In chapter 4, we suggested that an explicit political economy of accounting recognizes that
alternative financial reporting systems (for example regulated versus unregulated) have both private and social consequences, that in any system some people will fare better while others fare worse, and that the choice of system itself is a political as well as an economic act. Consistent with this, the FASB appears to recognize the existence of a diverse and pluralistic user group (see chapter 7). However, in practice, the FASB has focused on what it calls primary user groups (investors and creditors) who are assumed to be mainly interested in the amounts, timing, and uncertainties of future cash flows. The rationale for the investor- creditor focus is that other users either have a commonality of interest with investors and creditors or the means of getting alternative information, such as governments have for taxation purposes and rate-setting bodies for utility pricing. The FASB’s cost-benefit calculus is similarly restricted to benefits for investors and creditors, and cost considerations are confined only to producers. We don’t believe that the FASB’s focus on producers and the primary user group of investors and creditors fully represents the political economy of accounting. However, the purpose of this chapter is to examine theoretical and empirical evidence for the usefulness of financial accounting data to the FASB’s primary user group, investors and creditors. The chapter concludes with a brief assessment of the usefulness of accounting allocations.
ACCOUNTING DATA AND MODELS OF FIRM VALUATION
Gordon’s dividend valuation model is a useful starting point in understanding the relationship between accounting data and the value of the firm. This model posits that the value of the firm to stockholders is the present value of future expected dividens to be received ;by stockholders. Beaver uses the dividend valuation model to formulate the role of accounting earnings in determining firm value. First, present security prices are defined as a function of expected future dividens. Second, future dividends themselves are a function of future earnings. Finally, current accounting income is useful in predicting future earnings; therefore, current income is informative vis-à-vis its predictive ability with respect to future earnings (and ultimately future dividends). So, in this formulation, accounting income has value indirectly through its role in assessing future expected dividends. This, of course, is predictive value, which is one of the major arguments for the relevance of accounting information. More recent work in financial economics regarding the theoretical value of the firms traces back to Miller and Modigliani’s seminal work in which they argue that dividend policy is irrelevant to firm valuation. Ignoring the complicating effect of taxes, they show that the value of the firm can be equivalently modeled (independent of dividens) as the present value of future net cash flows, where net cash flows per period are defined as cash flows from operations minus cash investment in assets. This notion of net cash flow is the same used in capital budgeting-present value analysis. Miller and Modigliani’s net cash flow model was originally a certainty-equivalent model but has been extended to a more general model in which there is uncertainty as to the future operating cash flows. The attractiveness of the cash flow valuation model for accounting is that it maps directly into the accounting system : that is, cash flows are explicitly measured in accounting systems, whereas dividends are a matter of corporate policy and have nothing to do with accounting systems per se. Interestingly, the FASB has also adopted (implicity) the cash flow valuation model. In SFAC No.1, the role of financial reporting is characterized as aiding investors, creditors, and others in assessing the amounts, timing and uncertainty of the enterprise’s prospective net cash flows. Further the FASB has asserted that accrual accounting system, and accrual income numbers in particular are more useful for this purpose than are simpler cash-based systems: ….accrual accounting generally provides a better indication of an enterprise’s present and continuing ability to generate favocable cash flows than information limited to the financial effects of cash receipts and payments.(SFAC No.1,preface) Beaver agrees with this assertion, arguing that “an accrual can be viewed as a form of forecast about the future….” There is empirical evidence that future cash flows are better forecast with accrual data than with cash flow data. And, in stock market studies, security prices are more highly correlated with accrual income than with either cash flows or working capital flows. Numerous studies (reviewed in this chapter) have documented that changes in reported accounting earnings affect firm valuation through changes in stock prices. Changes in current period earnings should affect stock prices and the market’s valuation of the firm if investors view such changes as permanent or persisting into the future. If this is the case, then expectations of future period cash flows should also be affected, hence the explanation for changes in stock prices as a function of the expected persistensy of earnings changes. The implications of this theoretical literature is that accrual accounting systems incorporate the attribute that determines firm valuation—net cash flow data. However, the value to investors of the information in financial reporting does not lie in its role as an historical record; rather, its usefulness lies in its potential for revising investors assessments of future period cash flows. A theoretical formulation of how accounting information impacts upon assessments of future cash flows appears in appendix 8-A.
THE VALUE OF ACCOUNTING INFORMATION FOR INVESTORS
As mentioned above, the usefulness of accounting information to investors has been empirically investigated through the association (or lack thereof) of publicly released accounting data with changes in the firm’s security prices. If there is a significant association, then there is evidence that accounting information is useful with respect to firm valuation. These studies also constitute tests of the so-called efficient-markets hypothesis. The efficient-markets hypothesis (EMH) refers to speed with which securities in the capital market respond to announcements of new information. The classic definition of market efficiency is that (1) the market fully reflects available information and (2) by implication, market prices react instantaneously to new information. In other words, new information is quickly impounded in the price of the security. If the hypothesis is correct, an item of information has value to investors only if there is evidence of a price response to the new information. When this occurs, the item of information is said to have information content. There are three forms of the efficient-markets hypothesis. The weak form says that security prices reflect information contained in the sequence of historical (past) prices; the semistrong form says that prices reflect all past and current information that is publicly available; and the strong form says that prices reflect all information (both public and private). Most testing has been of the semistrong form, which deals with publicly available information. Much of the information tested has been of an accounting nature-for example, financial statement data and earnings announcements. The theoretical foundation of capital market or security price research comes from portfolio theory, which is a theory of rational investment choice and utility maximization : simply stated, risk can be reduced by holding a portfolio of investments. Risk that can be eliminated in this manner is called unsystematic (diversifiable) risk, while the remaining portfolio risk is called systematic (undiversifiable) risk. In portfolio theory, systematic risk is defined as the variance of expected investment returns. We conveniently think of expected return as a single number, but in reality it is a probability distribution of possible returns. The larger the variance around the mean of expected returns, the greater the risk associated with the investment. This variance may be quite high in individual stocks but when evaluated for a portfolio as a whole, it is much lower. The reason for this situation is that variances lof individual securities are offset when combined in a portfolio. In this way, it is possible to select a stock portfolio that minimizes risk (variance) for a given rate of return. What remains after eliminating all the risk possible is called nondifersifiableor systematic risk of the portfolio. And that risk which has been eliminated through diversification is called diversifiable or unsystematic risk. An investor will rationally select a portfolio with a risk- return relation that meets the investor’s own utility preferences. The theoretical choice of portfolios is graphically presented in Exhibit 8-1. The capital market line represents alternative portfolios of increasing levels of systematic risk. Since investors are risk averse, the expected portfolio return increases as risk increases. The capital market line is linear only under restrictive conditions, but whether linear or curvilinear, a direct relationship exists between the level of risk and expected returns. Portfolio theory is the foundation for a related development in finance-the pricing of individual stocks given the concept of diversified portfolios. A model called the capital asset pricing model has been developed for the theoretical pricing of individual stocks. Its first step is to relate the risk of an individual security relative to the market as a whole. The market is assumed to be a diversified portfolio. A correlation is made between the returns on individual stocks and market returns over a period of time. The correlations are illustrated as a scattergram in Exhibit 8-2. Regression analysis used to fit a line to the scattergram. The slope of the characteristic line is called beta and represents a market-based measure of the systematic risk of an individual security relative to the average risk in the market as a whole. If beta equals 1, the returns are perfectly associated and the risks are equal. If beta exceeds 1, the returns on the individual stock are greater than the market. In otherwords, if the rate of return on an individual security is greater than the market average, systematic risk of the security must also be greater because of the direct relationship between risk levels and expected returns. Higher returns must be accompanied by higher risks. The assumption of capital asset pricing model is that individual securities are priced solely on systematic risk. Given the assumption of diversified portfolios, it is argued that no one would pay for unsystematic risk. Beta is used to represent systematic risk of individual securities and to predict the risk-based price of securities. A standard two-parameter version of the capital asset pricing model defines the predicted rate of return for an individual security a Unexpected returns or abnormal returns for any time period are captured in the error term 𝑒𝑗 in Equation (8.3). A common research approach in accounting studies has been to regress these abnormal returns on accounting variables, such as unexpected reported earnings, for the same time period to determine if there is information content, in which case there would be evidence that firm valuation is correlated with accounting information. Before reviewing the empirical findings, we should make a few observations regarding the difficulties of doing this type of research. The study of price movements and the pricing mechanism in any market is an imposing task. Determining cause and effect between information and security prices is especially difficult because new information is continuously causing price movements. Since the set of information affecting security prices is large, it is extremely difficult to isolate the effects of one piece of information. This difficulty means that the tests are going to be somewhat crude rather than precise. The research should be examined with this in mind. Failure to find evidence of information content should thus be interpreted cautiously, for the methodology is not always capable of detecting information content. For this reason, the stronger evidence from efficient-markets research exists where there is information content rather than where there is none. Another weakness of capital market research is that it is a joint test of both market efficiency and information content. The absence of price responses is usually interpreted to mean that the information tested has no information content. This interpretation is correct only if the market is efficient. But what if the market is inefficient? If the market is inefficient, there is no way of determining what the absence of a price response means. This is another reason why the research findings are much stronger when there is evidence of information content. A final point is that market-based research necessarily considers only the aggregate effect of individual investor decision making. That is, the role of accounting information vis- à-vis an individual investor’s decision making is implicitly modeled as a black box : an “event”, the reporting of accounting information, occurs, and the effect of this event is then inferred from whether or not there was an aggregate (market) reaction. As an alternative , Appendix 8-A presents an investor decision model that explicity models the role of information in revising expectations about future cash flows at the level of an individual investor. INFORMATION CONTENTS OF EARNINGS ANNOUNCEMENTS The strongest evidence from capital market research concerns the information content of annual accounting earnings numbers. The seminal study, published in 1968, showed that the direction of change in reported accounting earnings (from the prior year) was positively correlated with security price movements. The study also found that the price movements anticipated the earnings results and that there was virtually no abnormal price movement one month after the earnings were announced. This is consistent with the semistrong form of the efficient-markets hypothesis. A later study showed that the magnitude as well as direction of unexpected earnings are associated with changes in security prices. Quarterly earnings announcements have also shown the same general results. These results are not surprising. We would expect accounting income to be part of the information used by investors in assessing risk and return. Capital market research has confirmed an almost self-evident proposition. The findings are important, though, in formally linking accounting information with investment decisions and hence with usefulness to investors.
ALTERNATIVE ACCOUNTING POLICIES AND SECURITY PRICES
A more complex type of securities-price research has examined the effect of alternative accounting policies on security prices. The initial purpose of these tests was to investigate the so-called naïve-investor hypothesis. Research has found that security prices respond to accounting income numbers. Alternative accounting policies-for example, flexibility in the choice of depreciation and inventory methods-can affect net income. Although these methods affect reported earnings, there is no apparent impact on company cash flows. These types of accounting alternatives simply represent different patterns of expense recognition or cost allocations. The questions of interest to researches is whether alternative accounting policies have a systematic effect on security prices. If security prices do respond to income levels that differ solely because of alternative accounting methods, with no cash flow consequences, then there is support for the naïve-investor hypothesis. On the other hand, if security prices do not respond to such artificial book-income differences, then there is evidence that investors in the market are sophisticated and able to see through such superficial bookkeeping differences. Virtually all the initial research was interpreted as rejecting the naïve-investor hypothesis. However, recent research findings have challenged some of the earlier conclusions and reopened what was once considered a closed issue in accounting research. ALTERNATIVES WITH NO KNOWN CASH FLOWS CONSEQUENCES Several studies have compared companies using different accounting methods. One of the earliest studies compared companies using accelerated versus straight-line depreciation methods. The two groups of companies had different accounting income numbers because they used alternative depreciation methods; thus there were differences in income between the two groups of companies due to the use of alternative depreciation accounting methods. There were also differences in price-earnings multiples between the two groups. Companies using accelerated methods had lower earnings but higher price-earnings multiples than companies using straight-line. However, when earnings of companies using accelerated methods were adjusted to a straight-line depreciation basis, the price-earnings multiple between the two groups of companies was not significantly different. The assessments of the companies in the market did not appear to be affected by arbitrary and alternative accounting income numbers. This finding is often expressed as the market is not “fooled” by arbitrary accounting differences. Other similar research has supported this conclusions. Additional areas tested include purchase versus pooling accounting, expensing versus capitalizing research and development costs, and recognition versus deferral of unrealized holding gains on marketable securities. A related area of investigation concerns security-price responses to a reported change in accounting policy by a company. Changes in depreciation policy have been researched, and there is no evidence that the change per se affects security prices. Another area tested has been a change from the deferral to flow-through method of accounting for the investment credit. Again, no prices effects were found. Although changes in accounting policies may cause the income number to change (solely because of the policy change), these research studies have not found that security prices respond to the changes. Higher accounting income achieved solely from a change in accounting policy with no apparent real changes in underlying cash flows does not appear to fool the market. The evidence from the type of research discussed in the preceding paragraphs supports the claim that there is no information content in accounting policy changes, at least where there are no apparent underlying changes in cash flows. This finding has also been interpreted as a rejection of the naïve-investor hypothesis. Investors appear to adjust accounting income to compensate for artificial bookkeeping differences with no real substance. That is, investors do not appear to respond mechanistically and naively to changes in reported accounting income numbers. AN ALTERNATIVE WITH CASH FLOW CONSEQUENCES: THE LIFO CHOICE One type of change in accounting policy that does produce a security-price response is a change from FIFO to LIFO inventory accounting. Changes to LIFO have been associated with a positive security-price movement, even though LIFO lowers accounting income in a period of rising inventory prices. Given the apparent sophistication of investors in other areas of accounting policy differences, what can be the logical explanation for these price responses? The suggested reason for the price response is that LIFO must be adopted for financial statement purposes if the tax benefit is desired. In a period of rising prices, tax expense will be lower for companies that use LIFO, in which case there are real cash flow consequences due to the change in accounting policy. Even though book income is lowered by the use of LIFO, cash flows are higher because the taxable income is lower. Positive security-price responses are therefore consistent with an increase in the value of the firm due to tax savings. Other studies, however, contradict these findings concerning the effect of the changes. These studies either found no evidence of price response or found evidence of a negative price response. Either result is contrary to the earlier finding of positive price responses. The recent studies suggest the earlier research may have failed to isolate the real effect of the LIFO change because of a self-selection bias. (this means that companies changing to LIFO had other things occurring simultaneously that confounded the results and may have caused the positive price response). But if these studies are correct, then there may be some support for the naïve-investor hypothesis. There are positive tax benefits associated with the LIFO change that should increase the value of the firm. Yet security-price responses were not positive. Since LIFO will lower accounting book income, a negative price response could be interpreted as a mechanistic response to a lower accounting number, a response made without considering the positive cash flow cosequences due to lower taxes. As discussed at the beginning of this section, security-price research is extremely difficult to conduct. The LIFO choice issue amply illustrates this point. The early LIFO research rejected the naïve-investor hypothesis. Later research on the LIFO question reopened what was once thought to be a closed issue with respect to market efficiency.
ALTERNATIVES WITH INDIRECT CASH CONSEQUENCES-AGENCY THERY
Recent security-price research has been probing a more subtle issue referred to as indirect consequences. An indirect consequence occurs when an accounting policy change affects the value of the firm through an indirect effects on owners, rather than a direct effect on company cas flows. One such study was motivated by an attempt to explain why securities prices of certain oil and gas companies responded negatively to a mandatory change in accounting policy. The required change from full costing to successful efforts was regarded as simply a change in how exploration costs are allocated to the income statement. Therefore, it was expected that no security-price response would be evident since there was no direct cash flow consequences to the companies. However, security-price responses were found to exist and since previous research had predominantly rejected the naïve-investor hypothesis, a search was made for the existence of some indirect cash flow consequences to explain the price response. The study posited that a change to successful-efforts accounting for oil and gas exploration costs lowered firms’ ability to pay dividends in the short term, because of restrictive debt covenants. Therefore, even though the change in accounting policy appeared to affect only book income on the surface, there were indirect cash flow consequences to investors, which might explain the negative price response. This explanation derives from agency theory. When accounting numbers are used to monitor agency contracts, there can be indirect consequences on the firm’s owner and creditors from changes in accounting policies. In the case of debt covenants restricting dividend payments, accounting numbers are used to protect the security of bondholders at the expense of stockholders. If an accounting policy change lowers accounting income (as could occur in a mandatory change to successful efforts), stockholder returns could be lowered, thus causing a negative price response. A similar type of study found negative security-price responses for firms using purchase accounting when pooling was restricted by the APB in favor of purchase accounting for combinations. Differences between purchase and pooling accounting appear on the surface to affect only book income with no real cash effects. However, the reduced use of pooling accounting could affect dividend distribution because of debt covenants. Income would normally be lower under purchase accounting than pooling, and the same effect of dividend restrictions as argued in the oil and gas study were also argued in the purchase/pooling study. Another research study along these lines examined the requirement to capitalize leases that had previously been reported as operating leases. There was some evidence of negative price responses for certain companies; this situation could have been due to the existence of debt covenants as well as the adverse effect lease capitalization would have on the firms’ future borrowing capacity.
SOME FURTHER QUESTIONS RELATIVE TO MARKET EFFICIENCY
Clearly there is some degree of efficiency present in securities-market transactions. The question is one of how much efficiency exists, which is virtually impossible to answer. However, several recent studies provide evidence that there may be somewhat less than is postulated in the semistrong form of the efficient-markets hypothesis. Ou and Penman, in a very extensive study, invoked the idea of fundamental stock analysis. Fundamental analysis assumes that securities markets are inefficient and that underpriced shares can be found by means of financial statement analysis. This view is directly opposed to the efficient-markets view that prices of securities rapidly reflect all publicly available information (the semistrong form of the hypothesis). Ou and Penman used traditional accounting measures such as return on total assets, gross margin ratio, and percentage of change in current assets in a multivariate model to predict whether the following year’s income would increase or decrease. The time period covered was between 1965 and 1977, the model included almost twenty accounting measures, and approximately 23.000 observations were made. Ou and Penman were able to describe the following year earnings changes correctly almost 80 percent of the time. The key point concerns whether their predictors were capturing information that was not already reflected in security prices but that would be subsequently reflected in security prices and would thus result in abnormal security return if investmet were based on the earnings predictions of their model. Their analysis indicates that this is exactly what would have occurred. They also believed that the excess security returns would not have been attributable to excess risk factors, though they were not entirely sure on this particular point. Ou and penman’s research thus indicates that markets are not as efficient as efficient-markets advocates would like to believe and that fundamental analysis is still important for investment purposes. This study also implies that “better” accounting standards might improve the predictive ability of accounting information, which leads us to Lev’s work. Lev concentrated on an issue that is complementary to the factors in the Ou and Penman study. Specifically, his point is that both over time and within years (cross-sectional studies), the correlation between earnings numbers and stock returns has been exceedingly low. Earnings, in other words, have very little explanatory power (as measured by R, te coefficient of correlation) relative to changes in stock prices. Lev believes that one of the principal reasons for this situation lies with the low quality of reported income numbers: Research on the quality of earnings shifts the focus to an explicit consideration of accounting issues by calling for a systematic examination of the extent to which the specific principles underlying accounting measurements and valuations, as well as managerialmanipulations, detract from the usefulness of earnings and other financial variables. Such research has the potential both to further our understanding of the role of financial information in asset valuation and to contribute meaningfully to accounting policymaking. Thus the Lev and Ou and Penman papers are complementary because one finds a low explanatory relationship between earnings and stock returns while the other sees a predictive role for accounting data in a market that may be less efficient than previously thought. One article (Lev’s) looks directly at the issue of mimlproving accounting measurements while the other may certainly be said to imply this point.
ACCOUNTING INFORMATION AND RISK ASSESSMENT
Capital market research has also investigated the usefulness of accounting numbers for assessing the risk of securities and portfolios. These studies have found high correlations between the variability of accounting earnings and beta, the market-risk measure. The high correlations imply that accounting data may be useful for assessing risk. Some other research has tried to determine if alternative accounting policies have any effect on risk. The purpose of this type of research is to identify how alternative accounting policies or disclosures may affect the usefulness of accounting numbers for assessing risk. For example, one study tried to determine if unfunded pension benefits (reported in footnotes) affected beta. There was no significant impact. From this evidence, it might be concluded that pension information is not useful for risk assessments. However, other studies found that supplemental segment (line of business) disclosures resulted in a revision of systematic risk, which suggests that such information is useful for risk assessments. Other studies have tested the association of financial ratios with beta. Some of the ratios and computations tested include dividend payout ratio, leverage, growth rates, asset size, liquidity, and pretax interest coverage, as well as earnings and earnings variability. In general, these tests indicate a strong association between the accounting-based ratios and the market measure of risk, beta. SUMMARY OF ACPITAL MARKET RESEARCH Empirical evidence from capital market research is supportive of these statements : 1. Accounting earnings appear to have information content and to affect security prices. 2. Alternative accounting policies with no apparent direct or indirect cash flow consequences to the firm do not seem to affect security prices, though this issue is not entirely settled. 3. Alternative accounting policies that have direct or indirect cash flow consequences to the firm (or its owners) do affect security prices. 4. There are incentives to choose certain accounting policies, where choice exists, owing to indirect cash consequences. 5. Accounting-based risk measures correlate with market risk measures, suggesting that accounting numbers are useful for risk assessment. In the early 1970’s, some argued that capital market research could be used as a basis for (1) choosing the best accounting policies and (2) evaluating the economic consequences of alternative accounting policies on security prices. Accounting policies that most affected security prices were thought to be most useful. In other words, such policies would have had the most information content. The argument had intuitive appeal, particularly since deductively based research had proved unable to resolve the normative accounting theory debate about the most desirable form of accounting. However, the early advocates of security-prices research now recognize the limitations of this research for such a use. Reasons for these limitations are the public-good nature of accounting information, the existence of free riders, and the resultant market failure in terms of optimal resource allocation. In spite of its inability to resolve accounting theory and policy questions, capital market research continues to be useful in empirically evaluating economic consequences of accounting policies vis-à-vis security prices and the usefulness of accounting numbers for risk-and-return assessments. Perhaps more than anything else, though, the impact of capital market research is that it brought a different perspective to accounting theory and policy at a time when the emphasis, was primarily on deductively based theory. SURVEYS OF INVESTORS Another way of determining the usefulness of accounting information is to directly ask investors how (if at all) they use annual reports. Surveys of investors have been undertaken in several countries and generally have shown a rather low readership of accounting information. Approximately one-half of the investors surveyed indicated they read financial satatements. Institutional investors have shown a much higher level of readership. These surveys , particularly of individual investors, should be interpreted cautiously, however. Individual investors may rely on investment analysts to process accounting information. It would be simplistic to assume accounting information has no usefulness to investors merely because many individual stockholders do not read annual reports in detail. Another type of survey research has asked investors to weigh the importance of different types of investment information, including accounting information. Several studies of this type have been reported. Accounting information ranks fairly high in importance in these surveys, though not at the top. This status seems to be attributable to the historical nature of accounting information and the reporting-lag effect. More timely accounting information from company press reports, and nonaccounting information such as general economic conditions and company announcements on products and markets, rank ahead of annual reports in perceived importance.
ACCOUNTING INFORMATION AND CROSS-SECTIONAL VALUATION
MODELS The research discussed in the previous section primarily examined the relationship between accounting data and changes in stock prices (measured as abnormal returns). Another approach has been to examine the association between accounting data reported in annual financial statements and the levels of stock prices (i.e, firm valuation, measured as market capitalization). Conceptually, this approach, which is reffered to as cross-sectional valuation, attempts to empirically estimate the theoretical model of equity valuation described at the beginning of this chapter. This approach has been used to investigate how (if at all) specific components of the financial statements are “priced”in the sense of being associated with the market valuation of the firm. If an item is “priced”as an asset/revenue, it should normally have a positive relation to market value, whereas if the item is “priced” as a liability/expense it should normally have a negative relation with market value. A number of authors have expressed enthusiasm for this methodology as a framework for evaluating the merits of alternative accounting methods/valuations. Several studies have used this framework to determine that a firm’s pension plan assets and liabilities (as reported off-balance sheet in footnote disclosures) are consistent with their being viewed as real (i.e, on-balance sheet) assets and liabilities, respectively. Another study determined that clomponents of pension expense (per SFAS No.87) are not weighted equally in terms of their association with market valuation. Of particular interest is that the transitional asset amortization component of pension expense was implicitly valued at zero. Which is consistent with the fact that there are no cash flows associated with the item. Another study examined the association of research and development (R&D) expendictures with firm value. The major finding was that, on average, each dollar of R&D was associated with a five-dollar increase in market value. This result provides evidence that the market is implicity capitalizing R&D outlays even though SFAS No.2 prohibits explicit capitalization. In other words, the market interprets R&D as an asset (investment) rather than an expense, contrary to the accounting treatment required by SFAS No.2. The financial services industry is another area in which cross-sectional valuation models have been used.studies have examined supplemental disclosures of nonperforming loans (default risk) and interest rate risk in banks and thrifts. Nonperforming loans are negatively associated with firm value, though this effect is greater for banks than for thrifts. Interest rate risk was negatively associated with firm value only for banks. Another study reported that banks supplemental disclosure of the “fair market value” of investment securities is associated with market value over and above that explained by historical costs alone, a finding that gives credence to the SEC’s and FASB’s recent push for mark-to-market accounting.
THE ROLE OF AUDITING IN THE FINANCIAL REPORTING PROCESS
An assumption underlying all of the research reviewed in this chapter is that financial statement information is reliable in the sense of having been prepared in accordance with generally accepted accounting principles applied on a consistent basis. The independent auditor’s role is to attest that this is in fact the case. For this reason, financial statements are properly understood as jointly produced by the firm and the auditor. The demand for auditing can be explained by agency theory, which was discussed in chapters 2 and 4. Because of conflicting incentives between owners and managers, monitoring or control of managers occurs via mechanisms such as boards of directors and independent audits. In addition, companies have voluntary incentives to signal to outsiders (potential investors and creditors) that the financial statements are reliable. Thus, independent audits also serve the role of enhancing outside credibility of financial statements, in addition to the control function within the firm of monitoring managers. How do audits enhance financial statement reliability? A recent comprehensive study drew on a large sample of actual auditor workpapers to determine dollar amounts of adjustments to financial statements required by auditors. These adjustments represented the auditor’s correction for material misstatements in the financial statements. Assuming a standard rule-of-thumb of 5 percent materiality level (i.e, 5 percent of net income or total assets), the study estimated that unaudited net income and total assets would have been overstated by amounts in the range of 2 to 8 times the materiality level (i.e, a 10 percent to 40 percent overstatement of net income and total assets). Of course, absent the prospect of an audit, the misstatements are likely to have been even higher. This is deterrence effect of knowing the financial statements will be audited. Another study found that subsequent period quarterly earnings announcement following the issuance of a qualified audit report, on average, led a lower stock price response than for companies having unqualified audit reports. In other words, following the issuance of a qualified audit report, investors are more skeptical of earnings announcements, at least until the next year’s annual audit report. Finally, a number of studies have examined the value of auditing by comparing companies audited by the well-known and putatively higher-quality brand name Big Six auditors with companies that are audited by other auditors. There is evidence that Big Six audted companies are valued more highly when initially going public (unseasoned stock issues) and when subsequently issuing securities (seasoned stock issues). There is also evidence that earnings announcementsby Big Six audited companies have more credibility. Specifically, unexpected earnings are associated with a larger stock price response when the auditor is a Big Six firm.
ACCOUNTING DATA AND CREDITORS
Theories underlying the usefulness of accounting information to creditors is not as well developed as is the role of accounting numbers vis-à-vis stock prices. It is, however, generally agreed that the price of interest-bearing debt is based on default risk, which is defined as the premium in excess of the risk-free interest rate on otherwise identical debt (for example, US.Treasury obligations). Thus, firm-specific information, including accounting data, aids creditors in assessing default risk. Several distinct lines of research have emerged: (1) the usefulness of accounting data in predicting corporate bankruptcy (which encompasses loan default); (2) the association of accounting data with ond ratings wherein such ratings are presumed to proxy for default risk; (3) the association of accounting data with estimates of interest-rate risk premiums on debt; and (4) experimental studies of the role of accounting data in lending decisions. We will present a brief overview of the research findings. Accounting-based ratios have been very useful in discriminating between firms that subsequently went bankrupt and those that did not. Predictability up to five years prior to bankruptcy has been demonstrated. These findings do not mean that companies with “bad” ratios will necessarily go bankrupt in the future. It simply means that bankrupt companies tend to have financial ratios prior to bankruptcy that differ from nonbankrupt companies. The existence of “bad”ratios does not mean bankruptcy will occur, just that it is more probable. Accounting data is also associated with both bond ratings and interest-rate risk premiums. Among the important ratios are profitability, earnings variability, and leverage. Research has also been used to evaluate which of alternative sets of accounting data are more highly associated with bankruptcy prediction, bond ratings, and risk premiums. Among the issues examined have been historical cost versus price-level-adusted income, the effect of lease capitalization versus noncapitalization, and recognition of pension liabilities versus footnote-only disclosure. Experimental (laboratory) studies have also tested the usefulness of accounting data for creditors. Accounting data in the context of a loan-related decision (for example, loan amount, bankruptcy prediction, and interest rates) are provided to subjects to determine how, if at all, it affects their hypothetical decisions. In these experiments, the accounting data are manipulated to see if the judgements are sensitive to whatever manipulations take place; for example, magnitudes of accounting ratios or financial statements prepared under alternative policies (for example, lease capitalization versus noncapitalization). Generally, these studies support the sensitivity of loan-related decision making to key accounting data and, in this sense, complement the findings based on economic field data.
THE USEFULNESS OF ACCOUNTING ALLOCATIONS
At present, the historical cost accounting model remains the basic framework for financial reporting. Central to this model are revenue recognition rules and the matching of costs to revenue. Many costs are recognized over multiple accounting periods. Some examples include depreciation, organizational start-up costs, goodwill amortization, and bond premium/discount amortization. The recognition of these types of costs over multiple periods is referred to as accounting allocation. Allocations have been criticized on the grounds that they are “incorrigible”. By this it is meant that there is no obviously correct way to allocate the costs because no single allocation method can be proved superior to another. For example, it cannot be proved that straight-line depreciationis any more appropriate than accelerated depreciation methods. Another way of describing this dilemma is to say that no allocation is completely defensible against other methods. For this reason, it has been concluded that all accounting allocations are, in the end, arbitrary. Conceptually, this is a very disturbing idea and strikes at the logical core of historical cost accounting. Because of the arbitrariness of accounting allocations, allocation-free financial staatements have been advocated as a better way of reporting useful information. Allocation-free accounting can be accomplished by using cash flow statements, exit-price systems (as discussed in appendix 1-A of Chapter 1), and certain types of replacement cost systems. However, the fact that accounting allocations are arbitrary does not prove that accounting information is useless. The allocation argument is deductive and examines the logic of historical cost accounting. Usefulness is an empirical question, not a matter of deductive logic. There is no evidence to support the contention that allocation-based financial statements are useless. In fact, there is a great deal of evidence from capital market research that supports the information content of accounting income numbers. Capital market research in the area of alternative accounting policies does support the arbitrariness of accounting allocations. Alternative policies with no known cash flow consequences have no effect on security prices, which supports the argument that allocations are arbitrary and convey no information to users. However, the research findings also support the factthat investors are not naïve and that they are capable of adjusting accounting numbers in order to achieve comparability between companies. In spite of allocations, income numbers are useful and investors appear able to achieve comparability by adjusting for the effects of arbitrary allocations. It must also be remembered that allocations represent only a part of the total accounting information in financial statements. Much accounting information contains no allocations. Even if the allocation criticism is valid, usefulness may still be high. That is, the historical cost allocation-based approach may still be the most cost-effective method of reporting financial information about firms. A policy implication of allocation research is that the FASB should not try to resolve problems by searching for the best allocation. On the other hand, the FASB should not necessarily avoid allocations. They may be the most cost-effective means of producing financial statements. Another implication is that the FASB should reduce flexibility in accounting allocations. Given the evidence from capital market research, there is no compellingreason to permit arbitrary flexibility. Rigid uniformity would be easier to apply and would eliminate some arbitrary differences between companies. It will be recalled that security prices adjust for such arbitrary differences in accounting allocations. In the case of accounting allocations with no real cash flow consequences a strong argument exists for rigid uniformity .