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Abstract:
We investigate whether the measurement and reporting of comprehensive income in financial statements systematically affects commercial bank equity analysts' investment risk assessments and valuation judgments. In an experiment in which 80 buy side analysts specializing in banking and financial institutions participated, we vary whether a bank is exposed to or hedged against interest rate risk across three different comprehensive income accounting regimes - piecemeal fair value accounting with comprehensive income reported in the statement of changes in equity, piecemeal fair value accounting with comprehensive income reported in a separate statement of performance, and full fair value accounting with comprehensive income reported in a separate statement of performance. When fair value changes are measured and reported on a piecemeal basis, we find no investment risk or valuation judgment differences across CI reporting regimes. Although we find that the analysts' investment risk judgments are influenced by the banks' risk management strategies, their valuation judgments are not. Only when fair value changes are measured completely and reported transparently (i.e., full fair value accounting) do analysts' valuation judgments distinguish between banks with different levels of risk. The study contributes to three avenues of literature concerned with financial-reporting transparency, risk, and fair value accounting. First, our ex ante evidence informs accounting standard setters as they evaluate whether to move to full fair value accounting for all financial instruments, and assess the degree to which differences in comprehensive income measurement and reporting affect the information analysts obtain from financial statements. Second, the study adds to the experimental accounting literature that examines comprehensive income reporting format effects and valuation judgments. Third, we add to archival accounting research on the information in comprehensive income by testing market participants' judgments under different comprehensive income reporting regimes, which cannot be directly investigated with archival data.

Fair value, Comprehensive income, Financial analysts, Behavioral finance

Abstract:
In this paper, we provide a framework in which to view management earnings forecasts. Specifically, we categorize earnings forecasts as having three components - antecedents, characteristics, and consequences that roughly correspond to the timeline associated with an earnings forecast. By evaluating management earnings forecast research within the context of this framework, we render three conclusions. First, forecast characteristics appear to be the least well-understood component of earnings forecasts - both in terms of theory and empirical research - even though it is the component over which managers have the most control. Second, much of the prior research focuses on how one forecast antecedent or characteristic influences forecast consequences and does not study potential interactions among the three components. Third, much of the prior research ignores the iterative nature of management earnings forecasts - that is, forecast consequences of the current period influence antecedents and chosen characteristics in subsequent periods. Implications for researchers as well as educators, managers, investors, and regulators are provided.

Management Earnings Forecasts, Framework, Review

Abstract:
We investigate whether clear disclosure of comprehensive income (CI) facilitates detection of earnings management by buy-side financial analysts and predictably affects their security price judgments. Because analysts and investors often must sort through voluminous footnotes and non-financial information to locate CI components and other value-relevant items, the Association for Investment Management and Research has recommended changes in the reporting of these items. In June 1997, the FASB issued SFAS No. 130-Reporting Comprehensive Income in response to this demand.

The efficient markets hypothesis suggests that this reformatting of the financial statements should not affect analysts' judgments. However, psychology research predicts that information will not be used unless it is both available and readily processable (i.e., clear). Therefore, we argue that analysts' valuation judgments will be affected by the clarity of CI disclosure.

The results of an experiment, in which 96 analysts participated, suggest that clear income statement (IS) disclosure of CI-as originally proposed in the FASB's CI Exposure Draft-enhances the transparency of a company's earnings management activities and reduces analysts' valuation judgments to the same level observed for a firm that does not manage its earnings. In contrast, we find that disclosure of CI in the statement of changes shareholders' equity-as allowed by SFAS No. 130 and likely to be adopted by a majority of US companies-is not as effective as IS disclosure in revealing earnings management. We discuss the implications of this study for users of financial accounting information and for accounting standard setters.

Abstract:
We investigate whether clear disclosure of comprehensive income (CI) facilitates detection of earnings management by buy-side financial analysts and predictably affects their security price judgments. Because analysts and investors often must sort through voluminous footnotes and non-financial information to locate CI components and other value-relevant items, the Association for Investment Management and Research has recommended changes in the reporting of these items. In June 1997, the FASB issued SFAS No. 130-Reporting Comprehensive Income in response to this demand.

The efficient markets hypothesis suggests that this reformatting of the financial statements should not affect analysts' judgments. However, psychology research predicts that information will not be used unless it is both available and readily processable (i.e., clear). Therefore, we argue that analysts' valuation judgments will be affected by the clarity of CI disclosure.

The results of an experiment, in which 96 analysts participated, suggest that clear income statement (IS) disclosure of CI-as originally proposed in the FASB's CI Exposure Draft-enhances the transparency of a company's earnings management activities and reduces analysts' valuation judgments to the same level observed for a firm that does not manage its earnings. In contrast, we find that disclosure of CI in the statement of changes shareholders' equity-as allowed by SFAS No. 130 and likely to be adopted by a majority of US companies-is not as effective as IS disclosure in revealing earnings management. We discuss the implications of this study for users of financial accounting information and for accounting standard setters.

Abstract:
Several researchers (e.g., Lundholm, 1999; Ryan, 1997; Petroni, et al, 2001) have proposed a reporting mechanism to enhance the reliability of estimates and other forward-looking information in the financial reporting process. Their proposal requires companies to report reconciliations of prior year estimates to actual realizations as supplemental information in their financial reports. Such disclosures would enable investors to distinguish between accurate and opportunistic reporting behavior, and arguably should create incentives for companies to accurately estimate in the first place.

Our study provides evidence on these proposals to expand the reporting model. We develop predictions based on research in psychology and conduct an experiment within the context of an important intangible asset requiring estimation-software development costs. Our results show that the reporting mechanism proposed by Lundholm, Ryan, Petroni, and others is effective in communicating information about the accuracy of financial estimates. However, we find that all disclosures are not equally useful. The most-effective disclosures transparently describe the implications of misestimation (if any) on both the balance sheet and on earnings. Merely disclosing what the software development asset would have been (i.e., balance sheet effect only) under perfect foresight does not always lead investors to completely distinguish between accurate and opportunistic estimators. Our results also show that when the disclosures transparently describe the implications of misestimation, investors reward those who are accurate estimators but do not punish those who are inaccurate. We conclude that information about previous estimate accuracy is useful to investors, and that regulators should consider the transparency of disclosure formats, as all disclosures may not be equally effective in creating management incentives for accurate estimation. Further, the effectiveness of the proposed reporting mechanism for enhancing the reliability of financial reports appears to rest on the relative competitive advantage conferred upon firms that provide accurate estimates.

Estimates, Disclosures, Opportunistic financial reporting, Intangibles

Abstract:
We examine how investor reaction to management earnings forecasts is a joint function of the form of the forecast and management's perceived credibility. In a laboratory experiment involving 126 individual investors, we compare investors' earnings predictions and their confidence therein after receiving point and closed range forecasts issued by managements whose previous forecasting accuracy is known to be either high or low. We used point and range forecasts, because they differ in the degree to which they communicate management's uncertainty about the future. We use management's prior forecasting accuracy as a measure of management's credibility, because prior research has documented the importance of this factor when considering the usefulness of management's voluntary forecasts.

Our results show that, as expected, investors' earnings predictions are responsive to management's forecasts. However, as we hypothesized, forecast form did not influence investors' earnings estimates. In contrast, investors' confidence in their earnings predictions was influenced by the form of management's forecasts, but this effect emerged only when management was previously accurate in their forecasting. A similar interactive pattern was found in the dispersion of investors' predictions about the company's future earnings. Finally, consistent with the hypothesis that confidence is an important determinant of investor behavior, we find that investors' judgments of future stock price appreciation are a positive function of both unexpected earnings and the change in their confidence.

Our study extends the literature on management forecasts by empirically testing the joint influence of management's credibility (i.e., forecasting accuracy) and forecast form. The prior literature has argued that both factors should be important, but has not delineated whether or how these two factors might interact. We present a theoretical framework that indicates when both factors should influence investor judgment.

Abstract:
An important problem facing firm managers is how to enhance the credibility, or believability, of their earnings forecasts. In this paper, we experimentally test whether a characteristic of an earnings forecast from managementýnamely, whether it is disaggregatedýcan affect its credibility. We also test whether disaggregation moderates the relation between managerial incentives and forecast credibility. Disaggregated forecasts include an earnings forecast as well as forecasts of other key line items comprising that earnings forecast. Our results indicate that disaggregated forecasts are judged to be more credible than aggregated ones and that disaggregation works to counteract the effect of high incentives. We also develop and test an original model that explains how disaggregation positively impacts three factors that, in turn, influence forecast credibility: perceived precision of management's beliefs, perceived clarity of the forecast, and perceived financial reporting quality. We show that forecast disaggregation works to remedy incentive problems only via its effect on perceived financial reporting quality. Overall, our study adds to our understanding of how firm managers can credibly communicate their expectations about the future to market participants.

Disaggregation, Credibility, Management Earnings Forecasts

Abstract:
An important problem facing managers is how to enhance the credibility, or believability, of their earnings forecasts. In this paper, we experimentally test whether a characteristic of a management earnings forecast - namely, whether it is disaggregated - can affect its credibility. We also test whether disaggregation moderates the relation between managerial incentives and forecast credibility. Disaggregated forecasts include an earnings forecast as well as forecasts of other key line items comprising that earnings forecast. Our results indicate that disaggregated forecasts are judged to be more credible than aggregated ones and that disaggregation works to counteract the effect of high incentives. We also develop and test an original model that explains how disaggregation positively impacts three factors that, in turn, influence forecast credibility: perceived precision of management's beliefs, perceived clarity of the forecast, and perceived financial reporting quality. We show that forecast disaggregation works to remedy incentive problems only via its effect on perceived financial reporting quality. Overall, our study adds to our understanding of how managers can credibly communicate their expectations about the future to market participants.

Abstract:
In this paper, we provide a framework in which to view management earnings forecasts. Specifically, we categorize earnings forecasts as having three components - antecedents, characteristics, and consequences - that roughly correspond to the timeline associated with an earnings forecast. By evaluating management earnings forecast research within the context of this framework, we render three conclusions. First, forecast characteristics appear to be the least well-understood component of earnings forecasts - both in terms of theory and empirical research - even though it is the component over which managers have the most control. Second, much of the prior research focuses on how one forecast antecedent or characteristic influences forecast consequences and does not study potential interactions among the three components. Third, much of the prior research ignores the iterative nature of management earnings forecasts - that is, forecast consequences of the current period influence antecedents and chosen characteristics in subsequent periods. Implications for researchers as well as educators, managers, investors, and regulators are provided.

Management Earnings Forecasts, Voluntary Disclosures

Abstract:
This paper reports the results of a content analysis of comment letters submitted to the Financial Accounting Standards Board in response to the Board's Comprehensive Income Reporting Exposure Draft (FASB, 1996). Although comment letters are an integral component of the FASB's standard setting process, little is known about their content and the types of arguments made by letter writers. In this study, we categorize and analyze the arguments contained in these comment letters, focusing on how firms attempt to persuade the FASB. Our analysis documents the relative frequency of theoretical, outcome-oriented, and other arguments included in the letters. Despite the FASB's suggestion that comments focus on theoretical (conceptual framework) aspects of proposed standards, our analysis suggests that many of the arguments in the letters are non-theoretical, or outcome-oriented, focusing on anticipated negative effects for particular firms and industries from the Exposure Draft. Our findings help to provide a better understanding of the comment letter and standard setting process and provide insights into how letter writers believe accounting information is used. The setting of our study is particularly interesting because the changes proposed in the Comprehensive Income Reporting Exposure Draft were strictly presentation-related and did not affect companies' reported net income or financial condition. Therefore, the contractual motivations related to debt covenants and/or management compensation offered in previous research to explain comment letter writing, are mostly not present in this setting.

Comprehensive Income Exposure Draft, Comment Letters, Content Analysis, Standard Setting

Abstract:
We examine how fair value income measurement affects commercial bank equity analysts' risk and value judgments. Normatively, holding information and other underlying economics constant, bank analysts' risk and valuation assessments should distinguish between banks with different risks, but should not depend on how banks measure income. In our experiment, we vary income measurement - full-fair-value (all fair value changes recognized in income) versus piecemeal-fair-value (some fair value changes recognized in income, others disclosed in the notes). We also vary interest rate risk exposure (exposed versus hedged). We find that bank analysts' risk and value judgments distinguish banks' exposure to interest rate risk only under full-fair-value income measurement. Our evidence contributes to research concerned with financial performance reporting, risk, and fair value accounting by demonstrating that differences in income measurement affect fundamental judgments of specialist analysts. Our findings are striking because they (1) point toward an important role for measurement and recognition of fair value gains and losses in income and (2) suggest that note disclosure is not a substitute for financial-statement recognition (even for professional analysts specializing in banks and working in a context that involves assessment of core operations of a bank). These results should be of interest to accounting standard setters as they evaluate whether to require full-fair-value income measurement.

banks, fair value, risk, performance reporting, income measurement, financial analysts, behavioral finance

Abstract:
Analytical procedures have become an increasingly important part of financial statement auditing over the last 10 years. First recommended for audits by the Auditing Standards Board in 1978, analytical procedures are mandated for planning and overall review purposes by Statement on Auditing Standards (SAS) No. 56. In response to increased concerns about audit efficiency and effectiveness, analytical procedures are increasingly being used in place of and as a supplement to substantive tests of details. Despite their increased use, little is known about how analytical procedures are performed in practice. The purpose of this study is to describe how auditors perform analytical procedures at the planning, substantive testing, and overall review stages of the audit. To accomplish this, we conducted a series of interviews with 36 audit professionals at various levels of experience and responsibility (i.e., seniors, managers, and partners) representing all of the U.S. Big Six accounting firms. The contributions of our study are threefold. First, by contributing to a more complete understanding of how analytical procedures are performed, we provide the basis for accounting researchers to identify current analytical procedure problems/issues and, thus, perform more relevant research. Second, we provide the Auditing Standards Board members with relevant information about current practice for their deliberations on revised guidance for analytical procedures. Third, we provide educators with a characterization of analytical procedures as performed in practice, thereby facilitating their classroom coverage of this important topic.

Abstract:
To improve the usefulness of financial reporting, the Jenkins Committee has recommended increased disclosure of forward-looking information. To encourage such disclosures, Congress recently passed legislation providing an enhanced "safe harbor" provision designed to shield companies from legal liability for voluntary disclosure of forecasted financial information that later proves incorrect. The purpose of this paper is to test whether investors' reactions to management's disclosures of forward-looking information depend on two factors: the credibility of management (i.e., their competence and tendency to bias their disclosures) and the form of the forecasted information (i.e., whether it is quantitative or qualitative). Results of two experiments reveal that individual investors' judgments are influenced by the credibility of management. Specifically, we find that investors accord higher stock ratings to companies with managements reputed to be competent; we also observe that investors accord higher ratings to managements who do not tend to bias their disclosures. In contrast to our expectations, we do not observe that quantitative disclosures lead to different stock ratings than qualitative disclosures. Finally, we note that these two factors do not interact in their effects on investor judgment. The implications of our findings and future research directions are discussed.