Showing papers in "Review of Accounting Studies in 2010"
TL;DR: Li et al. as mentioned in this paper found that abnormal related sales are not entirely accrual-based but can be cash-based as well, and they serve as a substitute rather than complement to accruals management for meeting earnings targets.
Abstract: Based on a sample of Chinese listed firms from 1998 through 2002, this paper documents that listed firms prop up earnings by using abnormal related sales to their controlling owners. Such related sales propping is more prevalent among state-owned firms and in regions with weaker economic institutions. We also find that these abnormal related sales are not entirely accrual-based but can be cash-based as well, and they serve as a substitute rather than complement to accruals management for meeting earnings targets. Since these abnormal related sales can be cash-based, there is significant cash transfer via related lending from listed firms back to controlling owners after the propping. However, no cash transfer via related lending is found to be associated with accruals earnings management.
632 citations
TL;DR: In this article, the authors explore whether the management discussion and analysis (MD&A) section of Form 10-Q and 10-K has incremental information content beyond financial measures such as earnings surprises and accruals.
Abstract: This study explores whether the management discussion and analysis (MD&A) section of Forms 10-Q and 10-K has incremental information content beyond financial measures such as earnings surprises and accruals. It uses a classification scheme of words into positive and negative categories to measure the tone change in the MD&A section relative to prior periodic SEC filings. Our results indicate that short window market reactions around the SEC filing are significantly associated with the tone change of the MD&A section, even after controlling for accruals and earnings surprises. We show that management’s tone change adds significantly to portfolio drift returns in the window of 2 days after the SEC filing date through 1 day after the subsequent quarter’s preliminary earnings announcement, beyond financial information conveyed by accruals and earnings surprises. The drift returns are affected by the ability of the tone change signals to help predict the subsequent quarter’s earnings surprise but cannot be completely attributed to this ability. We also find that the incremental information of management’s tone change depends on the strength of the firm’s information environment.
366 citations
TL;DR: This paper examined how firms' voluntary disclosure decisions are influenced by product market competition using separate measures to capture different dimensions of competition, and found that competition from potential entrants increases disclosure quantity while competition from existing rivals decreases disclosure quantity, and that competition enhances disclosure quality mainly through reducing the optimism in profit forecasts and reducing the pessimism in investment forecasts.
Abstract: This study examines how firms’ voluntary disclosure decisions are influenced by product market competition Using separate measures to capture different dimensions of competition, I show that competition from potential entrants increases disclosure quantity while competition from existing rivals decreases disclosure quantity I also find that competition enhances disclosure quality mainly through reducing the optimism in profit forecasts and reducing the pessimism in investment forecasts Moreover, I find that the above association is less pronounced for industry leaders, consistent with industry leaders facing less competitive pressures than industry followers
321 citations
TL;DR: In this paper, the authors analyzed the relation between equity prices and conditional conservatism and introduced a new measure of conservatism at the firm-year level, defined as the proportion of the total shock to expected current and future earnings recognized in current year earnings.
Abstract: This paper analyzes the relation between equity prices and conditional conservatism and introduces a new measure of conservatism at the firm-year level. We show that the asymmetric properties of conservative accounting, the existence of non-accounting sources of information, and the properties of GAAP related to special items combine to generate a nonlinear relation between unexpected equity returns and earnings news (the shock to expected current and future earnings). Based on this model, we construct a conservatism ratio (CR) defined as the ratio of the current earnings shock to earnings news. CR measures the proportion of the total shock to expected current and future earnings recognized in current year earnings. Ranking firms according to CR, we show empirically that higher CR firms have more leverage, increased volatility of returns, more incidence of losses, more negative accruals, and increased volatility of earnings and accruals, consistent with the literature on conservative accounting.
182 citations
TL;DR: The authors investigate the market reaction to, and the value-relevance of, information contained in the mandatory transitional documents required by International Financial Reporting Standards 1 (2005) and find significant negative abnormal returns for firms reporting negative earnings reconciliation.
Abstract: We investigate the market reaction to, and the value-relevance of, information contained in the mandatory transitional documents required by International Financial Reporting Standards 1 (2005). We find significant negative abnormal returns for firms reporting negative earnings reconciliation. Although the informational content of the positive earnings adjustments is value-relevant before disclosure, for negative earnings adjustments it is value-relevant only after disclosure. This finding is consistent with managers delaying the communication of bad news until IFRS compliance. A finer model shows that adjustments attributed to impairment of goodwill, share-based payments, and deferred taxes are incrementally value-relevant but that only the impairment of goodwill and deferred taxes reveal new information. Our results indicate that mandatory IFRS adoption alters investors’ beliefs about stock prices.
181 citations
TL;DR: In this paper, the authors examined the association between accounting restatements and the pricing of information risk and found evidence consistent with the restatement initiator (auditor vs. firm management) and the number of times a firm restates affecting the change in pricing of discretionary information risk.
Abstract: We examine the association between accounting restatements and the pricing of information risk. Using the Fama and French three-factor model augmented with discretionary and innate information risk factors, we find a significant increase in the factor loadings on the discretionary information risk factor for restatement firms after a restatement announcement. The increase in factor loadings results in an increase in the estimated cost of capital, which is cross-sectionally associated with the short-window price reaction to restatements. We study several potential determinants of the change in information risk pricing and find evidence consistent with the restatement initiator (auditor vs. firm management) and the number of times a firm restates affecting the change in the pricing of discretionary information risk. We also find an increase, of smaller magnitude, in the pricing of discretionary information risk for non-restatement firms in the same industries as the restatement firms, consistent with an information transfer effect.
153 citations
TL;DR: This article examined whether managers engage in real earnings management to meet quarterly financial reporting benchmarks using a unique database of monthly media advertising spending and found that managers, on average, reduce advertising spending to avoid losses and earnings decreases.
Abstract: Using a unique database of monthly media advertising spending, we examine whether managers engage in real earnings management to meet quarterly financial reporting benchmarks. We extend prior literature by (1) separately analyzing advertising activities, allowing us to explore the possibility that managers could reduce or boost advertising to meet benchmarks; (2) analyzing actual activities as opposed to inferring them from reported expenses, which are also subject to accrual choices; (3) investigating the timing, within a quarter, of altered advertising spending; and (4) examining quarterly earnings benchmarks. We find that managers, on average, reduce advertising spending to avoid losses and earnings decreases. However, we also report that firms in the late stages of their life cycle increase advertising to meet earnings benchmarks. Finally, we find some evidence that firms increase advertising in the third month of a fiscal quarter and in the fourth quarter to beat prior year’s earnings.
141 citations
TL;DR: In this paper, the authors examined the market reactions to 8-Ks filed under the new SEC regime and investigated whether periodic reports (10-K/Qs) became less informative under the change.
Abstract: The Securities and Exchange Commission (SEC) has mandated new disclosure requirements in Form 8-K, which became effective on August 23, 2004. The SEC expanded the list of items that have to be reported and accelerated the timeliness of these reports. This study examines the market reactions to 8-Ks filed under the new SEC regime and investigates whether periodic reports (10-K/Qs) became less informative under the new 8-K disclosure rules. We observe that the newly required 8-K items constitute over half of all filings and that most firms disclose the required items within the new shortened period (four business days). We find that all disclosed items (old and new) are associated with abnormal volume and return volatility around both the event and the SEC filing dates, and some items have significant return drifts after the SEC filings. Surprisingly, we find that the information content of periodic reports has not diminished by the more expansive and timely 8-K disclosures under the new guidance, possibly indicating that investors may use periodic filings to interpret the effects of material events that had been disclosed earlier.
124 citations
TL;DR: In this paper, the impact of new pension disclosures and subsequent full pension recognition under FRS 17 and IAS 19 in the United Kingdom and SFAS 158 in United States on pension asset allocation is examined.
Abstract: We examine the impact of new pension disclosures and subsequent full pension recognition under FRS 17 and IAS 19 in the United Kingdom and SFAS 158 in the United States on pension asset allocation. These standards require recognition of net pension surplus/deficit on the balance sheet and actuarial gains/losses in other comprehensive income. Therefore, these standards introduce volatility into comprehensive income and balance sheets. We identify a disclosure period during which UK companies disclosed all the required data under FRS 17 in the notes without recognition. We also identify a full recognition period starting 1 year before until 1 year after the adoption of FRS 17/IAS 19 (UK) and SFAS 158 (US). We predict and find that UK companies, on average, shifted pension assets from equity to debt securities during both the disclosure and the full recognition periods. We also find that while before the adoption of SFAS 158 US companies maintained a stable allocation to equities and bonds, these companies, on average, shifted funds from equities to bonds around the adoption of SFAS 158. Cross-sectional analysis shows that the shift away from equities is related to changes in funding levels, shorter investment horizons, increased financial leverage, and the expected impact of the new standards on shareholders’ equity.
113 citations
TL;DR: In this article, the authors examine how a firm's accounting methods can be influenced by the choices of other firms, which they label contagion, and test these predictions in the stock option expensing setting where firms had the choice to use the intrinsic or fair value method.
Abstract: I examine how a firm’s accounting methods can be influenced by the choices of other firms, which I label contagion. I model accounting method choice as a combination of intrinsic propensities to adopt a method and contagion effects. I predict contagion of accounting methods occurs for two reasons: (1) adoption decisions of other firms are informative for the adoption decision, and (2) prior adoptions change the net benefits of the decision. I test these predictions in the stock option expensing setting where firms had the choice to use the intrinsic or fair value method. Using a firm-level diffusion model, I document evidence consistent with my predictions.
110 citations
TL;DR: In this article, the authors investigate investor relations costs as an alternative incentive for managers to avoid small negative earnings surprises and find no statistically significant evidence that call tone is asymmetrically more negative for firms that miss expectations by a penny.
Abstract: Anecdotal and survey evidence suggest that managers take actions to avoid small negative earnings surprises because they fear disproportionate, negative stock-price effects. However, empirical research has failed to document an asymmetric pricing effect. We investigate investor relations costs as an alternative incentive for managers to avoid small negative earnings surprises. Guided by CFO survey evidence from Graham et al. (J Account Econ 40:3–73, 2005), we operationalize investor relations costs using conference call characteristics—call length, call tone, and earnings forecasting propensity around the conference call. We find an asymmetric increase (decrease) in call length (forecasting propensity) for firms that miss analyst expectations by 1 cent compared with changes in adjacent 1-cent intervals. We find no statistically significant evidence that call tone is asymmetrically more negative for firms that miss expectations by a penny. While these results provide some statistical evidence to confirm managerial claims documented in Graham et al. (J Account Econ 40:3–73, 2005) regarding the asymmetrically negative effects of missing expectations, our tests do not suggest severe economic effects.
TL;DR: The authors empirically test a limited attention explanation for these anomalous returns and find that stocks with sharp run-ups tend to attract individual investors' attention and investment dollars, particularly before their earnings announcements.
Abstract: We document that stocks with the strongest prior 12-month returns experience a significant average market-adjusted return of 1.58% during the five trading days before their earnings announcements and a significant average market-adjusted return of −1.86% in the five trading days afterward. These returns remain significant even after accounting for transactions costs. We empirically test a limited attention explanation for these anomalous returns—that stocks with sharp run-ups tend to attract individual investors’ attention and investment dollars, particularly before their earnings announcements. Our analysis suggests that the trading decisions of individual investors are at least partly responsible for the return pattern that we observe.
TL;DR: In this paper, the authors examine the effect of Regulation Fair Disclosure (Reg FD) on the cost of equity capital and find some evidence that the post-Reg FD period relative to the pre-reg FD period, on average, for a broad cross-section of US firms, is mainly for medium and large firms but is insignificant for small firms.
Abstract: We examine the effect of Regulation Fair Disclosure (Reg FD) on the cost of equity capital. We find some evidence that (1) the cost of capital declines in the post-Reg FD period relative to the pre-Reg FD period, on average, for a broad cross-section of US firms, (2) the decrease in the cost of capital post Reg FD is mainly for medium and large firms but is insignificant for small firms, and (3) the decrease in the cost of capital post Reg FD is systematically related to firm characteristics indicative of selective disclosure before Reg FD. In contrast, we find little evidence of a decrease in the cost of capital for American Depositary Receipts and US-listed foreign firms, which are legally exempt from Reg FD. Overall, our findings do not support a conclusion in recent studies that the cost of capital has increased post Reg FD and, if anything, suggest the opposite.
TL;DR: The authors found that firms accelerate their warnings in response to peer firms' warnings and conclude that the observed clustering is primarily due to herding, and provide a multi-firm perspective on managers' disclosure decisions that alerts researchers to consider or control for herding when they examine other determinants of managers’ disclosure decisions.
Abstract: An earnings surprise can be caused by a combination of firm-specific factors and market or industry factors. We hypothesize that managers have an incentive to time their warnings to occur soon after their industry peers’ warnings to minimize their apparent responsibility for earnings shortfalls. Using duration analysis, we find that firms accelerate their warnings in response to peer firms’ warnings. We conduct several tests to control for alternative explanations for warning clustering (for example, common shocks and information transfer) and conclude that the observed clustering is primarily due to herding. Our study is one of the first to empirically examine managers’ herding behavior and the first to document clustering of bad news. Moreover, we provide a multi-firm perspective on managers’ disclosure decisions that alerts researchers to consider or control for herding when they examine other determinants of managers’ disclosure decisions.
TL;DR: In this paper, the authors investigate the circumstances that might provide disincentives generally for GAAP line item disclosures and find that managers who regularly intervene in the earnings reporting process limit disclosures at the aggregate level and in each of the financial statements so as to more effectively guide investor attention to summary financial information.
Abstract: We provide new evidence on the disclosure in earnings announcements of financial statement line items prepared under Generally Accepted Accounting Principles (GAAP). First, we investigate the circumstances that might provide disincentives generally for GAAP line item disclosures. We find that managers who regularly intervene in the earnings reporting process limit disclosures at the aggregate level and in each of the financial statements so as to more effectively guide investor attention to summary financial information. Specifically, this disclosure behavior obtains when managers habitually cater to market expectations, engage in income smoothing, or use discretionary accruals to improve earnings informativeness. Second, we predict and find that the specific GAAP line items that firms choose to disclose are determined by the differential informational demands of their economic environment, consistent with incentives to facilitate investor valuation. However, these valuation-related disclosure incentives are muted when managers habitually intervene in the earnings reporting process.
TL;DR: In this paper, the authors examine the contribution of accounting estimates embedded in accruals to the quality of financial information, as reflected by their usefulness in the prediction of enterprise cash flows and earnings.
Abstract: Accounting estimates and projections potentially improve the relevance of financial information by providing managers a venue to convey to investors forward-looking, inside information. The quality of financial information is, however, compromised by the increasing difficulty of making reliable estimates and forecasts and the frequent managerial misuse of estimates. Given the ever-increasing prevalence of estimates in accounting data, particularly due to the move to fair value accounting, whether these opposing forces result in an improvement in the quality of financial information is among the most fundamental issues in accounting. We examine the contribution of accounting estimates embedded in accruals to the quality of financial information, as reflected by their usefulness in the prediction of enterprise cash flows and earnings. Our out-of-sample prediction tests indicate that accounting estimates beyond those in working capital items (excluding inventory) do not improve the prediction of cash flows. Estimates do, however, improve the prediction of next year’s earnings, though not of subsequent years’ earnings. We conclude that the usefulness of accounting estimates to investors is limited and provide suggestions for improving the usefulness of estimates.
TL;DR: In this paper, the authors investigate whether increasing a superior's span of control improves the effectiveness of the budgeting process and find that the superior's utility function consists of utilities for norm enforcement and wealth leading the superior to reject profitable projects believed to contain excessive slack.
Abstract: This study investigates whether increasing a superior’s span of control improves the effectiveness of the budgeting process. We characterize the superior’s utility function as consisting of utilities for norm enforcement and wealth, leading the superior to reject profitable projects believed to contain excessive slack. We develop theory to predict that superiors become more willing to reject projects as their span of control increases. Further, subordinates anticipate superiors’ behavior and reduce slack as span of control increases. Experimental results are consistent with these predictions. As span of control increases, superiors show a greater willingness to reject projects that they believe contain excessive slack, and subordinates submit budgets with less slack. The net result is that superiors earn more profit per subordinate under an expanded span of control. Our study suggests that increasing span of control can improve the effectiveness of the budgeting process, an important component of most firms’ control environments.
TL;DR: This article found that the difference in the levels of persistence between MBF and non-MBF exclusions declined after the introduction of Regulation G, which requires public companies that disclose non-GAAP earnings to also present GAAP earnings and a reconciliation of the two.
Abstract: Previous research has found that the items that are included in GAAP earnings but excluded from Street earnings to allow the firm to meet or beat analyst earnings forecasts (“MBF exclusions”) are more persistent than the other excluded items. In this study, I find that the difference in the levels of persistence between MBF and non-MBF exclusions declined after the introduction of Regulation G, which requires public companies that disclose non-GAAP earnings to also present GAAP earnings and a reconciliation of the two. Analysts underestimate the persistence of non-MBF exclusions, but the degree of this underestimation is lower in the post-regulation period. In contrast, there is little evidence to indicate that analysts underestimate the persistence of MBF exclusions in either time period. I also find strong (weak) evidence that investors underestimate the persistence of Street exclusions in the pre- (post-) regulation period. These results suggest that Regulation G constrains the practice of excluding recurring expenses from Street earnings to meet or beat analyst forecasts and helps analysts and investors to understand the persistence of Street exclusions.
TL;DR: This article examined whether financial analysts fully incorporate expected inflation in their earnings forecasts for individual stocks and found that expected inflation proxies, such as lagged inflation and inflation forecasts from the Michigan Survey of Consumers, predict the future earnings change of a portfolio long in high inflation exposure firms and short in low or negative inflation exposure companies.
Abstract: We examine whether financial analysts fully incorporate expected inflation in their earnings forecasts for individual stocks. We find that expected inflation proxies, such as lagged inflation and inflation forecasts from the Michigan Survey of Consumers, predict the future earnings change of a portfolio long in high inflation exposure firms and short in low or negative inflation exposure firms, but analysts do not fully adjust for this relation. Analysts’ earnings forecast errors can be predicted using expected inflation proxies, and these systematic forecast errors are related to future stock returns. Overall, our evidence is consistent with the Chordia and Shivakumar (J Account Res 43(4):521–556, 2005) hypothesis that the post-earnings announcement drift is related to investor underestimation of the impact of expected inflation on future earnings change.
TL;DR: In this article, the authors study the capacity allocation problem in a multidivisional firm where an upstream division provides capacity services for itself and a downstream division, and explore whether the divisions should be structured as investment or profit centers.
Abstract: This paper studies the acquisition and subsequent utilization of production capacity in a multidivisional firm. In a setting where an upstream division provides capacity services for itself and a downstream division, our analysis explores whether the divisions should be structured as investment or profit centers. The choice of responsibility centers is naturally linked to the internal pricing rules for capacity services. As a benchmark, we establish the efficiency of an arrangement in which the upstream division is organized as an investment center, and capacity services to the downstream division are priced at full historical cost. Such responsibility center arrangements may, however, be vulnerable to dynamic hold-up problems whenever the divisional capacity assignments are fungible in the short-run, and therefore, it is essential to let divisional managers negotiate over their actual capacity assignments. The dynamic hold-up problem can be alleviated with more symmetric choice of responsibility centers. The firm can centralize ownership of capacity assets with the provision that both divisions rent capacity on a periodic basis from a central unit. An alternative and more decentralized solution is obtained by a system of bilateral capacity ownership in which both divisions become investment centers.
TL;DR: The authors measured changes in investor beliefs around earnings announcements using changes in the dispersion of individual analysts' forecasts and found that the 3-day market response to earnings announcements is negatively associated with changes in dispersion, consistent with the cost of capital hypothesis.
Abstract: Existing research provides competing theories about how dispersion of investor beliefs might affect stock prices. We measure changes in dispersion of investor beliefs around earnings announcements using changes in the dispersion of individual analysts’ forecasts. We find that the 3-day market response to earnings announcements is negatively associated with changes in dispersion, consistent with the cost of capital hypothesis. The results hold after controlling for the current earnings surprise, forecast revisions of future earnings, and reported earnings relative to various earnings thresholds. Our study provides new insight about the information contained in earnings announcements that is incremental to the magnitude and timing of cash flows.
TL;DR: In this paper, the authors show that the potential for investors to be active always increases the signaling cost in case of non-contractible investor effort, whereas the effect is ambiguous if investor effort is contractible.
Abstract: Active investors provide risk-sharing and value-adding effort in form of advising, networking, monitoring, etc. This paper demonstrates a conflict between two key objectives for high-quality entrepreneurs: to elicit such investor effort and to signal the firm’s type by retaining shares. This conflict may give rise to stable (and economically meaningful) pooling equilibria for startup firms. More established firms, with access to multiple signals, can always realize both of these objectives but may still decide to forego investor effort if eliciting it would require them to deviate substantially from the cost-minimizing signal mix. In comparison with otherwise identical pure-exchange settings (with passive investors), we find that the potential for investors to be active always increases the signaling cost in case of noncontractible investor effort, whereas the effect is ambiguous if investor effort is contractible. At the same time, we identify conditions under which signaling is welfare-enhancing as it helps guide investors’ effort towards more promising ventures.
TL;DR: In this article, the authors revisited the effectiveness of audits and the misreporting of private information in light of audit thresholds and showed that the predictability of such misstatements may actually serve to promote efficiency.
Abstract: The accounting profession has faced considerable criticism in recent years for failing to effectively combat reporting manipulation. A particular point of contention is the use of audit thresholds. The tendency for auditors to suppress inconsistencies that are deemed immaterial has been viewed as an open invitation for abuse. This paper revisits the effectiveness of audits and the misreporting of private information in light of audit thresholds. The paper demonstrates that while audit thresholds may create incentives for misstatements, the predictability of such misstatements may actually serve to promote efficiency. In effect, an environment in which parties are expected to systematically bias their reports can bring the threat of audit consequences for further exaggeration to the forefront. Such a consideration also suggests that more relaxed audit thresholds (and the ensuing increase in equilibrium misstatements) may be condoned by report recipients and can actually lessen inefficiencies wrought by adverse selection.
TL;DR: This article examined the effect of information quantity and consistency on the judgments and trading behavior of naive investors, holding constant the quality (or predictive value) of information, and found that increased quantity of information leads naive investors to show greater judgment confidence and trading aggressiveness.
Abstract: Advances in technology, as well as regulatory and legislative actions, have led to an increase in the quantity of information available to the public. This paper experimentally examines the effects of information quantity and consistency (or directional agreement) on the judgments and trading behavior of naive investors, holding constant the quality (or predictive value) of information. In my experiment, investors receive accounting signals and make predictions and trading decisions for 24 separate firms. I find that increasing the quantity and consistency of information leads naive investors to show greater judgment confidence and trading aggressiveness. Increased quantity reduces investors’ expected wealth in laboratory markets, while the effect of consistency on expected wealth depends on the relationship between the low- and high-quality signals investors receive. Results highlight possible unintended consequences of increased disclosure and suggest directions for future experimental and archival research.
TL;DR: In this paper, the authors reinterpreted the residual income model by highlighting the shareholders' abandonment (liquidation or adaptation) option and found that the real options model has a stronger predictive power for future abnormal stock returns.
Abstract: This study re-interprets the properties of the residual income model by highlighting the shareholders’ abandonment (liquidation or adaptation) option. We estimate the value of this real option as an explicit component of abnormal earnings in the residual income model and test the improvement in valuation after incorporating it into the model. Relative to the traditional specification of the residual income model, this real options model has a stronger predictive power for future abnormal stock returns. We also find that the superior return predictability of the real options model is pronounced in the set of firms with a high probability of exercising liquidation options (for example, those with low profitability, low growth opportunities, high underlying asset volatility, and low intangible assets), which is consistent with the importance of shareholders’ abandonment option in equity valuation. The results are robust to extensive sensitivity checks.
TL;DR: Li et al. as discussed by the authors examined how product market competition affects voluntary disclosure by firms and found that both the competitive threat from potential entrants into an industry and from existing rivals affect the quantity and accuracy of voluntary profit and investment forecasts by firms in that industry.
Abstract: Li (2010, this issue) examines how product market competition affects voluntary disclosure by firms. Using several competition proxies, she finds that both the competitive threat from potential entrants into an industry and from existing rivals affect the quantity and accuracy of voluntary profit and investment forecasts by firms in that industry. However, the study’s findings are inconclusive mainly because each competition proxy used can reflect both types of competitive threat. The focus of my discussion is to provide some comments and suggestions for future researchers to consider in examining how the nature of product market competition affects voluntary firm disclosure.
TL;DR: In this article, a negative association between bond yield spreads and sustained growth in earnings for firms with high risk was found, while non-revenue growth was not rewarded for either sample.
Abstract: Viewing equity as a call option on the firm’s assets with a strike price equal to contractual debt obligations yields an asymmetric prediction on how debt and equity markets view sustained growth. Debt holders are expected to benefit from sustained growth when the default risk is high, while equity holders value such growth when risk is low. Using Altman’s z-score and debt ratings as alternative proxies for the default risk, we document a negative association between bond yield spreads and sustained growth in earnings for firms with high risk only. In sharp contrast, using earnings multiples from returns-earnings regressions as a proxy for equity market rewards, we find that earnings multiples are larger when earnings growth is sustained for the low risk sample only. Decomposing earnings growth into revenue and nonrevenue growth, we find that the debt market rewards for firms with revenue growth are confined to the high risk sample only, while nonrevenue growth firms are not rewarded for either sample. Equity investors value revenue-led earnings growth for low and high risk samples while nonrevenue growth is rewarded for the low risk sample only. Our study adds to our understanding of how changes in firm value from sustained earnings and revenue growth are divided between key providers of capital and how default risk plays an instrumental role in this valuation process.
TL;DR: In this article, Dutta and Reichelstein study the role of transfer pricing and organizational choice in providing incentives for efficient decisions on the acquisition and subsequent reallocation of capacity within decentralized firms.
Abstract: Dutta and Reichelstein (2010) study the role of transfer pricing and organizational choice in providing incentives for efficient decisions on the acquisition and subsequent reallocation of capacity within decentralized firms. Their analysis suggests that transfer prices based on the historical cost of capacity facilitate the efficient allocation of resources. They also find that symmetric responsibility center structures are generally better suited for providing efficient investment incentives than hybrid organizations. An important condition for the derivation of the two results is the linearity of the shadow prices of capacity. If shadow prices are nonlinear, transfer prices should be below (above) the historical cost of capacity in order to counteract the managers’ incentives to underinvest (overinvest). Because profit center organizations can use transfer prices for mitigating the inefficiency caused by nonlinear shadow prices, they offer a natural advantage over pure investment center organizations in implementing efficient capacity decisions. Overall, these observations suggest that the curvature of profit functions is an important factor in determining the suitable instruments for decentralized capacity management.
TL;DR: In this article, the authors examined whether compensation committees consider this while determining CEO compensation, and they found that growth from increased profitability is perceived by markets to add value while growth from investment does not.
Abstract: Prior research shows that firms generating earnings growth by improving profitability create shareholder value, while firms generating earnings growth through investment destroy value. This paper examines whether compensation committees consider this while determining CEO compensation. We first confirm prior results that growth from increased profitability is perceived by markets to add value while growth from investment does not. While growth from increased profitability is positively associated with compensation, so is growth from investment. The presence of institutional ownership increases the weight on growth from increased profitability, but does not reduce the weight on growth from investment. Further, value-oriented institutional ownership increases the sensitivity of compensation growth to growth from increased profitability and reduces the sensitivity to growth from investment. Contrarily, growth-oriented institutional ownership increases the sensitivity of compensation growth to growth from investment. Our results highlight the importance of understanding the nature of earnings growth in determining executive compensation.
TL;DR: In this article, the authors discuss the relevance of HRT to these literatures and comment on their implementation and experimental design, and offer suggestions for future research, one of which is to explicitly introduce monitoring into experiments on span of control.
Abstract: This paper is a discussion of Hannan et al. (Rev Account Stud, 2010), wherein subordinate-participants are endowed with private information, and superior-participants can potentially affect budget requests through their ability to reject them. Their findings are of interest to research on both the design of budgeting systems and span of control. I discuss the relevance of HRT to these literatures and comment on their implementation and experimental design. Also, I offer suggestions for future research, one of which is to explicitly introduce monitoring into experiments on span of control.