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Abstract:
We examine 2,190 SEC Accounting and Auditing Enforcement Releases (AAERs) issued between 1982 and 2005. We obtain 676 firms that are alleged to have misstated their quarterly or annual financial statements. We examine the characteristics of misstating firms along five dimensions: accrual quality; financial performance; non-financial measures; off-balance sheet activities; and market-based measures. We compare misstating firms to themselves during non-misstatement years and misstating firms to the broader population of all publicly listed firms. The results reveal that during misstatement years, accruals and cash and credit sales are unusually high, while return on assets and the number of employees are declining. In addition, misstating firms finance more of their assets through operating leases and have relatively less PP&E. We find that market pressures appear to affect incentives to misstate. Misstating firms are raising new financing, have higher market-to-book ratios, and strong prior stock price performance. We develop a model to predict accounting misstatements. The output of this model is a scaled logistic probability that we term the F-Score, where values greater than one suggest a greater likelihood of a misstatement.

earnings quality, accounting misstatement, fraud prediction, accrual quality, F-Score

Abstract:
We examine the relation between accruals quality and internal controls using 705 firms that disclosed at least one material weakness from August 2002 to November 2005 and find that weaknesses are generally associated with poorly estimated accruals that are not realized as cash flows. Further, we find that this relation between weak internal controls and lower accruals quality is driven by weakness disclosures that relate to overall company-level controls, which may be more difficult to audit around. We find no such relation for more auditable, account-specific weaknesses. We find similar results using four additional measures of accruals quality: discretionary accruals, average accruals quality, historical accounting restatements, and earnings persistence. Our results are robust to the inclusion of firm characteristics that proxy for difficulty in accrual estimation, known determinants of material weaknesses, and corrections for self-selection bias.

earnings quality, accruals quality, internal control, material weaknesses

Abstract:
We examine the relation between accruals quality and internal controls using 705 firms that disclosed at least one material weakness from August 2002 to November 2005 and find that weaknesses are generally associated with poorly estimated accruals that are not realized as cash flows. Further, we find that this relation between weak internal controls and lower accruals quality is driven by weakness disclosures that relate to overall company-level controls, which may be more difficult to "audit around." We find no such relation for more auditable, account-specific weaknesses. We find similar results using four additional measures of accruals quality: discretionary accruals, average accruals quality, historical accounting restatements, and earnings persistence. Our results are robust to the inclusion of firm characteristics that proxy for difficulty in accrual estimation, known determinants of material weaknesses, and corrections for self-selection bias.

Accruals quality, earnings quality, internal control

Abstract:
We examine determinants of weaknesses in internal control for 779 firms disclosing material weaknesses from August 2002 to August 2005. We find that these firms tend to be smaller, younger, financially weaker, more complex, growing rapidly, or undergoing restructuring. Firms with more serious entity-wide control problems are smaller, younger and weaker financially, while firms with less severe, account-specific problems are healthy financially but have complex, diversified, and rapidly changing operations. Finally, we find that the determinants also vary based on the specific reason for the material weakness, consistent with each firm facing their own unique set of internal control challenges.

Internal Control, Material Weakness, Sarbanes-Oxley

Abstract:
We examine determinants of internal control deficiencies using a sample of 779 firms disclosing material weaknesses from August 2002 to August 2005. We find that material weaknesses in internal control are more likely for firms that are smaller, younger, financially weaker, more complex, growing rapidly, or undergoing restructuring. We next investigate whether these determinants differ based on whether the problem is at the transaction-level or is a more serious company-level problem. We find that firms with more serious entity-wide control problems are smaller, younger and weaker financially, while firms with account-specific problems tend to be healthy financially, but have complex, diversified, and rapidly changing operations. We also provide evidence that the determinants vary based on the specific reason for the material weakness. For example, firm size and age are strong determinants of staffing issues, consistent with each firm facing their own unique set of internal control challenges.

Internal Control; Material Weakness; Sarbanes-Oxley

Abstract:
We argue that high accruals are likely to be the outcome of rules with an income statement perspective, while low accruals are likely to be the outcome of rules with a balance sheet perspective and that this has implications for the properties of earnings. Specifically, earnings persistence is affected both by the magnitude and sign of the accruals. Accruals improve the persistence of earnings relative to cash flows in high accrual firms, but reduce earnings persistence in low accrual firms. We show that the low persistence of earnings in low accrual firms is primarily driven by special items. We then show that special item-low accrual firms have higher future stock returns than other low accrual firms. This is consistent with investors misunderstanding the transitory nature of special items. Further analysis reveals that special item-low accrual firms have poor past performance and declines in investor recognition (analyst coverage and institutional holdings). Special items continue to explain future returns after controlling for these factors.

accrual anomaly, earnings persistence, cash flows, special items, investor recognition

Abstract:
We argue that high accruals are likely to be the outcome of rules with an income statement perspective, while low accruals are likely to be the outcome of rules with a balance sheet perspective and that this has implications for the properties of earnings. Specifically, earnings persistence is affected both by the magnitude and sign of the accruals. Accruals improve the persistence of earnings relative to cash flows in high accrual firms, but reduce earnings persistence in low accrual firms. We show that the low persistence of earnings in low accrual firms is primarily driven by balance sheet adjustments relating to special items. We then show that low accrual firms with special items have higher future stock returns than other low accrual firms. This is consistent with investors misunderstanding the transitory nature of special items. Further analysis reveals that special item-low accrual firms have performed poorly, are financially distressed, and have declines in investor recognition (analysts coverage and institutional holdings). We find that special items continue to explain future returns after controlling for these factors. Our results suggest that investors underestimate the probability that special item-low accrual firms will successfully turn themselves around.

Earnings, cash flows, special items, accruals, anomaly, future returns

Abstract:
This paper examines the implications of the off-balance-sheet treatment of operating leases for future earnings and stock returns. The property rights granted by an operating lease contract generate both future benefits (off-balance-sheet capital investment) and future obligations (off-balance-sheet financing liabilities) for the lessee. The change in the off-balance-sheet capital investment can be viewed as a form of growth in net operating assets and also a form of off-balance-sheet accruals. By examining the footnote disclosure on operating leases, this paper shows that, after controlling for current earnings, greater off-balance-sheet operating lease activities lead to lower future earnings. This finding is consistent with diminishing marginal returns to investment in operating lease activities. Additional tests show that investors incorrectly estimate the implications of off-balance-sheet lease activities for future earnings. A long-short investment strategy that exploits this misestimation generates significant future abnormal stock returns. These results suggest that the accrual anomaly documented in prior research extends to off-balance-sheet lease accruals.

Operating lease, Earnings persistence, Off-balance-sheet financing, Capital investment

Abstract:
This paper investigates why CFOs become involved in material accounting manipulations. To address this question, we examine various costs and benefits for CFOs who are associated with the manipulations in order to test two explanations: (i) CFOs instigate the earnings manipulations for immediate personal financial benefit, versus (ii) CFOs acquiesce to CEOs’ pressure to manipulate earnings. Consistent with CFOs being acquiescent, we find that CFOs bear higher litigation cost yet reap less financial benefit than CEOs using a comprehensive sample of material accounting manipulations disclosed between 1982 and 2005. CFOs are more likely to be charged by the SEC for accounting manipulations than CEOs. Regarding financial benefit, while CEOs of manipulation firms have higher pay-for-performance sensitivity than CEOs of matched non-manipulating firms, CFOs of manipulating firms have similar pay-for-performance sensitivity to other non-CEO executives of manipulating firms and to CFOs of the matched firms. Moreover, we find that accounting manipulations are more likely when CEO power is high. Finally, our AAER context analyses suggest that CEOs of manipulation firms are more likely than CFOs to be described to have orchestrated the manipulation and to be ordered to disgorge financial gains from the manipulation. Taken together, our findings are consistent with the explanation that CFOs are involved in material accounting manipulations because they succumb to CEO pressure, rather than because they seek immediate personal financial benefit.

earnings quality, accounting manipulation, CFO turnover, CEO power, incentive compensation

Abstract:
The costs and benefits of frequent mutual fund portfolio disclosure have been a strong subject for debate. This study investigates both the determinants and potential effects of portfolio disclosure frequency by comparing funds providing voluntary quarterly disclosure to funds providing only mandatory semiannual disclosure.

We find that funds with higher turnover, higher expense ratios, and higher likelihood of committing fraud, tend to disclose their holdings less frequently. These characteristics are likely proxies for a fund's informational advantage and/or agency problems.

To differentiate between the information effect (i.e. the potential costs of frequent disclosure are higher for funds with informational advantage) and the agency effect (i.e. the potential benefits of frequent disclosure to investors are higher for funds with agency problems), we examine the relation between disclosure frequency and future fund performance conditioned upon fund investment skills. We use past performance as a proxy for fund investment skills. We expect the information effect to outweigh the agency effect for skilled funds and vice versa for unskilled funds. Our findings show a significant asymmetric relation between disclosure frequency and future fund performance for past winners and losers. Consistent with the information effect, past winners who disclose less frequently outperform past winners who disclose more frequently. Consistent with the agency effect, past losers who disclose less frequently underperform past losers who disclose more frequently. These findings are robust to various performance measures.

Finally, we analyze the relation between disclosure frequency and fund new money to examine whether investors reward frequent disclosure. Controlling for other fund characteristics, we find higher new money growth for funds providing more frequent disclosure among poorly performing funds.

Mutual fund; Portfolio disclosure; Fund performance; Fund cash flow; Agency cost; Information

Abstract:
This paper examines the effect of Chief Financial Officers' (CFOs') individual philosophy or "style" on corporate financial reporting practices. We track 691 CFOs across different firms over time and investigate whether CFO-specific factors explain a firm's earnings related and disclosure related reporting choices. We find that, across a wide range of financial reporting strategies, individual CFOs styles do matter. CFO-specific factors explain a significant portion of the heterogeneity in financial reporting practices. Moreover, we trace the CFO style to observable CFO characteristics. Specifically, we examine whether CFOs' gender, age, and educational background affect their styles. We find that older CFOs are generally more conservative in deciding financial reporting strategies, while CFOs with undergraduate business school backgrounds appear to be more aggressive.

Managerial Style, Management Turnover, Accounting Choice, Voluntary Disclosure

Abstract:
This paper examines how stock prices reflect the off-balance sheet operating lease adjustments to accounting measures of risk and earnings based on two different estimation methods: the multiples method based on heuristics and the discounted cash flow (DCF) method based on theory. Using a sample of 4,233 Compustat firms and a sample of 868 firm covered by Moody's Financial Metrics, we document that (i) the two estimation methods provide significantly different adjustments to accounting measures of risk, (ii) for the Compustat sample, investors' assessment of equity risk appears to be more associated with adjustments based on the multiples method while for firms covered by Moody's analysts, investors' assessment of equity risk appears to be more associated with adjustments based on the DCF method, and (iii) the operating lease adjustments to earnings are not positively related to stock returns. Our results suggest that, except for firms with Moody's coverage, investors do not appear to be using the information disclosed in the operating lease footnote. While, empirically, we are not able to distinguish between investors' limited attention and costly information processing as potential explanations, our results support the need for capitalization of operating leases as assets and liabilities.

Abstract:
Over the years, researchers have devised various measures of “earnings quality” to represent decision usefulness in specific decision contexts. These measures, however, have become proxies for “earnings quality” in a generic sense, absent a decision context. The result is that some papers use a proxy for earnings quality that does not match the hypothesized form of decision usefulness in their study, but they nonetheless find results that are consistent with their hypothesis. Other papers are intentionally agnostic and find robust results across multiple proxies for earnings quality. The fact that researchers find consistent and robust results across proxies suggests that there is common component to the various measures of quality, which is the firm’s fundamental earnings process. Existing research does not clearly distinguish the impact of a firm’s fundamental earnings process on the decision usefulness (“quality”) of its earnings from the impact of the application of accounting measurement to that process. Research attention has focused on earnings management that reduces the reliability of earnings rather than on the ability of specific features of an accrual-based accounting system to provide a more decision-useful measure, conditional on the firm’s fundamental earnings process.

earnings quality, accruals, earnings persistence, earnings response coefficient

Abstract:
This paper examines how stock prices reflect the off-balance sheet operating lease adjustments to accounting measures of risk based on two different estimation methods: the multiples method based on heuristics and the discounted cash flow (DCF) method based on theory. Using a sample of 4,233 Compustat firms and a sample of 868 firm covered by Moody's Financial Metrics, we document that (i) the two estimation methods provide significantly different adjustments to accounting measures of risk, (ii) investors' assessment of equity risk, while not consistently related to adjustments based on either method, appears to be more frequently associated with adjustments based on the multiples method, and (iii) the operating lease adjustments to earnings are not positively related to stock returns. Our results suggest that investors do not appear to be using the information disclosed in the operating lease footnote. While, empirically, we are not able to distinguish between investors' limited attention and costly information processing as potential explanations, our results support the need for capitalization of operating leases as assets and liabilities.

operating lease, equity risk, off-balance sheet debt, market efficiency

Abstract:
This paper focuses on a sample of 261 companies that have disclosed at least one material weakness in internal control in their SEC filings after the effective date of the Sarbanes-Oxley Act of 2002. Based on the descriptive material weakness disclosures provided by management, we find that poor internal control is usually related to an insufficient commitment of resources for accounting controls. Material weaknesses in internal control tend to be related to deficient revenue recognition policies, lack of segregation of duties, deficiencies in the period-end reporting process and accounting policies, and inappropriate account reconciliation. The most common account-specific material weaknesses occur in the current accrual accounts, such as the accounts receivable and inventory accounts. Material weakness disclosures by management also frequently describe internal control problems in complex accounts, such as the derivative and income tax accounts. In our statistical analysis, we find that disclosing a material weakness is positively associated with business complexity (e.g., multiple segments and foreign currency), negatively associated with firm size (e.g., market capitalization), and negatively associated with firm profitability (e.g., return on assets).

internal control, material weakness, Sarbanes-Oxley