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Abstract:
Economic Value Added (EVA) has attracted considerable attention as an alternative to traditional accounting earnings for use in both valuation and incentive compensation. With a host of consultants now marketing related metrics, numerous claims have been made - most based on anecdotal evidence or in-house studies. This paper summarizes independent evidence regarding EVA's alleged advantages. We begin by reviewing the theory that links the underlying concept of residual income to shareholder value. Second, we discuss how Stern Stewart modifies residual income to produce its proprietary EVA metric and show how median EVA compares with residual income, net income and operating cash flows over the period 1988-97. Third, we examine the claim that EVA is more closely associated with stock returns and firm value than is net income. The evidence indicates that EVA does not dominate net income in associations with stock returns and firm values. Fourth, we examine a second claim that compensation plans based on residual income motivate managers to take actions consistent with increasing shareholder value. Here, the independent evidence suggests that managers do respond to residual income-based incentives. Finally, we discuss how a metric such as EVA can be useful for internal incentive purposes even if it conveys little news to market participants regarding the firm's valuation.

Abstract:
We investigate whether accounting discretion is (i) abused by opportunistic managers who exploit lax governance structures, or (ii) used by managers in a manner consistent with efficient contracting and shareholder value-maximization. Prior research documents an association between accounting discretion and poor governance quality and concludes that such evidence is consistent with abuse of the latitude allowed by accounting rules. We argue that this interpretation may be premature because, if such association is indeed evidence of opportunism, we ought to observe subsequent poor performance, ceteris paribus.

Following Core et al. (1999) we conduct our analysis in two stages. In the first stage, we extend the prior literature and again find a link between poor governance and managers' accounting discretion. However, in the second stage we fail to detect a negative association between accounting discretion attributable to poor governance and subsequent firm performance. This suggests that, on average, managers do not abuse accounting discretion at the expense of firms' shareholders. Rather, we find some evidence that discretion due to poor governance is positively associated with future operating cash flows, which suggests that shareholders may benefit from earnings management, perhaps because it signals future performance.

Accounting discretion, earnings smoothing, abnormal accruals, corporate governance, managerial opportunism, signaling, firm performance.

Abstract:
Accountants and economists have claimed that residual income has attributes superior to reported accounting earnings. In recent years, Stern Stewart & Co. has successfully marketed a variant of residual income ("economic value added"; or EVA?) to U.S. and international corporations. The purpose of this paper is to 1) empirically test assertions that EVA is more highly associated with stock market returns and firm values than are earnings and cash from operations, and 2) evaluate which components of EVA, if any, are contributing to its association with stock returns.

We first compare the relative information content of residual income and EVA versus two currently mandated performance measures, earnings and cash from operations. Results for the full sample suggest that, while each measure is individually significant, earnings is more highly associated with market-adjusted returns than is residual income, EVA, or cash from operations. Next, we conduct incremental information content tests on components of EVA (e.g., cash from operations, operating accruals, capital charge, and accounting "adjustments";). Results suggest that cash from operations and accruals are of primary importance while EVA components are statistically significant only in some samples. Finally, we conduct sensitivity analyses by repeating our tests using: a) subsets of firms categorized into "firm-types" by Stern Stewart; b) positive and negative values of each independent variable to allow the regression coefficients to differ; c) subsets of firms that report using EVA for internal business decisions; and d) five-year return intervals. Considered together, these results do not support claims that EVA dominates earnings in relative information content, and suggest rather that earnings generally outperforms EVA.

Abstract:
This study tests assertions that Economic Value Added (EVA) is more highly associated with stock returns and firm values than accrual earnings, and evaluates which components of EVA, if any, contribute to these associations. Relative information content tests reveal earnings to be more highly associated with returns and firm values than EVA, residual income, or cash flow from operations. Incremental tests suggest that EVA components add only marginally to information content beyond earnings. Considered together, these results do not support claims that EVA dominates earnings in relative information content, and suggest rather that earnings generally outperforms EVA.

Value-relevance, relative information content, incremental information content, firm market value, economic value added, EVA, residual income, economic profits, earnings, cash from operations, charge for capital.

Abstract:
This study investigates determinants of the present value of future residual income for firms operating in the pharmaceutical industry. It is well known that residual income has both economic and accounting components. We exploit the industrial organization and competitive strategy literatures to identify general features of economic context that are likely to be related to the generation of economic profit. Applying this framework to the pharmaceutical industry, we identify product innovation, product promotion, strategic success, and operating efficiency as four determinants of the economic component of residual income and select ten accounting variables to proxy for these determinants. We then draw on prior accounting research to specify when we expect accounting rules to create period-by-period timing differences between economic profit and residual income. In the pharmaceutical industry, research and development and advertising are important activities and the accounting rules for these items are likely to systematically bias residual income relative to economic profit. We combine our analysis of economic and accounting determinants of residual income to develop industry-wide hypotheses relating the ten accounting variables to the prediction of the present value of future residual income. The results of our empirical analyses are generally consistent with these hypotheses and the explanatory power of the model is quite high. Most firms in the pharmaceutical industry offer a mix of products that span three product segments with differing economic and accounting contexts. We exploit this richness of the pharmaceutical industry to develop hypotheses for industry segment related differences in the magnitudes of the multipliers on the ten accounting variables. The results are generally consistent with our predictions that the magnitudes of these multipliers are conditioned on the firm?s product mix and that the impact of accounting bias introduced by certain accounting rules varies as predicted. We supplement the analysis of the present value of residual income with a direct examination of the explanatory power of the ten accounting variables for equity value. The explanatory power of our model is again quite high and is considerably higher than that of comparison models taken from the prior literature. Overall, our approach for considering economic and accounting contexts in the pharmaceutical industry is successful in identifying value relevant accounting data beyond earnings and beyond a simple decomposition of earnings.

Key Words: Economic context; Accounting Context; Value relevance; Residual income; Abnormal earnings; Structure; conduct; Performance; Pharmaceutical industry; Industry segments; Non-financial data

Abstract:
This study synthesizes and extends the prior literature examining economic motives for manager's accounting method choices. First, we present a framework for organizing the economic factors that potentially influence managers' accounting decisions. We apply our framework to examine inventory and depreciation method choices because they are directly observable and have large sustained effects on earnings. Second, we present descriptive statistics on the distribution of these and combined-method choices for the years 1984, 1990, and 1996. Both firm and industry level data show a preponderance of income-increasing methods in each year as well as a trend toward more income-increasing methods over time. Third, we identify 19 independent variables (largely drawn from the past 20 years of research) to explain the inventory, depreciation, and combined-method choices of over 2,000 firms for the years 1984, 1990 and 1996. Taken together, these variables explain a high percentage of the cross-sectional variation in method choices (e.g., adjusted R2 of 23%-27% for combined-method choices). Finally, we add variables that proxy for industry determinants of accounting method choice, which increases total explanatory power to 28%-37% for combined-method choices. Both sets of variables, economic and industry, have incremental explanatory power over the other. Given earlier studies often explained less than 5%, our results suggest that, cumulatively, the accounting literature has made considerable progress in identifying economic factors associated with managers' accounting method choices.

Abstract:
There is limited direct evidence on the impact of analyst coverage on the cost of capital. In this paper, we hypothesize that the amount and nature of analyst coverage can reduce information asymmetry among investors and thus lower the cost of raising equity capital. We investigate the effect of analyst coverage on the underpricing of seasoned equity offerings (SEOs), which is a substantial cost of issuing new shares. Based on 4,766 SEOs in the period 1984-2000, our results suggest that more analyst coverage is associated with lower SEO underpricing. Compared with firms without analyst coverage, firms with the median level of analyst coverage - three analysts - have a 1.19% lower SEO underpricing, a relative decrease of 38%. This effect is robust to controlling for other factors affecting SEO underpricing. We also examine additional attributes of analyst coverage and find that firms followed by analysts working for the lead underwriter, with a reputation for superior ability, or with lower forecast dispersion have incrementally lower SEO underpricing.

Analyst coverage, information asymmetry, cost of capital, seasoned equity offering

Abstract:
The financial press and accounting regulators (e.g., the SEC and FASB) have expressed concern about pressures on Internet firms to report high levels of revenue. This study verifies the association between market capitalization and revenue, and examines economic factors that potentially influence Internet company managers' decisions to adopt allegedly aggressive revenue recognition policies. Specifically, we examine factors hypothesized to influence reporting of advertising barter revenue and grossed-up sales levels.

We begin by providing descriptive evidence on the use of barter and grossed-up revenue across Internet sectors. While common in some sectors, we find that use of these accounting policies is not pervasive overall. We limit our empirical analyses to Internet companies that have the opportunity to report grossed-up or advertising barter revenue. Our cross-sectional predictions are based on both external and internal incentives to maximize revenues as well as constraints that may limit management's discretion. We predict that the following factors increase the likelihood that a firm will report grossed-up and/or barter revenue: shorter time before needing additional external financing, more active individual investor interest in the firm's stock, more active pursuit of growth via acquisitions, and greater use of stock options in employee compensation. We also posit that barter transactions might be an inexpensive way for firms to evaluate the viability of future marketing or content alliances with potential partners. Finally, we predict constraints on management discretion to be related to the reputation/quality of the firm's auditor and underwriter, and the extent of management ownership.

We find that firms with greater cash burn rates and higher levels of activity on Motley Fool message boards are consistently associated with barter and grossed-up revenue reporting. This suggests that the pressure to seek external funding and the extent of active individual investor interest in a firm influence Internet managers' use of allegedly aggressive revenue reporting practices. In addition, it appears that firms reporting barter revenue are more likely to enter into marketing and content alliances, suggesting the potential for future alliances may be another motivation for managers to enter into barter transactions.

tax, VAT, fiscal policy

Abstract:
The financial press and accounting regulators (e.g., the SEC and FASB) have expressed concern about pressures on Internet firms to report high levels of revenue. This study verifies the association between market capitalization and revenue, and examines economic factors that potentially influence Internet company managers' decisions to adopt allegedly aggressive revenue recognition policies. Specifically, we examine factors hypothesized to influence reporting of advertising barter revenue and grossed-up sales levels.

We begin by providing descriptive evidence on the use of barter and grossed-up revenue across Internet sectors. While common in some sectors, we find that use of these accounting policies is not pervasive overall. We limit our empirical analyses to Internet companies that have the opportunity to report grossed-up or advertising barter revenue. Our cross-sectional predictions are based on both external and internal incentives to maximize revenues as well as constraints that may limit management's discretion. We predict that the following factors increase the likelihood that a firm will report grossed-up and/or barter revenue: shorter time before needing additional external financing, more active individual investor interest in the firm's stock, more active pursuit of growth via acquisitions, and greater use of stock options in employee compensation. We also posit that barter transactions might be an inexpensive way for firms to evaluate the viability of future marketing or content alliances with potential partners. Finally, we predict constraints on management discretion to be related to the reputation/quality of the firm's auditor and underwriter, and the extent of management ownership.

We find that firms with greater cash burn rates and higher levels of activity on Motley Fool message boards are consistently associated with barter and grossed-up revenue reporting. This suggests that the pressure to seek external funding and the extent of active individual investor interest in a firm influence Internet managers' use of allegedly aggressive revenue reporting practices. In addition, it appears that firms reporting barter revenue are more likely to enter into marketing and content alliances, suggesting the potential for future alliances may be another motivation for managers to enter into barter transactions.

Abstract:
In 1998, the SEC expressed concern that conference calls encourage selective disclosure by revealing new information to financial analysts privy to the call. This study investigates whether the regular use of earnings-related conference calls increases the amount of information available to financial analysts by examining the effect of conference calls on analysts' forecast error and dispersion. Results indicate that conference calls increase analysts' ability to forecast earnings accurately, suggesting that these calls increase the total information available about a firm. We also find some evidence that conference calls decrease dispersion among analysts. Given conference calls were generally restricted during our sample period, our evidence suggests that conference calls may have contributed to an information gap between analysts privy to the call and the remainder of the investment community.

We also investigate whether conference calls differentially affect analysts' forecast errors depending on analysts' prior forecasting ability or brokerage-house affiliation. We find evidence suggesting that analysts with relatively weak prior forecasting performance benefit more from conference calls, suggesting that conference calls help "level the playing field" across analysts.

conference calls, security analysts, forecast error, forecast dispersion, disclosure, information environment, Reg FD

Abstract:
In 1998, the SEC expressed concern that conference calls encourage selective disclosure by revealing new information to financial analysts privy to the call. This study investigates whether the regular use of earnings-related conference calls increases the amount of information available to financial analysts by examining the effect of conference calls on analysts' forecast error and dispersion. Results indicate that conference calls increase analysts' ability to forecast earnings accurately, suggesting that these calls increase the total information available about a firm. We also find some evidence that conference calls decrease dispersion among analysts. Given conference calls were generally restricted during our sample period, our evidence suggests that conference calls may have contributed to an information gap between analysts privy to the call and the remainder of the investment community.

We also investigate whether conference calls differentially affect analysts' forecast errors depending on analysts' prior forecasting ability or brokerage-house affiliation. We find evidence suggesting that analysts with relatively weak prior forecasting performance benefit more from conference calls, suggesting that conference calls help "level the playing field" across analysts.

Conference calls, Security analysts, Forecast error, Forecast dispersion, Disclosure, Information environment, Reg FD

Abstract:
Earnings press releases provide managers a forum to present their firm's quarterly financial information and perhaps influence perceptions of the firm's stakeholders. We explore the use of managerial emphasis as a disclosure tool and contribute to the debate over pro forma earnings. We examine (1) the determinants of emphasis placed on pro forma and GAAP earnings within quarterly earnings press releases, (2) whether there has been a shift away from emphasizing pro forma earnings toward GAAP earnings, and (3) whether stock market reactions to earnings news were influenced by emphasis placed on metrics within the press release. We find that firms emphasize metrics that are more value-relevant and portray more favorable firm performance. We also find that the extent of a firm's media coverage affects managers' emphasis decisions. Further, our results indicate a highly significant shift toward GAAP emphasis and away from pro forma emphasis in 2002 relative to 2001. Finally, our stock market tests suggest that greater emphasis on an earnings metric results in a stronger market reaction to the surprise in that metric. Overall, these findings are consistent with managers using emphasis in the earnings press release as a disclosure tool and this emphasis influencing at least one important stakeholder group - investors.

press release, emphasis, metrics, disclosure, pro forma and GAAP earnings, determinants, stock market reactions

Abstract:
Although some argue that whistle-blowing allegations are often frivolous and of little merit, the Sarbanes-Oxley Act of 2002 increased protection for employees who allege corporate financial misdeeds. We document what we believe is the first systematic evidence on the characteristics and economic consequences of firms subject to employee allegations of corporate financial misdeeds over the years 1989-2004. Compared to a control group that avoided public whistle-blowing allegations (a combined sample of lawsuit firms and restatement firms), firms subject to whistle-blowing events tend to have a recently downsized workforce, relatively strong recent stock return performance, and tend to be relatively large, growing, highly regarded, poorly governed, and concentrated in select industries, including healthcare and defense contracting where the whistle-blower may share in a fraud settlement with the U.S. government. On average, a whistle-blowing announcement is associated with a negative 2.8% market-adjusted 5-day stock price reaction and this reaction is especially negative if the allegation involves earnings management (-7.3%). Compared to a control group that exhibits characteristics similar to whistle-blowing targets, firms subject to whistle-blowing allegations are associated with further negative consequences including earnings restatements, shareholder lawsuits, and negative future operating and stock return performance, suggesting that whistle-blowing allegations are a useful mechanism for uncovering agency issues. Relative to a control sample, whistle-blowing targets exposed by the press are more likely to make governance changes that reduce the size of the board, reduce insider representation on boards and replace the CEO.

whistle-blowing, corporate governance, fraud

Abstract:
This study adds to the literature that attempts to explain firms' accounting method choices by expanding the traditional set of independent variables to include those derived from implicit claims between the firm and its customers suppliers employees and short-term creditors. On large samples of surviving firms over five non-adjacent years we find that implicit claims variables explain on average 13% (and never less than 10%) of the cross-sectional variation in combined scores for inventory and depreciation methods. We find that our implicit claims variables remain incrementally significant when we include independent variables found to have explanatory power in prior studies (i.e. leverage bonus compensation tax and regulatory/political exposure variables). Taken together implicit claims and traditional variables explain on average 19% of the variation in combined scores for inventory and depreciation methods (and never less than 16.6%).

Abstract:
Fair value accounting (FVA) has been blamed for amplifying the recent financial crisis. We conduct an event study of policymaker deliberations, recommendations and decisions about FVA and impairment rules in the banking industry. If FVA was a key contributor to the financial crisis as some industry pundits and academic research suggest, we first should observe positive stock market reactions to proposals to curtail FVA and negative reactions when policymakers support FVA. Second, we expect especially positive reactions to the curtailment of FVA and impairment rules for banks that are relatively sensitive to pro-cyclical contagion. Third, we investigate cross-sectional reactions to factors that potentially contribute to pro-cyclical contagion, including relatively (i) low regulatory capital, (ii) more assets recorded at fair value, (iii) poor asset liquidity, (iv) larger potential impairments, and (v) more trading assets. Finally, we expect banks that have fewer alternative sources of information about fair values beyond those reported in financial statements to experience relatively negative reactions to potential relaxation of FVA and impairment rules.

We examine ten event windows related to FVA and impairment rules for financial institutions. We find that events that signaled an increased (decreased) probability that existing FVA standards would be relaxed (retained) generally produced positive (negative) abnormal stock price reactions for sample banks. As predicted, the magnitude of the stock price reactions was positively related to our proxy for individual bank’s susceptibility to contagion. Further, stock price reactions were associated with specific attributes that could contribute to contagion, including banks’ capital levels, holdings of illiquid assets and banks’ likelihood of being subject to other-than-temporary-impairments. Finally, stock price reactions were negatively related to the absence of analyst coverage, our proxy for the weakness of banks’ information environment. In sum, while stock market participants appeared to welcome relaxation of FVA and impairment rules during the financial crisis of 2008-09, the potential loss of fair value information was perceived to be significant for banks with a thin information environment. We believe our study informs the debate about the role of FVA in the recent financial crisis.

Fair value accounting, mark-to-market, financial crisis, credit crunch, contagion, subprime crisis, standard setting

Abstract:
There is limited direct evidence on the impact of analyst coverage on the cost of capital. In this paper, we hypothesize that the amount and nature of analyst coverage can reduce information asymmetry among investors and thus lower the cost of raising equity capital. We investigate the effect of analyst coverage on the underpricing of seasoned equity offerings (SEOs), which is a substantial cost of issuing new shares. Based on 4,766 SEOs in the period 1984-2000, our results suggest that more analyst coverage is associated with lower SEO underpricing. Compared with firms without analyst coverage, firms with the median level of analyst coverage - three analysts - have a 1.19% lower SEO underpricing, a relative decrease of 38%. This effect is robust to controlling for other factors affecting SEO underpricing. We also examine additional attributes of analyst coverage and find that firms followed by analysts working for the lead underwriter, with a reputation for superior ability, or with lower forecast dispersion have incrementally lower SEO underpricing.

Analyst coverage, information asymmetry, cost of raising capital, seasoned equity offering

Abstract:
We investigate whether accounting discretion is (i) abused by opportunistic managers who exploit lax governance structures, or (ii) used by managers in a manner consistent with efficient contracting and shareholder value-maximization. Prior research documents an association between accounting discretion and poor governance quality and concludes that such evidence is consistent with abuse of the latitude allowed by accounting rules. We argue that this interpretation may be premature because, if such association is indeed evidence of opportunism, we ought to observe subsequent poor performance, ceteris paribus.

We conduct our analysis in two stages. In the first stage, we extend the prior literature and again find a link between poor governance and managers' accounting discretion. However, in the second stage we fail to detect a negative association between accounting discretion attributable to poor governance and subsequent firm performance. This suggests that, on average, in our relatively large sample, managers do not abuse accounting discretion at the expense of firms' shareholders. Rather, we find some evidence that discretion due to poor governance is positively associated with future operating cash flows and ROA, which suggests that shareholders may benefit from earnings management, perhaps because it signals future performance.

Accounting discretion, earnings smoothing, abnormal accruals, corporate governance

Abstract:
Earnings press releases provide managers a forum to present their firm's quarterly financial information and perhaps influence perceptions of the firm's stakeholders. We explore the use of managerial emphasis as a disclosure tool and contribute to the debate over pro forma earnings. We examine (1) the determinants of emphasis placed on pro forma and GAAP earnings within quarterly earnings press releases, (2) whether there has been a shift away from emphasizing pro forma earnings toward GAAP earnings, and (3) whether stock market reactions to earnings news were influenced by emphasis placed on metrics within the press release. We find that firms emphasize metrics that are more value-relevant and portray more favorable firm performance. We also find that the extent of a firm's media coverage affects managers' emphasis decisions. Further, our results indicate a highly significant shift toward GAAP emphasis and away from pro forma emphasis in 2002 relative to 2001. Finally, our stock market tests suggest that greater emphasis on an earnings metric results in a stronger market reaction to the surprise in that metric. Overall, these findings are consistent with managers using emphasis in the earnings press release as a disclosure tool and this emphasis influencing at least one important stakeholder group - investors.

press release, emphasis, metrics, disclosure, pro forma and GAAP earnings, determinants, stock market reactions