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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:
We provide evidence that analysts' stock-price judgments depend on (1) the method of accounting for a business combination, and (2) the number of years that have elapsed since the business combination. Consistent with business-press reports of managers' concerns, analysts' stock-price judgments are lowest when a company applies the purchase method of accounting and ratably amortizes the acquisition premium. The number of years since the business combination only affects analysts' price estimates when the company applies the purchase method and ratably amortizes goodwill-analyst' price estimates are lower when the business-combination transaction is further in the past. However, this joint effect of accounting method and timing is mitigated by the Financial Accounting Standards Board's proposed income-statement format requiring companies to report separate line items for after-tax income before goodwill charges and net-of-tax goodwill charges. When a company uses the purchase method of accounting and writes off the acquisition premium as in-process research and development, analysts' stock-price judgments are not statistically different from their judgments when a company applies pooling-of-interest accounting.

Abstract:
We investigate whether analysts' common-stock valuation judgments are predictably affected by (1) different methods of accounting for business combinations and (2) the number of years that elapse after the business combinations occur. Numerous articles in the business press suggest that companies go to great lengths to avoid amortization of the purchase-method acquisition premium, either by structuring acquisitions to qualify for pooling treatment or aggressively allocating the acquisition premium to "in-process" research and development (IPRD) and immediately expensing it. Firms' reluctance to capitalize and amortize the acquisition premium often is based on their managers' belief that amortizing the acquisition premium impairs firm value, especially in years subsequent to the transaction. However, research to date neither refutes nor defends this belief.

We report the results of an experiment in which 113 buy-side equity analysts participated. Consistent with our expectations, analysts' post-combination valuation judgments are lower when a parent company records and amortizes an acquisition premium in a purchase-method business combination and equivalently higher when the company either immediately expenses the entire purchase-method acquisition premium as IPRD or records the business combination using the pooling-of-interests method. In addition, in the case where the parent company records and amortizes an acquisition premium in a purchase-method business combination, analysts' stock-price judgments are significantly lower if the business combination occurred three years ago as compared to one year ago. We also test the FASB's proposal to report separate sub-totals (and related EPS figures) for pre-goodwill-amortization operating income, after-tax goodwill amortization, and net income. Our results suggest that the Board's proposed goodwill-reporting format mitigates the valuation difference between combinations that occurred one-year ago versus three-years ago. 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:
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 the risk relevance of the standard deviation of three performance measures: net income, comprehensive income, and a constructed measure of full-fair-value income for a sample of 202 U.S. commercial banks from 1996 to 2004. We find that, for the average sample bank, the volatility of full-fair-value income is more than three times that of comprehensive income and more than five times that of net income. We find that the incremental volatility in full-fair-value income (beyond the volatility of net income and comprehensive income) is positively related to market-model beta, the standard deviation in stock returns, and long-term interest rate beta. Further, we predict and find that the incremental volatility in full-fair-value income (1) negatively moderates the relation between abnormal earnings and banks' share prices and (2) positively affects the expected return implicit in bank share prices. Our findings suggest full-fair-value income volatility reflects elements of risk that are not captured by volatility in net income or comprehensive income, and relates more closely to capital-market pricing of that risk than either net-income volatility or comprehensive-income volatility.

Abstract:
The paper investigates how auditor resignations affect capital market participants' perception of firms from which the auditors resign ("former clients") and of firms that continue as clients of the resigning auditor ("continuing clients"). We find that resignation announcements result in significant negative abnormal returns for former clients and in significant positive abnormal returns for a sample of continuing clients (matched on industry, time period, and recent stock-price performance). As in prior work on auditors' actions, these effects are most pronounced when the news media reports the resignation. We investigate continuing clients because in recent years auditors have adopted a portfolio approach to risk management that includes centralized risk-based screening. We propose that the absence of resignation signals that, despite its poor performance, the continuing client has satisfied the auditor's unobservable risk-screening process. Therefore, the positive abnormal returns observed for the continuing clients suggest that despite their poor recent performance, the auditor believes the continuing clients' accounting methods and financial reporting choices are not misleading. We rule out a competition-based intra-industry information transfer as an alternative explanation for the positive abnormal returns.

Resignation, Auditor change, Auditing

Abstract:
The Financial Reporting Policy Committee of the Financial Accounting and Reporting Section of the American Accounting Association responded to the SEC's July 13, 2007 proposal to accept financial statements prepared in accordance with International Financial Reporting Standards (IFRS) from foreign-private issuers without reconciliation to U.S. GAAP (the SEC subsequently voted in favor of the proposal on November 15, 2007). Our commentary summarizes and interprets relevant academic research. Our main findings are that material reconciling items exist that are relevant to U.S. investors, there are differences in the implementation of uniform standards and that compliance to IFRS or U.S. GAAP by foreign firms is a concern, foreign firms benefit from greater access to capital by listing in the U.S. and the U.S. requirements do not make the U.S. market less attractive to foreign firms, U.S. investors tend to prefer U.S. GAAP suggesting that elimination of the reconciliation may discourage U.S. investment in foreign firms, and that U.S. GAAP - IFRS harmonization might improve the functioning of the U.S. capital markets. We conclude that eliminating the reconciliation requirement was premature.

International Accounting, US GAAP Reconciliation, Foreign Private Issuers

Abstract:
We characterize the operating-activities section of the indirect-approach statement of cash flows as backwards because it presents reconciling adjustments in a way that is opposite from the intuitively appealing, future-oriented, Conceptual Framework definitions of assets, liabilities and the accruals process. We propose that the reversed-accruals orientation required in the currently mandated indirect-approach statement of cash flows is unnecessarily complex, causing increased cash-flow forecast error and dispersion. We also predict that the mixed pattern (i.e., +/-, -/+) of operating cash flows and operating accruals reported by most companies also impedes investors' ability to learn the time-series properties of cash flows and accruals. We conduct a carefully controlled experiment and find that (1) cash-flow forecasts have lower forecast error and dispersion when the indirect-approach statement of cash flows starts with operating cash flows and adds changes in accruals to arrive at net income and (2) cash-flow forecasts have lower forecast error and dispersion when the cash flows and accruals are of the same sign (i.e., +/+, -/-) with the sign-based difference attenuated in the forward-oriented statement of cash flows. We also conduct a quasi-experiment to test our mixed-sign versus same-sign hypotheses using an archival sample of publicly available Value Line cash-flow forecasts. We find that Value Line analysts' cash-flow forecasts exhibit the same pattern of forecast error as documented in our experiment.

analysts, cash flows, forecasting, complexity, judgment and decision making

Abstract:
In this study we report the results of a laboratory experiment in which we examine whether the credibility of management's balance-sheet classification of hybrid securities as liabilities or equity is a joint function of (1) the level of classification discretion in the reporting environment, (2) whether management's classification choice is consistent or inconsistent with reporting incentives, and (3) management's reporting reputation. Our results suggest that when classification is mandated, credibility is unrelated to management's reporting reputation and whether management's classification choice is consistent or inconsistent with incentives. When classification is discretionary, financial report users consider management's classification choice more credible when it is inconsistent with incentives. Users are sensitive to management's reporting reputation only when classification is discretionary and management's classification choice is consistent with incentives. We also find that the association between the credibility of management's classification choice and user assessments of financial performance depends upon whether the classification is consistent or inconsistent with incentives. Finally, our results suggest that a good reporting reputation leads to higher financial performance assessments in both mandated and discretionary reporting environments. Implications, limitations, and future research are also discussed.

credibility, financial reporting reputation, discretionary disclousre, hybrid securities, financial statement analysis

Abstract:
The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB), in their joint Financial Statement Presentation project, are reconsidering the basic format of financial statements. The Boards' preliminary discussions related to this joint project indicate that they intend to modify the required financial statements to increase the proximity of performance-related information for each reported period, but also to reduce the number of reported periods. We provide evidence related to each of these potential changes by investigating the effects of financial-statement information proximity and the number of periods of reported performance on investors' ability to learn the forecast-relevant time-series properties of reported cash flows and accruals. Our experimental results suggest that nonprofessional investors are able to more quickly learn the relation between current period cash flows and accruals and future cash flow realizations when financial-statement information is presented in a single statement rather than separated into two statements. In addition, we find that nonprofessional investors exhibit lower levels of absolute forecast errors and less forecast dispersion when financial-statement information is unified into a single statement. Interestingly, we find that decreasing the number of periods of reported information from three to one does not negatively impact nonprofessional investor learning and prediction performance, both in terms of forecast errors and forecast dispersion. Overall, our results provide useful information related to the design of effective financial statement presentation format.

proximity, feedback, financial statement format, cash flows, forecasting, judgment and decision making

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