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Abstract:
This essay describes implications of the subprime crisis for accounting. First, I overview the institutional and market aspects of subprime lending with the greatest accounting relevance. Second, I discuss the critical aspects of FAS 157's fair value definition and measurement guidance and explain the practical difficulties that have arisen in applying this definition and guidance to subprime positions during the crisis. I also raise a potential issue regarding the application of FAS 159's fair value option. Third, I discuss issues that have arisen regarding sale accounting for subprime mortgage securitizations under FAS 140 and consolidation of securitization entities under FIN 46(R) associated with mortgage foreclosures and modifications. Fourth, I indicate ways that accounting academics can address the implications of the subprime crisis in their research and teaching.

Subprime crisis, credit crunch, fair value accounting, securitization

Abstract:
This essay describes implications of the subprime crisis for accounting. First, I overview the institutional and market aspects of subprime mortgages and other positions, focusing on those with the greatest relevance for accounting. I explain how the investment performance of subprime-mortgage-related positions has a binary quality that depends on subprime mortgagors' ability to obtain cash-out refinancing. I describe how the subprime crisis evolved in four waves that roped in more positions and affected those positions more severely over time. Second, I discuss the critical aspects of FAS 157's definition of fair value and guidance for fair value measurements. I explain the practical difficulties that have arisen in applying that definition and guidance to subprime positions in the current illiquid markets. I also raise a potential issue regarding the application of FAS 159's fair value option. Third, I discuss issues that have arisen regarding sale accounting for subprime mortgage securitizations under FAS 140 and consolidation of securitization entities under FIN 46(R) associated with foreclosures and modifications of mortgages. Fourth, I indicate ways that accounting academics can address the implications of the subprime crisis in their research and teaching.

Subprime crisis, credit crunch, fair value accounting, securitization

Abstract:
The purpose of this essay is to provide useful guidance for empiricists interested in measuring conditional conservatism and in interpreting associations of those measures with variables of interest. Conditional conservatism involves the more timely recognition of bad news than good news in earnings (often referred to as asymmetric timeliness), as occurs with impairment accounting for many types of assets. Conditional conservatism is distinct from unconditional conservatism, which involves the predetermined understatement of the book value of net assets, as occurs with the immediate expensing of the costs of most intangibles. This purpose is predicated on the now widely held view among accounting researchers that conditional conservatism is a distinct and important type of conservatism, one with stronger or at least different ties to contracting than unconditional conservatism.

I argue that, despite its limitations documented in the literature, asymmetric timeliness is the most direct implication of conditional conservatism. Moreover, alternative measures that have been proposed need not capture any type of conservatism. Hence asymmetric timeliness should retain its primacy of place in the literature investigating conditional conservatism. I provide four specific suggestions for estimating asymmetric timeliness and for interpreting it as a measure of conditional conservatism.

Conservatism, Asymmetric Timeliness

Abstract:
We hypothesize and provide evidence that characteristics of banks' loan securitizations accounted for as sales determine the extent to which banks retain the risks of the securitized loans. We show that banks retain more risk when: (1) the types of loans have higher and/or less externally verifiable credit risk, (2) the loans are closed-ended and banks retain larger contractual interests in the loans, and (3) the loans are closed-ended and banks retain types of contractual interests that more strongly concentrate the risk of the securitized loans. We show that the magnitude and type of retained contractual interests are not risk-relevant in revolving loan securitizations, because banks have more incentive and ability to provide implicit recourse, a non-contractual interest.

Securitizations, banks, retained interests, implicit recourse, SFAS No. 140, risk

Abstract:
We hypothesize and provide evidence that certain general characteristics of banks' loan securitizations accounted for as sales determine the extent to which banks retain the risks of the securitized loans. We show that banks retain more risk when: (1) the types of loans have higher and/or less externally verifiable credit risk (specifically, commercial loans more than consumer loans more than mortgages), so banks must retain larger contractual or noncontractual first-loss interests in the loans; (2) the loans are closed-ended and banks retain larger contractual interests in the loans; and (3) the loans are closed-ended and banks retain types of contractual interests that more strongly concentrate the risk of the securitized loans (specifically, credit-enhancing interest-only strips more than other subordinated asset-backed securities). We also show that the magnitude and type of retained contractual interests are not risk-relevant in revolving loan securitizations, because banks have more incentive and ability to provide implicit recourse, a noncontractual interest. We infer that banks retain more of the risk of their securitized loans when their total equity risk as measured by future stock return volatility is more positively associated with the off-balance sheet securitized loans and the on-balance sheet contractual retained interests in those loans, all else being equal.

Securitizations, loans, banks, risk, retained interests, implicit recourse

Abstract:
Research on the usefulness of financial information generally focuses on the innovation in the information examined, such as an earnings surprise or cash flow growth. Consequently, prior research sheds little light on the role of the rich historical record of financial information in users' decision-making. Using a sample of published restatements of earnings, we show that the revision of the historical pattern of earnings, distinct from the magnitude of the restatement and its impact on current earnings, significantly affects investors' decisions and predicts class action lawsuits. Specifically, we find that restatements that eliminate or shorten histories of earnings growth or positive earnings have significantly more adverse effects for investor valuations and the likelihood of lawsuits than other restatements. This evidence about the value-relevance of refreshing the historical record of earnings is pertinent to the FASB's recent cautious expansion of the scope of circumstances that require a restatement of financial information in FAS 154.

Historical record, revisions, financial information, investors' decisions, class action lawsuits

Abstract:
We investigate whether the market prices the change in net trading assets as an operating or non-operating activity or some mixture of the two, and whether this market pricing is consistent with the (fundamental) association of the change in net trading assets with future cash flows from operations. Our investigation is motivated by the observation that despite the classification of the cash flows on trading positions as operating under FAS 102 trading is economically a hybrid operating/non-operating activity. Reflecting this hybrid nature, we hypothesize and find that the change in net trading assets has a less positive association with returns and future CFO than do the pure operating components of cash flows and accruals, and that it has a more positive association with returns and future CFO than do the pure non-operating components of cash flows. To the best of our knowledge, our paper is the first to propose and test hypotheses about the valuation implications of such hybrid cash flows and accruals.

Abstract:
We investigate whether the market prices the change in net trading assets as an operating or non-operating activity or some mixture of the two, and whether this market pricing is consistent with the (fundamental) association of the change in net trading assets with future cash flows from operations (CFO). Our investigation is motivated by the observation that - despite the classification of the cash flows on trading positions as operating under FAS 102 - trading is economically a hybrid operating/non-operating activity. Reflecting this hybrid nature, we hypothesize and find that the change in net trading assets has a less positive association with returns and future CFO than do the pure operating components of cash flows and accruals, and that it has a more positive association with returns and future CFO than do the pure non-operating components of cash flows. To the best of our knowledge, our paper is the first to propose and test hypotheses about the valuation implications of such hybrid cash flows and accruals.

Classification, cash flows, accruals, trading, banks

Abstract:
We provide evidence that banks smooth income by managing provisions for loan losses and loan charge-offs in a coordinated fashion that varies across the bust and boom phases of the business cycle and across homogeneous and heterogeneous loan types. In particular, during the 1990s boom, we predict and find that banks accelerated provisioning for loan losses and made this less obvious by accelerating loan charge-offs, especially for homogenous loans for which charge-offs are determined using number-of-days-past-due rules. We also provide evidence that the valuation implications of banks provisions for loan losses and loan charge-offs vary across the phases of the business cycle and loan types reflecting the effect of these factors on banks income smoothing. In particular, during the 1990s boom, we predict and find that charge-offs of homogenous loans have a positive association with current returns and future cash flows, because these charge-offs are recorded primarily by healthy banks with good future prospects reducing over-stated allowances for loan losses. We also predict and find that these charge-offs have a positive association with future returns that is explained by their positive association with future net income and recoveries. Our results are consistent with the market only partially appreciating healthy banks overstatement of charge-offs of homogeneous loans based on number-of-days-past-due rules during the 1990s boom, because of the perceived non-discretionary nature of these charge-offs.

Income smoothing, business cycle, banks, provisions for loan losses, loan charge-offs

Abstract:
We examine the determinants of the timing of and financial instruments involved in banks’ initial fair value option (“FVO”) elections upon their adoption of SFAS No. 159. We focus on regular (in 2008:Q1) adopters of the standard, and distinguish their FVO elections from those of early (in 2007:Q1) adopters. Song (2008), Henry (2009), and Guthrie, Irving, and Sokolowsky (2009) find that early adopters’ elections exploited SFAS No. 159’s transition guidance to manage their accounting numbers. These studies provide essentially no evidence that either early or regular adopters complied with the standard’s intent that FVO elections remedy accounting mismatches for economically offsetting positions. In contrast, we hypothesize and provide evidence that regular adopters complied with that intent, having learned from guidance the SEC and others provided about that intent and from the scrutiny early adopters’ FVO elections received. Specifically, we predict and find that variables related to accounting mismatches explain regular adopters’ FVO elections but not early adopters’ elections. We predict and find that variables related to the management of accounting and regulatory capital numbers explain early adopters’ FVO elections but not regular adopters’ elections.

We also examine banks’ initial FVO elections for the three most frequently elected types of financial instruments: AFS securities and debt for early adopters and loans held for sale for regular adopters. We provide four distinct economic and accounting reasons why banks’ FVO initial elections for AFS securities and debt were both amenable to exploitation of SFAS No. 159’s transition guidance and likely to create accounting mismatches, whereas banks’ initial FVO elections for loans held for sale were both not amenable to exploitation of the standard’s transition guidance and likely to remedy accounting mismatches. Based on these reasons, we predict and find that regular adopters’ FVO elections for loans held for sale remedied accounting mismatches and did not exploit SFAS No. 159’s transition guidance. We predict and find the opposite for early adopters’ FVO elections for AFS securities and debt.

Our findings are consistent with regular adopters’ FVO elections, particularly for loans held for sale, complying with SFAS No. 159’s intent. Our findings are broadly consistent with Henry’s (2009) evidence that some early adopters rescinded or revised their FVO elections because of informal mechanisms that arose to help firms interpret and implement SFAS No. 159.

Fair value option, Fair value accounting, SFAS No. 159, Banks

Abstract:
We examine the implications of the presence of risky debt-which embeds an economic written put option on the firm (Merton 1974)-and mixed-attribute accounting for assets versus debt-an accounting option exercisable by accounting standard setters and/or firms preparing financial statements-for the empirical identification of conditional conservatism as asymmetry. We first conduct analytical and simulation analyses to develop a rich set of testable hypotheses about the effects of these two options on asymmetry. We then conduct archival empirical analysis to show that researchers can control for the riskiness of debt using measures of economic leverage, equity return volatility, and debt credit ratings. In this analysis we control for a measure of the percentage of economic assets that are recognized for accounting purposes and so are potentially subject to conditional conservatism. We find that, after controlling for declines in economic leverage and the asset recognition percentage over time, the upward trend in asymmetry is stronger and more monotonic than is the upward trend in the asymmetry for the overall sample that Basu (1997) documents.

risky debt, mixed-attribute accounting, conditional conservatism, asymmetry

Abstract:
Research on the usefulness of financial information generally focuses on the innovation in the information examined, such as an earnings surprise or cash flow growth. Consequently, prior research sheds little light on the role of the rich historical record of financial information in users' decision-making. Using a sample of published restatements of earnings, we show that the revision of the historical pattern of earnings, distinct from the magnitude of the restatement and its impact on current earnings, significantly affects investors' decisions and predicts class action lawsuits. Specifically, we find that restatements that eliminate or shorten histories of earnings growth or positive earnings have significantly more adverse effects for investor valuations and the likelihood of lawsuits than other restatements. This evidence about the value-relevance of refreshing the historical record of earnings is pertinent to the FASB's recent cautious expansion of the scope of circumstances that require a restatement of financial information in FAS 154.

Historical record, revisions, financial information, investors, decisions, class action lawsuits.

Abstract:
Despite the classification of the cash flows on trading positions as operating under SFAS No. 102, trading is economically a hybrid operating/non-operating activity. As a consequence of this hybrid nature, we hypothesize and find that the change in net trading assets has a less positive association with returns and future CFO than do the pure operating components of cash flows and accruals, and it has a more positive association with returns and future CFO than do the pure non-operating components of cash flows. Our paper is the first to propose and test hypotheses about the valuation implications of such hybrid cash flows and accruals.

Trading, cash flows, accruals, classification, market pricing, banks

Abstract:
Prior research shows that during the pre-1990 bust financially weak banks managed income upward by delaying provisions for losses on heterogeneous loans. In contrast, we predict and find that during the 1990s boom profitable banks managed income downward by accelerating provisions for losses on homogeneous loans. Profitable banks obscured their income smoothing by accelerating charge-offs of homogeneous loans and by recording more gross charge-offs to offset recoveries of previously charged-off loans. Over the three years subsequent to the acceleration of charge-offs, they had higher and more persistent income before provisions for loan losses than other banks, consistent with income smoothing over a prolonged horizon.

Income smoothing, business cycle, banks, provisions for loan losses, loan charge-offs

Abstract:
We investigate two explanations for the declining contemporaneous linear relation between annual stock returns and accounting earnings over the past 30 years: (1) earnings increasingly reflect news with a lag relative to stock prices and (2) earnings increasingly reflect good and bad news in an asymmetric fashion. We hypothesize and find that annual earnings have a weaker association with current price changes and a stronger association with lagged price changes over time. We hypothesize and find that annual earnings reflect current positive price changes less strongly and current negative price changes more strongly over time. We also find that asymmetry with respect to lagged price changes is increasingly important over time. Strikingly, we find that, since the mid-1980s, the aggregation of earnings over a four-year window does increasingly less to reduce the importance of lags and asymmetry.

capital markets, returns-earnings relation, earnings lags, earnings asymmetry

Abstract:
We distinguish two sources of variation in the book-to-market ratio (BTM) -- bias and lags -- with different implications for future book return on equity (ROE). We hypothesize that the bias and lag components of the BTM both have negative implications for future ROE, but the bias component's implications persist while the lag component's implications decay over the period that the firm's currently unrecognized economic gains or losses are recognized. We forecast ROE over horizons from one to five years and the terminal value in the discounted residual income valuation model at a five-year horizon, and find results generally consistent with our hypotheses. We also predict and find that the association between the bias (but not the lag) component and future ROE is less negative for higher growth firms.

Abstract:
This study empirically documents that firms with large ratios of current capital expenditures to prior four-year average capital expenditures enjoy positive contemporaneous abnormal returns. It further documents that average capital expenditures across Compustat-covered U.S. corporations are significantly greater (smaller) in the fourth (first) quarter of the fiscal year than in other quarters. This capital expenditure timing effect holds consistently across years, industries, fiscal year ends, and a variety of firm attributes. The study tests a number of potential economic and accounting explanations for the capital expenditure timing effect, including "use it or lose it", uncertainty resolution, taxes and income smoothing. It reports evidence consistent with "use it or lose it" and to a lesser degree with taxes and income smoothing. It finds weak or no evidence for uncertainty resolution and other explanations. The study concludes with a discussion of the implications of these findings for financial statement analysis.

Abstract:
Prior research has found that loan loss provisions are positively associated with bank stock returns and future cash flows, conditional on less discretionary information about loan default. We find that these positive valuation implications obtain only for loan loss provisions for low regulatory capital banks in the fourth fiscal quarter. Our regulatory capital-based tests are motivated by the idea that increased discretionary loan loss provisions are plausibly good news only for banks which appear to have loan default risk problems based on prior information. Our fiscal quarter tests are motivated by findings in prior literature that suggest that managers have incentives to delay income decreasing accruals until the fourth quarter when the audit occurs, implying that income decreasing accruals are more likely and therefore more expected in the fourth quarter than in other fiscal quarters (Mendenhall and Nichols, 1988 and Boyd, et al., 1994).

Abstract:
We compare the accuracy of analyst (I/B/E/S consensus) and earnings-to-price ratio (E/P)-based forecasts of annual earnings across firms. We find that generalizations of Beaver Lambert and Morse's (BLM 1980) E/P-based forecasting model are more accurate than analyst forecasts both for most firms and on average though analyst forecasts are more accurate for the two lowest and the highest E/P decile firms. This result reflects prior research's finding that analyst forecasts are biased and do not fully incorporate the implications of the current annual price and earnings changes for future earnings. Only when the errors in analyst forecasts due to these sources comprise a relatively unimportant portion of the subsequent earnings change (i.e. in the extreme E/P deciles) do analysts beat E/P-based models.