HUI ZHOU, University of Illinois at Urbana-Champaign
Email: huizhou2@uiuc.edu

This study investigates the income statement effect of SFAS 133, which requires the application of fair value accounting to hedging derivatives, by examining 1) whether SFAS 133 improves the information content of accounting earnings, and 2) whether the differential accounting treatment of different categories of hedging activities under SFAS 133 induces opportunistic earnings management behavior. Using a sample of bank holding companies during the period from 1995 through 2005, I find evidence that SFAS 133 results in more informative earnings. However, this improvement in earnings quality is mitigated by differential accounting treatment of cash flow hedge that defers the recognition of derivative gains/losses, and I find evidence that firms take advantage of this deferral mechanism to avoid earnings decreases.

KATHERINE GUTHRIE, College of William and Mary - Mason School of Business
Email: katherine.guthrie@mason.wm.edu
JAN SOKOLOWSKY, University of Michigan
Email: jansoko@umich.edu

We present empirical evidence that firms inflate earnings around seasoned equity offerings in the presence of large outsider blockholdings, but not in their absence. The finding is robust to several alternative explanations, including differences in firm characteristics, growth, performance, CEO incentives, and capital usage. While we do not dispute that CEOs behave opportunistically, we challenge that earnings management is solely a symptom of weak governance. We conclude that strengthening shareholder power to alleviate the conflict between shareholders and management can also have the unintended consequence of intensifying the conflict between current and future shareholders.

TODD L. SAYRE, University of San Francisco - School of Business and Management
Email: sayre@usfca.edu

This paper demonstrates that shareholder ownership, a sacred cow of business, is a myth. According to our legal system, shareholders do not own the Modern Corporation itself, nor do they own the corporate assets or profits. While this finding raises many important questions, the focus of this paper is on the accounting profession. By equating shareholders’ equity to net assets and having it encompass profit, the accounting equation implies that shareholders own the corporate net assets and profit. Insinuating that shareholders have stronger claims to corporate resources than they actually do runs counter to accounting profession’s prime directive to provide useful information. A solution would be to replace shareholders’ equity with its components, such that Assets = Liabilities Capital Retained Earnings. This would better reflect the reality that corporation’s have no legal obligation to give shareholders any of the net assets or profit.

TOMMY RAULSTON, affiliation not provided to SSRN
Email: tommy.raulston@okstate.edu

Because Employee Stock Options (ESOs) provide a tax-deduction and generate cash for a firm, they have been shown to be a substitute for debt. Aier and Moore (2008) found a negative association between debt and ESOs for tax-sensitive firms (those firms whose marginal tax rate was likely to be affected by the deductibility of ESOs), but no association for tax insatiable firms (who had so much taxable income that their marginal tax rate would likely not be affected by ESOs). SFAS No. 123R changed the reporting requirement for ESOs. Prior to enactment, ESOs could be disclosed in the footnotes of the financial statements. Upon enactment, ESOs were required to be expensed in the body of the financial statements. This study will attempt to see if the enactment of SFAS No. 123R changed the relationship between ESOs and debt, and if that change, if any, was different based on the tax status of the firm.

W. BROOKE ELLIOTT, University of Illinois at Urbana-Champaign
Email: wbe@uiuc.edu
FRANK D. HODGE, Michael G. Foster School of Business
Email: fhodge@u.washington.edu
LISA M. SEDOR, University of Washington - Department of Accounting
Email: LSEDOR@U.WASHINGTON.EDU

Restatements are economically significant events that damage investor trust in a firm’s financial reporting. We conduct an experiment to investigate how using online video to announce a restatement interacts with the level of responsibility a manager assumes for the restatement to influence investors’ perceptions of management’s trustworthiness and post-restatement investment decisions. We examine the use of online video for restatement disclosure due to video’s recent, explosive growth as a corporate communication tool. Our results reveal that when the CEO’s firm is the only firm restating, participants viewing the restatement announcement online via video make larger investments in the firm and are more confident in the firm’s future ability to meet analysts’ expectations than are participants who view the restatement announcement online via text. However, we do not observe this effect when the CEO’s firm and its industry peers are restating. Our results also reveal that participants’ perceptions of management’s trustworthiness mediate the influences of disclosure venue and assumed responsibility on post-restatement investment decisions. These findings are important given the dramatic increase in the number of restatements over time, the resultant deterioration of investor trust, and the Security and Exchange Commission’s recent emphasis on transitioning from traditional, paper-based to new, Internet-based disclosure venues.

LUC LAEVEN, International Monetary Fund (IMF), Centre for Economic Policy Research (CEPR)
Email: LLAEVEN@IMF.ORG
HARRY HUIZINGA, CentER, European Banking Center (EBC), Tilburg University, Centre for Economic Policy Research (CEPR)
Email: H.P.Huizinga@uvt.nl

This paper shows that banks use accounting discretion to overstate the value of distressed assets. Banks' balance sheets overvalue real estate-related assets compared to the market value of these assets, especially during the U.S. mortgage crisis. Share prices of banks with large exposure to mortgage-backed securities also react favorably to recent changes in accounting rules that relax fair-value accounting, and these banks provision less for bad loans. Furthermore, distressed banks use discretion in the classification of mortgage-backed securities to inflate their books. Our results indicate that banks' balance sheets offer a distorted view of the financial health of the banks.