity of the objectives and a testimony to the open-mindedness of the Board. Without restating either set of objectives, it is fair to say that the fundamental and basic objective of financial reporting can be summed up to be to present information useful in assessing the amount, timing, and uncertainty associated with the cash flows of the firm, because such information in turn is through to be useful in assessing the amount, timing, and related uncertainty of the cash flows to investors and creditors. Concepts Statement 2 advances certain qualitative characteristics that accounting information ought to have to further the objectives of Concepts Statement 1.

The article investigates the impact of the expansion of the legal liability of accountants in the U.S. on the practice of accounting and the market for auditing services. Auditors are assumed to face two risks: the risk of suits brought by investors who experience losses when an auditor fails to qualify an opinion and the risk of lost business and client suits when an auditor issues an unnecessary qualification. An increasing amount of class action litigation by disgruntled shareholders and bondholders has only served to exacerbate the situation. Whatever the rationale for limiting the protection that privity affords accountants, it remains to be seen how recent changes in liability rules will affect accountants, their clients, audit fees, and general auditing quality. A mathematical model was presented which depicts the expansion in liability implied by a shift from privity into the foreseeable as an increase in penalty faced by an auditor who provides an unjustified clean opinion. Some have argued that third-party liability is unnecessary for accountants since private contracting and the treat of reputation loss can yield proper amounts of professional care and an optimal degree of negligence.

This article focuses on the changes in the Journal of Accounting, Auditing & Finance under new editorship as of January 1987. The journal will pursue a new path toward its original objective, meshing the resources of academic research and the needs of practicing accountants. Practitioners and academics have long grappled with what many refer to as a communication gap. Essentially, practitioners could not relate to research published in academic journals, not necessarily because the research is not relevant to the real world but simply because academics write is a language that is distinct from the language of accounting and finance. Furthermore, economic forces led to the emergence of two separate languages for the two publics. As accounting and finance practitioners deal with the real world, complexities of circumstances and parallel ambiguity make the language of business more appropriate than the language of academe. Hence, the communication gap emerges is consistent with the efficient production of academic thought and the efficient production of professional ideas. Attempts to bridge this communication gap by having academics create research output that can be describe in the language of business or inducing practitioners to engage in academic research that could be reported by using the language of business were doomed to failure.

The article analyzes the biases inherent in the adjustment of income figures to reflect changing prices. Current cost-information is valuable to financial officers and accountants of every business enterprise. The assessment of future cash flows aids companies in managing its affairs and in projecting its performance. The U.S. Financial Accounting Standards Board is encouraging companies to adopt its standards and adhere to its current-cost requirements.

Smoothing of income has long been regarded as a device that managements use to "manipulate" financial statements to further their own interests. This article proposes that income smoothing may not be as evil as one might think. Specifically, it is argued that the smoothing of income could enhance the ability of external users to predict future income numbers. [ABSTRACT FROM AUTHOR]

This article presents a critique of the methods of using index numbers found in proposals for both general price-level accounting and replacement cost accounting. Presumably, the purpose of general price-level adjustments is to obtain a measure of the degree to which the investor's command over goods and services derived from the firm's earnings has changed over time. Price and quantity indices computation is based on two underlying concepts. Under the first concept, changes in levels of price or quantity are monitored relative to a fixed set of quantities or prices, respectively, applicable to a past base period--this is the Laspeyres formula. Under the second concept, the Paasche formula, changes in prices or quantity are monitored relative to the set of quantities or prices, respectively, applicable to the current period. The Laspeyres and Paasche indices are generally used to approximate indices of real consumption and indices of real production that are of interest to economists, as well as to others who wish to interpret financial statements. The consumption constant utility index can be approximated by either the Laspeyres or the Paasche price index, but only with a bias. The index of real consumption is overestimated by the Laspeyres quantity index and underestimated by the Paasche quantity index.

The SEC now requires substantially increased disclosure of quarterly financial data as well as summarized quarterly operating data in a footnote to the financial statements filed with the SEC. The inclusion of this interim data in the footnotes to annual financial statements links the public accountant with this data. The SEC has justified the regulation by a statement that the benefit of audit involvement will outweigh the costs. This article questions that conclusion, and addresses itself to an empirical investigation of some aspects of the benefits of audit involvement in interim reporting, and outlines a general methodology that can be utilized to test—from a cost-benefit point of view—the desirability and the degree of audit involvement in all areas of financial reporting. [ABSTRACT FROM AUTHOR]

This section introduces a series of articles on U.S. tax policy.