Showing papers in "Review of Accounting and Finance in 2003"

Economic Properties of the Risk Sensitive Criterion for Portfolio Management

Abstract: The idea of using stochastic control methods for theoretical studies of portfolio management has long been standard, with maximum expected utility criteria commonly being used. But in recent years a new kind of criterion, the risk sensitive criterion, has emerged from the control theory literature and been applied to portfolio management. This paper studies various economic properties of this criterion for portfolio management, thereby providing justification for its theoretical and practical use. In particular, it is shown that the risk sensitive criterion amounts to maximizing a portfolio's risk adjusted growth rate. In other words, it is essentially the same as what is commonly done in practice: find the best trade‐off between a portfolio's average return and its average volatility.

The impact of firm‐specific attributes on the relevance in earnings and cash‐flows : a nonlinear relationship between stock returns and accounting numbers

Abstract: The role of accounting information in setting security prices is one of the most fundamental issues in accounting and finance. The purpose of this study is to extend the research on the value relevance of accounting numbers in three important directions. Firstly, we consider the French context and analyze if earnings and/or cash flows are relevant to explain stock returns. Secondly, we test whether the explanatory power of accounting variables can be improved by using a nonlinear specification. Thirdly, we investigate how firm‐specific attributes such as size, debt level and firm life‐cycle influence the relative relevance of accounting measures (earnings and cash flows). Our results support a nonlinear relationship between stock returns and accounting variables. They indicate also that the relevance of earnings is conditional on size, debt level and life cycle of the firm. In contrast, the earnings change reveals more information when the firms are large, mature or characterized by a low degree of debt. These results are consistent with difference in earnings persistence between firms. With regards to cash flows, we find that they do not reveal additional information beyond that contained in earnings.

What Do Analysts' Stock Recommendations Really Mean?

Abstract: This paper provides evidence that will help stock market participants interpret sell‐side analyst buy/sell recommendations. We examine whether recommendation levels (e.g. buy) correspond with traditional predictors of the underlying stock's performance, and whether recommendation revisions (e.g. an upgrade) are consistent with news analysts receive. Consistent with theory, we find that more optimistic recommendations are associated with higher mean forecast errors, forecast revisions, and forecasted earnings‐to‐price ratios. However, contrary to expectations, they also have higher market‐to‐book ratios, higher market values, and lower ratios of value to price (Lee et al. 1999). These results are probably driven by specific differences between buys and the less optimistic recommendations, as holds and sells are rarely distinguishable from each other. Our recommendation revision findings are consistent with our expectations. Upgrades have significantly larger earnings forecast errors, earnings forecast revisions, and unexpected earnings growth than do reiterations or downgrades.

The Effect of Institutional Ownership on Board and Audit Committee Composition

Abstract: We investigate the relationship between institutional shareholdings and the firm's corporate governance by looking at changes in the composition of the board of directors and audit committee while institutional ownership increases over time. Our comparison of 74 firms showing increased institutional ownership with a matched control group of 62 firms finds that increased institutional ownership is positively associated with a higher proportion of outsiders on the board and with audit committee and board members who are less entrenched. These factors are widely regarded as signs of a strengthened system of corporate governance and control, underscoring the important role that institutional ownership may play in the firm's corporate governance structure.

A Capital Asset Pricing Model with Variable Asset Supply

Abstract: The assumption of variable asset supply is incorporated into the standard capital asset pricing model because of consistent and strong empirical results showing that equity is issued when share prices are high. The results of the model show that the “beta” of the asset is influenced by both its demand and supply functions. Available empirical evidence suggests that the supply of corporate equity, over a time period of a year, is inelastic and that demand is elastic. More empirical research is needed.

Accounting Research in the German Language Area—First Half of the 20th Century

Abstract: After some introductory words about the preeminence of German accounting research during the first half of the 20th century, the paper offers a survey of the most important theories of accounts classes that still prevailed during the first two decades or longer. Following World War I, the issue of hyperinflation in Austria and Germany stimulated a considerable amount of original accounting research. After the inflationary period, a series of competing Bilanztheorien, discussed in the text, dominated the scene. Two figures emerged supremely from this struggle. The first was Eugen Schmalenbach, with his “dynamic accounting”, a series of further important contributions to inflation accounting, to the master chart of accounts, to cost accounting, and to other areas of business economics. The other scholar was Fritz Schmidt, with his organic accounting theory that promoted replacement values and his emphasis on the profit and loss account, no less than the balance sheet. The gamut of further eminent personalities, listed in chronological order, contains the following names: Schar, Penndorf, Leitner, Gomberg, Nicklisch, Rieger, Prion, Osbahr, Passow, Dorfel, Sganzini, Walb, Calmes, Kalveram, Meithner, Lion, Tondury, Mahlberg, le Coutre, Geldmacher, Max Lehmann, Leopold Mayer, Karl Seidel, Alfred Isaac, Mellerowicz, Seyffert, Beste, Gutenberg, Kafer, Seischab, Kosiol, Munstermann, and others. Separate Sections or Sub‐Sections are devoted to charts and master charts of accounts in German accounting theory, as well as to cost accounting and the writing of accounting history.

Accounting research in the French language area – second half of the 20th century

Abstract: This paper offers a general survey of accounting literature in the French language area of the first half of the 20th century: After a general Introduction, referring mainly to renowned French authors of past centuries, it deals first with historical accounting research (Dupont, de Roover, Gomberg, Vlaemminck, etc). Then come publications in financial accounting theory and its application (Faure, Dumarchey, Delaporte, Penglaou, de Fages de Latour, etc.), followed by a section on cost accounting and managerial control (Julhiet, de Fage de Latour, Detoeuf, Satet, Bournisien, Brunei, Sauvegrai, etc.). Alarger Section is devoted to inflationary problems (Delavelle, Raffegeau and Lacout, Bayard, Leger, Faure, Thomas, Bisson, Dumarchey, Durand, Beaupere, Ratier, etc.). Another large section refers to charts of accounts and public supervision (Otlet, Faure, Blairon, Detoeuf, Caujolle, Fourastie, Gabriel, Chardonnet, Gamier, etc.). The paper closes with a concise general conclusion about this period of transition from a mainly traditional agricultural to an industrial society with its costing problems, its organizational control, and its greater service orientation.

A Canonical Correlation Analysis of CEO Compensation and Corporate Performance in the Service Industry

Abstract: This paper attempts to examine a canonical (simultaneous) relationship between service industry CEOs' compensation and corporate performance with respect to accounting‐based and market‐based performance measures. In addition, this study examines the effect of firm size on compensation. The results of this study suggest that executive compensation depends simultaneously on both market‐based and accounting‐based performance measures. EPS, ROA, ROE and Market Rate of Return are positively associated with both cash compensation and long‐term compensation. Firm size is also positively related to the long‐term compensation.

Anticipatory Income Smoothing and the Investment Opportunity Set: An Empirical Test of the Fudenberg and Tirole (1995) Model

Abstract: Fudenberg and Tirole (1995) argue that concern about job security creates an incentive for managers to smooth earnings. Consistent with their model, Defond and Park (1997) show that managers smooth earnings in consideration of both current and future relative performance. To provide a more direct evidence of anticipating smoothing and job security, we hypothesize that the extent of income smoothing will vary with managers' job security concerns as proxied by the level of the investment opportunity set or growth opportunities. Our results confirmed our predictions.

On the Relationship between Earnings, Cash Flows and Returns: An Australian Postscript to Lev and Zarowin (1999)

Abstract: In a recent US study, Lev and Zarowin (1999) documented a steady decline in the value relevance of financial statements over a twenty year period. They attribute this decline, in part, to the inadequate financial reporting of intangibles, and particularly US accounting requirements for the immediate expensing of these items. In contrast to US accounting standards, capitalization of R&D expenditure is permitted in Australia under Approved Australian Accounting Standard AASB 1011 “Accounting for Research and Development Costs.” As expected, the capitalization of intangibles was found to be significantly higher in the new economy sector, with an increasing trend towards capitalization over the past five years. The results are broadly consistent with the US study. However, while not unequivocal, the results also suggest that the earnings‐return relationship was steadier, and the cash flow‐return relationship stronger overall in the new economy sector, indicating some tentative support for proponents of capitalization.

Corporate Disclosure Quality and Corporate Reputation

Abstract: The paper investigates the link between a firm's overall disclosure quality and its corpoate reputation. The results show that the measure of corporate reputation is positively related to the disclosure measure, after controlling for market and accounting signals indicating the size of assets, market assessment of the value of the assets in place and rate of return on assets.

The Relative Value of Non‐U.S.‐Based Annual Reports and Accounts: A Price and Trading Volume Analysis

Abstract: This paper reports the results of the effects of the release, in the United Kingdom, annual reports and accounts (ARA), on security prices and trading volume of the U.K. firms. If the information reported in the annual reports and accounts (ARA) is relevant, the U.S. security market will respond to the release news through return and volume variances. Both signals are indicators of the relevance of the annual reports and accounts. The results of the analysis suggest the existence of unexpected returns to the annual reports and accounts and no corresponding U.S. trading volume response. The price results are in marked contrast to the findings of previous research that examined the information content of U.S. domestic annual reports, but do not detect a stock price response (e.g., Foster et al. 1986; Bernard and Stober 1989; Cready and Mynatt 1991). Our stock price analyses indicate that non‐U.S. GAAP accounting measures do not impede U.S investors' ability to use U.K. firms' ARA in valuing the sample firms. Indeed, U.S. investors use information from the ARA in their valuation of U.K. firms. Since trading responses to a disclosure are generally more easily detected than price responses (Cready and Hurtt 1999), these findings jointly suggest the provincial nature of the ARA release.

An Analysis of the Association Between Firm Risk, Executive Share Options and Accounting Performance: Some Australian Evidence

Abstract: This paper examines whether the financial performance of the firm is associated with the risk‐taking propensity of executives, which is inferred from the structure of their share option portfolio. The objective of this paper is to determine if executives have greater risk bearing preferences when they have more share options than shares in their firm. In turn, executives' risk‐taking preferences suggest that these decision‐makers adopt value‐increasing strategies. The results of this study support this notion. The results of the study of 182 Australian firms demonstrate that the negative relationship between firm risk and firm performance is weaker when executives hold a higher proportion of share options than shares in their investment in the firm. These results hold implications for executives' compensation contracts. That is, executives who share in their firms' risk via share options are more likely to undertake risky activities with high‐expected performance outcome.

The Functional Relationships Among Earnings, Cash Flows and Stock Returns in Korea

Abstract: This paper investigates the functional relationships between stock returns and two representative performance measures. The two measures are earnings and cash from operations. In addition, this paper assesses the association of stock returns with the decomposed components of earnings. Our study documents that earnings dominate cash from operations in terms of the relationships with the stock returns. When the stock returns are regressed on the decomposed components of earnings, cash from operations consistently shows strong positive relationships with stock returns. The efficient capital market hypothesis posits that changes in reported earnings without cash flow implications should not affect stock prices. However, our regression results indicate that non‐current accruals have strong relationships with the stock returns even though they lack cash flow implications. Perhaps this may imply that cosmetic earnings increases might be rewarded with increases in stock prices.

Incremental Value‐Relevance of SFAS 106

Abstract: This study investigates the incremental value‐relevance of non‐pension postretirement benefit obligations and expenses (disclosed by firms pursuant to SFAS 106). Our study is motivated by previously published evidences that investors value the SFAS 106 measure of postretirement benefit obligations. However, prior research does not address incremental value‐relevance of the SFAS 106. We address two related questions. First, “do the SFAS 106 measures of non‐pension postretirement benefit obligations and expenses provide incremental value relevance (after controlling for information available from non‐SFAS 106 sources).” Second, “under what circumstances are the SFAS‐106 measures more likely to provide incremental value relevance.” The key findings of this paper are: (i) on average, SFAS 106 measures of postretirement benefit obligations and expenses have no significant incremental value‐relevance after controlling for non‐SFAS 106 information; and (ii) labor intensity and the magnitude of postretirement benefit obligation increases the incremental value‐relevance of SFAS 106 measures.

Market Effects, Size Contingency and Financial Ratios

Abstract: This study presents theoretical and empirical analyses to suggest a previously‐unknown size‐related contingency in the relationship between market variables and various commonly‐used financial ratios, including Net Income/Total Assets, Current Assets/Sales, Current Assets/Current Liabilities, Current Assets/Total Assets, Cash/Total Assets, Long‐Term Debt/Total Assets, Accounts Receivable/Sales. The size contingency in this relationship is shown to be due to the cross‐sectional variability of the ratios themselves. Moreover, simply adding a size dummy to the model will not correct for the problem. Empirical results show that the effect is very strong and subjects to severe misinterpretation any study that uses financial ratios on the right‐hand‐side of a linear model.

Feltham — Ohlson Framework: The Implication of Corporate Tax

Abstract: In this paper, I provide an empirical work in order to test the tax‐adjusted market valuation (residual income) model. Feltham‐Ohlson's (1995) residual income model can be extended by adding corporate tax: firm market value is a function of the bottom line after‐tax accounting data, e.g., book value and after‐tax earnings. Under this tax‐adjusted framework, certain issues are examined: the information from the firm's operating activities is not enough to measure the firm's market value; financial activities also affect firm market value. In particular, abnormal financial earnings are not equal to zero, due to the tax deduction on interest expenses. An empirical analysis, using the financial reporting data of Canadian firms for the years 1994–1999, demonstrates that the current book value of financial assets and operating assets, abnormal operating earnings, and abnormal financial earnings are all relevant to firm market value. The sensitivity tests, which define the corporate tax rates in different ways, do not change the results. The sensitivity test, which uses the financial analysts' forecasts, does not change the results, either. Furthermore, the empirical analysis shows that abnormal financial earnings enhance firm share price more when the firm has lower non‐tax costs, i.e., firm business risk (financial distress) and bankruptcy costs. It supports the previous research on capital structure to the extent that debt financing benefits a firm more when non‐tax costs are lower.

Modeling the Early Adoption Decision: The Case of SFAS 96

Abstract: This study investigates whether management's choices of adoption timing and transition method are associated with factors influencing their economic incentives in the case of early adoption of Statement of Financial Accounting Standards No. 96 (SFAS 96), Accounting for Income Taxes. SFAS 96 provides an interesting setting for this model because firms needed to make a choice of not only whether to adopt the standard earlier than required, but also of the transition method (cumulative effect versus retroactive restatement). The results support the political cost hypothesis and the debt and compensation contract hypotheses for both the early adoption decision as well as the transition method choice decision. The results also indicate the superiority of the interactive effects models thus confirming the results of Ali and Kumar (1994).

Institutional Investors and Trading Volume Reactions to Management Forecasts of Annual Earnings

Abstract: This paper examines the effect of institutional investors on the trading volume reaction to management forecasts of annual earnings. Based on a sample of forecasting firms between 1990 and 1992, institutional investors are examined as heterogeneous types, rather than as a single group as done in prior research. The findings contribute to the growing literature on institutional investor types in two ways: (1) institutional categories differ in their trading patterns, and (2) if the categories are classified into active and inactive types, then greater trading by active institution‐types signals greater investor‐level information asymmetries and greater trading by inactive institution‐types signals lower investor‐level information asymmetries. Overall, the results suggest that increased firm voluntary disclosures, as encouraged by the SEC and the AICPA, may be differentially informative to different types of investors.

Expected Long‐Run Return on Equity in a Residual Income Valuation Model

Abstract: I show that the common residual income model assumption that return on equity approaches zero in the long run as competitive advantage dissipates is incorrect. This erroneous assumption comes from the common misinterpretation of the spread between return on equity and the cost of equity as a measure of economic profit. I also show that an unbiased accounting system (Feltham and Ohlson, 1995), which would make such an interpretation acceptable, is unlikely to exist in actual financial statements. Finally, I argue that because an accounting system can be deemed to be unbiased only if the firm's value is already known, the concept is of little practical use for actual valuation work.

Dimensions of Competence in an Accounting Domain

Abstract: Research in the area of competence suggests that familiarity with a domain affects decision making. We extend Heath and Tversky's (1991) competence hypothesis research by examining the following propositions: (1) competence increases the propensity to take credit for success and place blame for failure, and (2) professional accountants' feelings of competence can be altered, as measured by the propensity to take credit for success and place blame for failure, by calling attention to what others know relative to what they know. Participants in the experimental study were accountants with varying levels of tax experience. Results indicated that more competent participants took more credit for being right, and placed more blame externally for being wrong, than did less competent participants. Also, participants who were told about an applicable tax regulation that was not available during the experiment took more blame for being wrong, suggesting that competence is affected by features of the context in which professional tasks are performed.

Accounting for Future Tax Assets and Liabilities under CICA Handbook Section 3465

Abstract: This paper explores the value relevant information of future income taxes under The Canadian Institute of Chartered Accountants (CICA) handbook section 3465. CICA handbook section 3465 requires Canadian companies to use the asset and liability method to account for income taxes. Consistent with prior studies, this paper shows that future tax assets are positively associated with share prices, suggesting that they are valued as assets. Future tax liabilities are negatively associated with share prices, suggesting that they are valued as liabilities. Future tax value allowance, which is created for future tax assets, is negatively associated with share prices. This study also explores the value relevant information of future tax asset and liability categories. In addition, this paper explores what determines the valuation of future tax assets and liabilities. It is argued that future tax assets are more (less) valuable if (no) sufficient future income will be generated in the near future to utilize these tax assets; future tax liabilities will reduce share prices more (less), if there is a higher (lower) likelihood of reversal in the short run. The results support this argument. It is shown that (1) future tax assets are less valuable if the firm's value allowance is higher (i.e., the management does not expect the firm will generate sufficient taxable income in future years to utilize these tax assets), or the firm's leverage is higher (another proxy for no sufficient future taxable income), and (2) future tax liabilities reduce share prices less if the firm's investment in capital properties is increased.

Are Bigger State and Local Public Pension Plans More Cost Efficient? An Analysis of Economies of Size

Abstract: State and local public pension plans cover a significant number of workers and represent a major component of the nation's retirement system. This study examined the size‐administrative cost relationship of public pension plans to ascertain whether cost savings can be realized by increasing pension plan size. The results indicated that while the consolidation of smaller plans will generate administrative cost savings, the consolidation of larger plans will generate savings only up to an optimal membership size at which point cost savings will end. In addition, optimal size was found to differ for active and beneficiary members indicating that membership composition needs to be considered when assessing the potential for cost savings.