Showing papers in "Journal of Business Finance & Accounting in 2012"

Religious Social Norms and Corporate Financial Reporting

Abstract: Religion has been shown to influence economic choices and outcomes in a variety of contexts. Honesty and risk aversion are two social norms forwarded to characterize the religious. Using the level of religious adherence in the county of a US firm's headquarters as a proxy for these religious social norms, we find that higher levels of religious adherence are associated with both a lower likelihood of financial restatement and less risk that financial statements are misrepresented because of overstated (understated) revenue/assets (expenses/liabilities). We also find that accruals of managers in areas of high religious adherence exhibit smaller deviations from expectations, and deviations, when they occur, tend to improve the time series mapping of accruals into cash flows. These results hold overall and separately for both Catholic and Protestant religious adherence. Further analysis reveals that the effects of religious social norms extend beyond accrual choices. We find that firms located in areas of high religious adherence are less likely to engage in tax sheltering, and are more forthcoming with bad news in their voluntary disclosures. Collectively, our results provide new evidence on the role of religion and social norms in corporate financial reporting.

Resources or Power? Implications of Social Networks on Compensation and Firm Performance

Abstract: Using a sample of 4,278 listed UK firms, we construct a social network of directorship-interlocks that comprises 31,495 directors. We use social capital theory and techniques developed in social network analysis to measure a director's connectedness and investigate whether this connectedness is associated with their compensation level and their firms overall performance. We find connectedness is positively associated with compensation and with the firm's future performance. The results do not support the view that executive and outside directors use their connections to extract economic rents. Rather the company compensates these individuals for the resources these better connections provide to the firm.

IPO Survival in a Reputational Market

Abstract: We examine IPO survival in a ?reputational? market, the Alternative Investment Market (AIM), where principle-based regulation pivots on the role of a regulatory agent, the nominated advisor (Nomad) to the IPO company. We find that Nomad reputation has a significant impact on IPO survival. IPOs backed by reputable Nomads survive longer (by about two years) than those backed by other Nomads. We also find that survival rates of AIM IPOs are broadly comparable to those of North American IPOs. While these results are of obvious interest to various stakeholders of AIM firms, they also provide important lessons for market places modeled on AIM including the upper-tier of the U.S. over-the-counter market (OTCQX), Italy?s AIM Italia, and Japan?s Tokyo AIM.

Non‐Audit Services and Knowledge Spillovers: Evidence from New Zealand

Abstract: New Zealand provides a natural laboratory to test whether knowledge spillovers arise from auditor-provided non-audit services. Unlike prior research, we do not assume constant audit quality but first test whether audit quality varies with auditor-provided non-audit services and audit efficiency. Results show that higher non-audit fees paid to the auditor in conjunction with shorter audit lag does not reduce the quality of the audit. Results reveal a negative association between non-audit fees and audit lag, thus suggesting the presence of knowledge spillovers. However, the knowledge spillover effect is limited to the city office providing both the audit and non-audit services.

Cross-Border versus Domestic Acquisitions and the Impact on Shareholder Wealth

Abstract: We analyse the impact on targets and bidders from cross-border acquisitions into and out of the UK, in comparison to companies involved in similar domestic acquisitions. We find both targets and bidders to gain more in cross-border than in comparable domestic acquisitions, with target and bidder cross-border effects of 10.1 and 1.5 percentage points, respectively. The cross-border effect is significantly higher for targets acquired by companies from countries with superior governance systems to their own. There is weak evidence to suggest bidders gain from entering new markets but for targets to gain more where the bidder already operates in the target country.

How a Two‐Step Approach Discloses Different Determinants of Voluntary Social and Environmental Reporting

Abstract: Previous research on the determinants of voluntary social and environmental disclosure assumes that the determinants underlying the company's decision to disclose and the disclosure level are the same. This paper addresses the influence of this assumption on: (i) the operationalization of the dependent variables; (ii) the estimation method; and (iii) the subsequent empirical results, using both a sample of listed Belgian and US firms. Overall, the findings suggest that not distinguishing between the determinants underlying the decision to disclose and the disclosure level may be misleading.

Motives for Mergers and Acquisitions: Ex-Post Market Evidence from the US

Abstract: Despite extensive research, merger motivation is largely inconclusive. Incomparable methodologies further exacerbate debates in the extant literature. This study uses a recently developed technique to examine post-acquisition evidence as to the motives behind merger and acquisition activity. Using a sample of 3,520 domestic acquisitions in the United States, we find that 73% are related to market timing; 59% are related to agency motives and/or hubris; and 3% are responses to industry and economic shocks. Our results also show that about 80% of the mergers in our sample involved multiple motives. Thus, in general it is very difficult to have a clear picture of merger motivation because value-increasing and value-decreasing motives may coexist.

Has the Regulation of Pro Forma Reporting in the US Changed Investors’ Perceptions of Pro Forma Earnings Disclosures?

Abstract: We explore whether investors’ perceptions of pro forma earnings numbers have changed following the regulation of pro forma reporting imposed by the Sarbanes-Oxley Act of 2002 (SOX). First, we find that investors appear to pay more attention to pro forma earnings disclosures in the post-SOX period, consistent with the notion that they perceive that regulation generally renders these disclosures more credible. Second, the results indicate that investors discount aggressive pro forma earnings reports in both periods. However, they appear to discount at least some potentially misleading pro forma earnings disclosures more in the post-SOX period. Finally, our results imply that the regulation of pro forma reporting has increased the average quality of pro forma earnings disclosures by filtering out those that are most likely to be misleading. These results are consistent with the conclusions that (1) the quality of pro forma reporting has improved following SOX, and (2) investors’ perceptions of pro forma earnings metrics have changed in the post-SOX regulatory environment.

Differential Audit Quality, Propensity Score Matching and Rosenbaum Bounds for Confounding Variables

Abstract: Via propensity score matching (PSM) and Rosenbaum Bounds (RB), this paper reports new evidence on the premiums charged by big 4 and the top 4 mid-tier (mid 4) auditors relative to their smaller counterparts in the private corporate market. The results demonstrate that big 4 and mid 4 premiums are in accord with theoretical predictions on auditor quality differences; and that these premiums are relatively insensitive to potential hidden bias when gauged by the RB method for appraising confounding variables under bounded uncertainty. Given the limitations of conventional methods, PSM is being increasingly adopted in accounting studies to estimate treatment effects. Employing paired and simultaneous multi-sample PSM premium estimates, we provide a comprehensive evaluation and illustration of the RB method, together with the advantages and limitations of PSM, on which RB is predicated, when compared to alternative estimators. We demonstrate that PSM, when coupled with RB, provide novel empirical evidence for premiums estimated across three different matched audit quality tiers, to those estimated in prior studies which employ Heckman methods, to hidden bias equivalents and to the sensitivity of the bounds parameters to the omission of covariates employed in the study. New evidence on premiums across size quartiles, and quantile regression estimates over audit fee percentiles, support the PSM findings.

Credit rating migration risk and business cycles

Abstract: Basel III seeks to improve the financial sector’s resilience to stress scenarios which calls for a reassessment of banks’ credit risk models and, particularly, of their dependence on business cycles This paper advocates a Mixture of Markov Chains (MMC) model to account for stochastic business cycle effects in credit rating migration risk The MMC approach is more efficient and provides superior out-of-sample credit rating migration risk predictions at long horizons than a na¨?ve approach that conditions deterministically on the business cycle phase Banks using the MMC estimator would counter-cyclically increase capital by 6% during economic expansion and free up to 17% capital for lending during downturns relative to the na¨?ve estimator Thus, the MMC estimator is well aligned with the Basel III macroprudential initiative to dampen procyclicality by reducing the recession-versus-expansion gap in capital buffers

CEO Centrality and Meeting or Beating Analysts’ Earnings Forecasts

Abstract: Using a sample of S&P 500 firms over the period 2000–2005, we examine whether CEO centrality – the relative power of the CEO within the top executive team – is associated with a higher probability of meeting or barely beating financial analysts’ earnings forecasts. We argue that CEOs with relatively high centrality are able to manipulate earnings in order to meet or just beat analysts’ forecasts. Specifically, our results show that there is a positive association between CEO centrality and the likelihood of meeting or just barely beating analysts’ forecasts. This finding holds after controlling for previously identified determinants proxying for managerial incentives, and earnings-related and forecast-related attributes. Additional tests show that CEO centrality is related to managing reported earnings upwards so that earnings targets can be met. Interestingly, our results show that as an explanatory variable, CEO centrality outperforms other proxies for CEO power used in prior studies. Collectively, our results suggest that a concentration of power in the top management team with the CEO can result in undesirable financial reporting behavior.

The Impact of Earnings Predictability on Bank Loan Contracting

Abstract: This study examines how earnings predictability affects bank loan contracting. Using a sample of 8,022 US bank loan contracts, we find that firms with more predictable earnings have more favorable loan terms, such as lower interest rates, longer maturities, and fewer covenants and collateral requirements. These results are robust to alternative specifications and earnings predictability measures. Additional analyses indicate that the relation between earnings predictability and bank loan cost varies with the availability of private information about borrowers, lenders’ monitoring incentives, the competition between banks and bond investors, and firm size. Overall, this study demonstrates that earnings predictability is an important determinant in the design of bank lending contracts affecting both price and nonprice loan terms.

Market Underestimation of the Implications of R&D Increases for Future Earnings: The US Evidence

Abstract: This study shows that future abnormal returns to R&D increases are concentrated around subsequent earnings announcements. It further shows that market expectations, implied from stock prices, underestimate the future earnings benefits of increase in R&D. Finally, it documents that in their forecasts of future earnings, security analysts also underestimate the effect of increase in R&D spending. These results suggest that future abnormal returns following R&D increases are at least in part due to the market's underestimation of the earnings benefits of R&D increases. The finding in this study contributes to the longstanding debate in accounting on whether the US GAAP requirement to expense R&D costs when incurred causes investors to underestimate the benefits of R&D.

The Relationship between Borrower Risk and Loan Maturity in Small Business Lending

Abstract: We empirically test a set of hypotheses on the relation between borrower risk and loan maturity in small business lending. Analyzing data on new loan approvals and renewals made by a German bank in 2005, we find a robust, significantly positive and monotonic riskmaturity relation. This relation is more pronounced in case of loans to commercially active individuals (relative to SMEs), relatively high asymmetric information, and low borrower bargaining power. Our results are consistent with both theoretical models on adverse selection and the view that relationship lenders provide liquidity insurance to certain borrowers.

Is there really no conglomerate discount

Abstract: Recent research questions the existence of a conglomerate discount. This study addresses two of the most important explanations for the conglomerate discount and finds evidence in support of an economically and statistically significant discount. The first explanation is that the risk-reducing effect of diversification increases debt value and consequently the use of the book value of debt leads to an underestimation of firm value in diversified firms. We show that the effect of using an imputed market value of debt reduces the conglomerate discount only by a small fraction. However, consistent with the value-transfer hypothesis, we find the discount to increase in leverage and no discount for all-equity firms. An agency cost-based explanation, which reconciles these conflicting findings, is that managers in levered firms become aligned with creditors and reduce firm risk at the expense of shareholders. Hence, the diversification discount only occurs in levered firms and stems from conflicts of interest between managers and shareholders over corporate risk taking. Second, the conglomerate discount may emerge from a neglect of the endogenous nature of the diversification decision. We first show that the conglomerate discount in fact disappears when we account for endogeneity in a Heckman selection model. However, when we account for fixed effects, the conglomerate discount remains statistically and economically significant, also in a Heckman selection-model or instrumental variables framework.

Bank Lending Networks, Experience, Reputation, and Borrowing Costs: Empirical Evidence from the French Syndicated Lending Market

Abstract: We investigate the network structure of bank lending markets and evaluate the impact of lenders' network centrality, considered a measure of their experience and reputation, on borrowing costs. We show that the French market for syndicated bank loans is a ‘small world’ characterized by large local density and short social distances between lenders. Such a network structure allows for better information and resources flows between banks thus enhancing their social captial. We then show that lenders' experience and reputation play a significant role in reducing loan spreads and thus increasing borrower's wealth.

Determinants of Expected Stock Returns: Large Sample Evidence from the German Market

Abstract: This paper conducts a comprehensive asset pricing study based on a unique dataset for the German stock market. For the period 1963 to 2006 we show that value characteristics and momentum explain the cross-section of stock returns. Corresponding factor portfolios have significant premiums across various double-sorted characteristic-based test assets. In a horse race of competing asset pricing models the Fama-French 3-factor model does a poor job in explaining average stock returns. The Carhart 4-factor model performs much better, but a 4factor model containing an earnings-to-price factor instead of a size factor does even slightly better.

CEO Compensation from M&As in Australia

Abstract: We investigate Australian CEO compensation following mergers and acquisitions (M&As). We find CEOs of acquiring firms receive higher compensation in the year of M&A completion and one year after. We also find a positive correlation between CEO compensation and firm performance, and some measures of CEO effort and skill in completing the deal. However, CEOs of bidding firms receive a lower bonus and other compensation if they wield more managerial power (that is, if the CEO sits on the nominating committee, has a higher level of share ownership, or the board has more executive directors). This result is in sharp contrast to the US where compensation is influenced by CEO power. Overall our findings are more consistent with the predictions of the incentive alignment theory rather than the managerial power theory.

Executive Compensation Restrictions: Do They Restrict Firms’ Willingness to Participate in TARP?

Abstract: We examine the implications of regulatory intervention in pay-setting, by studying whether executive compensation restrictions associated with the Troubled Asset Relief Program (TARP) influence banks’ participation in the program. We find that banks more likely to be impacted by the restrictions are less likely to participate in TARP. Among banks accepting funds, we find that the likelihood of repaying before the end of 2009 is positively related to CEO incentive compensation. We find greater subsequent executive turnover and lower pay increases in banks accepting funds, consistent with concerns about talent drain. We also find that proxies for self-serving behavior are related to declining funds, suggesting pay preservation as a potential motive. Despite the motives behind declining funding, we find no evidence that the restrictions limited the objectives of TARP based on banks’ financial health or lending and may have allowed the government to allocate funds more effectively.

Firm Valuation in Venture Capital Financing Rounds: The Role of Investor Bargaining Power

Abstract: This study explores the impact of the bargaining power of venture capital (VC) firms on the valuation of their portfolio companies. VC firm types with greater bargaining power vis-a-vis the entrepreneur are expected to negotiate lower valuations compared with VC firm types with less bargaining power. Consistent with this hypothesis, university and government VC firms, which have comparatively greater bargaining power, negotiate lower valuations compared with independent VC firms. The valuations of captive VC firms equal those of independent VC firms. Our findings suggest that valuations in the VC contract reflect the relative bargaining power of the VC investor.

The Timing of Quarterly 'Pro Forma' Earnings Announcements

Abstract: While some prior studies suggest that the timing of earnings announcements may reflect management's attempt to better inform investors, other studies suggest that managers opportunistically time their earnings releases in an effort to alter investors’ perceptions of firm performance. However, there is limited empirical evidence on the relation between earnings announcement timing and the manipulation of reported earnings. We extend this research by examining the timing of quarterly earnings announcements that contain an adjusted (‘pro forma’) earnings measure and whether managers’ behavior is more consistent with opportunistic or information-related motives. We find that, on average, managers accelerate the timing of earnings announcements in quarters in which they disclose an adjusted earnings metric within the earnings press release relative to quarters in which they do not. In addition, we find that the acceleration of the earnings announcement increases with the level of managers’ exclusions of recurring expenses and their use of less transparent reconciliation formats. Consistent with managerial opportunism, we find that the recurring item exclusions used to calculate pro forma earnings in accelerated earnings announcements are of relatively lower quality and are more predictive of lower future earnings. We also find that investors fail to fully unravel the low-quality nature of the recurring item exclusions used to calculate pro forma earnings in these accelerated announcements and that this failure is attenuated by managers’ use of less transparent reconciliation formats. Taken together, our results suggest that the acceleration of pro forma earnings news is at least partially attributable to managerial opportunism.

IPO Underpricing to Retain Family Control under Concentrated Ownership: Evidence from Hong Kong

Abstract: This study examines whether family firms utilize IPO underpricing in order to retain family control as a means of avoiding outside blockholders. Using a sample of firms listed in Hong Kong where corporate ownership is concentrated, we find that larger IPO underpricing is associated with stronger family involvement, and with greater potential for diffusing ownership among family members. We further find evidence that firms with strong family involvement attract more subscription for their shares, have less concentrated outside blockholdings, and reduce ownership more slowly than do firms with weak family involvement, suggesting that family owners use underpricing to reduce outside blockholdings. We also find that firms controlled by family trusts have less IPO underpricing, suggesting that IPO underpricing and the family trust are effective substitute methods for retaining family control.

Why Firms Do Not Pay Dividends: The Canadian Experience

Abstract: We use a survey approach to investigate the factors leading to the decision not to pay cash dividends in Canada. Our results show that Canadian managers perceive growth opportunities, low profitability and cash constraints as the major reasons underlying a firm's decision not to pay dividends. Questionnaire results also show that, for non-dividend-paying firms, taxation is at best a second-order determinant of dividend policy and that stock repurchases are not substitutes for dividends. Finally, our findings are inconclusive regarding managers’ views on the relationship between dividend policy and stock prices and the signaling role of dividend policy.

Determinants of the Use of Value-based Performance Measures for Managerial Performance Evaluation

Abstract: As value-based (VB) performance measures include firms' cost of capital, they are considered more congruent than earnings measures. Prior studies, however, find that their use for managerial performance evaluation is less extensive than their presumed benefits would suggest. We examine how the importance of VB measures for evaluation varies with firms' need and managers' opportunity to manage capital costs, and find this to increase with a need for intensive asset use, delegated authority and reduced unit interdependencies. In addition, importance of intensive asset use simultaneously limits the delegation of authority, partially offsetting the increase in importance of VB measures. © 2013 Blackwell Publishing Ltd.

Abnormal Accrual Estimates and Evidence of Mispricing

Abstract: To estimate abnormal accruals, prior research employs a wide variety of models and estimation procedures. We evaluate the performance of three representative models – modified Jones model (MJ), MJ with operating cash flows (MJOCF), and MJ with return on assets (MJROA) – and two estimation procedures – industry-specific and firm-specific regressions. In evaluating the performance of various models, we use mispricing tests (i.e., relating current accruals to future returns) as our main test. We find that the best performing model is the firm-specific MJOCF model followed by the industry-specific MJROA model. However, when we use the recursive firm-specific procedure (i.e., based on current and previous years’ information only), we do not find the firm-specific MJOCF model outperforms the industry-specific MJROA model. We recommend that researchers use the industry-specific MJROA model to estimate abnormal accruals when investigating earnings management. For evaluating earnings quality that can include management estimation error, the firm-specific MJOCF remains clearly the best model from the perspective of abnormal accrual mispricing.

Why Do Firms Go Public? The Role of the Product Market

Abstract: This paper investigates the effect of product market characteristics on the decision to go public. When firms decide to go public or remain private, they trade off product market related costs and benefits. Costs arise from the loss of confidential information to competitors, e.g., in the IPO prospectus and subsequent mandated public disclosures, while benefits emerge from raising capital allowing the firm to strengthen its position in the product market. Our results show that UK firms are more likely to go public when they operate in a more profitable industry and in an industry with lower barriers to entry. These firms are more likely to go public in order to improve their position in the product market and to deter new entrants into the industry. However, firms from more competitive industries and firms with smaller market share are less likely to go public. For these firms the loss of confidential information to rivals outweighs the benefits of going public.

On the Anomalous Stock Price Response to Management Earnings Forecasts

Abstract: This paper examines stock price formation subsequent to management forecasts of quarterly earnings. In the post-announcement period, we find a significant upward price drift for both good news forecasts and bad news forecasts. Combined with the asymmetry in the initial market response, the upward post-guidance drift in stock prices is consistent with a reversal of an initial overreaction to managers’ bad news forecasts and a continuation of an initial underreaction to managers’ good news forecasts. This interpretation is supported by a negative (positive) relationship between the initial market response and the post-guidance drift in the bad news (good news) group. The drift pattern is robust to issues arising from measurement. Trading strategies exploiting the post-announcement drift suggest the existence of economically significant trading profits, net of estimated trading costs.

Do Compensation Committees Pay Attention to Section 404 Opinions of the Sarbanes‐Oxley Act?

Abstract: This study examines whether compensation committees adjust CEO/CFO compensation using the auditor opinions on internal control effectiveness (SOX 404 opinions), and whether the emphasis on internal controls depends on the level of compensation committees’ financial expertise. Following SOX 404, a firm's CEO and CFO are required to evaluate the effectiveness of internal controls over financial reporting, subject to the auditor's attestation. In light of recent accounting fraud, we expect and find that compensation committees adjust CEO/CFO compensation by reference to the SOX 404 opinions. Using different measures of financial expertise, we also find that the relationship is more pronounced in firms with higher levels of financial expertise. Our results suggest the importance of including directors with financial expertise on compensation committees.

Which Competitive Efforts Lead to Future Abnormal Economic Rents? Using Accounting Ratios to Assess Competitive Advantage

Abstract: Strategy theory suggests that firms can impede mean reversion of economic rents by employing competitive efforts, thereby impacting profitability, forecasting, and valuation. We use realized operating performance to establish which competitive effort proxies effectively protect rents. The inclusion of competitive advantage proxies improves future accounting return forecasts and several efforts generalize across industries including power over suppliers and the credible threat of expected retaliation (Porter, 1980). Traditional barriers-to-entry proxies (product differentiation, innovation, and capital requirements) do not result in higher profitability once risk- and industry-adjusted. Finally, competitive efforts are not fully impounded into stock price, resulting in abnormal future returns.

Accounting Discretion and Fair Value Reporting: A Study of US Banks’ Fair Value Reporting of Mortgage‐Backed‐Securities

Abstract: This study looks at US banks’ fair value reporting of mortgage-backed-securities (MBS) before and after a new accounting rule, FSP 157–3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active, initially issued by the US Financial Accounting Standard Board (FASB) and later adopted by the International Accounting Standard Board (IASB) into IFRS No. 13 Fair Value Measurement. FSP 157–3 allows for additional accounting discretion in fair value reporting when the market for a financial asset is inactive and significant adjustment needs to be exercised in estimating fair value. By evaluating MBS’ fair value reporting against observable economic factors, firm-specific reporting incentives, and the reporting entity's mortgage-banking activities, this study makes inference on the relationship between accounting discretion exercised under FSP 157–3 and any unobservable, private information conveyed in the MBS’ fair value reporting. Empirical results indicate that additional accounting discretion has been exercised in MBS’ fair value reporting under FSP 157–3. While MBS’ fair value reporting is less associated with economic factors and firm-specific characters under the new rule, it is reflective of the reporting entity's mortgage-banking activities.