The Division of Risk, Strategy and Financial Innovation, or “RSFI”, was formed, in part, to integrate rigorous data analytics into the core mission of the SEC. Often referred to as the SEC’s “think tank,” RSFI consists of highly trained staff from a variety of backgrounds with a deep knowledge of the financial industry and markets. We are involved in a wide variety of projects across all Divisions and Offices within the SEC and I believe we approach regulatory issues with a uniquely broad perspective.

Because my Division has a slightly cumbersome name – which is why you might hear us colloquially called “RiskFin” (though I prefer the more inclusive and accurate “RSFI,” as you can see) – today in my remarks I thought I’d focus on one word in our magisterial title: “Risk.” Risk, particularly as relates to the financial markets, can be a capacious term, and my Division certainly touches on many of those various meanings. But we are particularly focused on developing cutting-edge ways to integrate data analysis into risk monitoring.

…continue reading: Risk Modeling at the SEC: The Accounting Quality Model

In our paper, Fair Value Accounting for Financial Instruments: Does it improve the Association between Bank Leverage and Credit Risk?, which was recently made publicly available on SSRN, we contribute to the debate on whether financial instruments should be measured at fair value in financial statements. Accounting standard setters have been deliberating the role of fair values for financial instruments for decades. A fair value is the price at which two willing parties would exchange an asset or settle a liability. Starting after the savings and loan crisis in the late 1980s, the Financial Accounting Standards Board (FASB) has increased the extent to which financial instruments are recognized at fair value (see Godwin, Petroni, and Wahlen 1998). In 2010, the FASB proposed to require that all financial instruments be recognized at fair value, with limited exceptions for receivables and payables and some companies’ own debt (FASB 2010). The proposal was controversial, with over 2,800 comment letters submitted, the vast majority of which objected to the fair value measurement of loans, deposits, and financial liabilities. The FASB is redeliberating this project and has tentatively decided that all financial instruments should be measured at fair value except certain debt financial assets and most financial liabilities (including deposits), which would be measured at amortized cost (FASB 2011).

To empirically provide insight on the controversy, we assess whether a fair value leverage ratio can explain measures of a bank’s credit risk better than a leverage ratio based on a mixture of fair values and historical costs consistent with the mixed-attribute model of US Generally Accepted Accounting Principles (GAAP) and a leverage ratio based on even fewer fair values than GAAP, which is consistent with regulatory Tier 1 capital. We focus on balance sheet leverage because it is very commonly used for assessing firm risk. We define a bank’s credit risk as the risk that the bank defaults on its obligations, and we focus on credit risk because understanding a bank’s credit risk is essential to understanding its financial condition.

…continue reading: Fair Value Accounting for Financial Instruments

In my paper, Managerial Investment and Changes in GAAP: An Internal Consequence of External Reporting, which was recently made publicly available on SSRN, I investigate whether changes in Generally Accepted Accounting Principles (GAAP) affect corporate investment decisions. I hypothesize that the relation between changes in GAAP and investment manifests for at least two non-mutually exclusive reasons. First, I hypothesize that changes in GAAP can affect investment because the numbers reported in financial statements have a direct bearing on contractual outcomes. For example, debt contracts often contain covenants based on numbers reported in financial statements (Leftwich [1983]). Consequently, if a change in GAAP has an unfavorable (favorable) impact on current and future financial statements, and debt covenants are not adjusted to incorporate the changes, the change in GAAP will likely tighten (loosen) covenant slack. As a result, managers may alter their actions to avoid covenant violation. Specifically, since most investments have an uncertain future outcome and some positive probability that the outcome is a loss, they increase the probability of violating covenants in the future by adversely impacting future financial ratios. Consequently, managers might respond to changes in GAAP that adversely affect financial statements by cutting investment in risky assets with the goal of preserving net worth and preventing deterioration of financial ratios.

…continue reading: Managerial Investment and Changes in GAAP

In the paper, Accounting Standards and Debt Covenants: Has the “Balance Sheet Approach” Led to a Decline in the Use of Balance Sheet Covenants?, forthcoming in the Journal of Accounting and Economics as published by Elsevier, I examine whether the “balance sheet approach” has led to a decline in the use of balance sheet covenants. Debt contracts, and especially private loan agreements, frequently include accounting-based debt covenants. Many of these covenants require the borrower to maintain a threshold level of some financial ratio or measure. A broad range of financial measures are employed in these financial covenants. Some are written on earnings from the income statement; the borrower may be required to maintain a minimum level of earnings relative to their interest expense (interest coverage) or their total debt (debt-to-earnings). Similarly, covenants are also written on values from the balance sheet; these include covenants requiring a minimum level for the book value of equity (net worth) or a maximum amount of debt in the capital structure (leverage). If the borrower fails to maintain a covenant threshold, the debt enters technical default. In technical default, the creditor has the option to attempt action against the borrower; a common consequence is renegotiation with stricter contract terms.

…continue reading: Accounting Standards and Debt Covenants

In the paper, Non-GAAP and Street Earnings: Evidence from SFAS 123R, recently made publicly available on SSRN, we examine how key market participants—managers and analysts—responded to SFAS 123R‘s controversial requirement that firms recognize stock-based compensation expense. Despite mandated recognition of the expense, some firms’ managers exclude it from non-GAAP earnings and some firms’ analysts exclude it from Street earnings.

…continue reading: Non-GAAP and Street Earnings

In our paper, How Did Financial Reporting Contribute to the Financial Crisis? forthcoming in the European Accounting Review, we scrutinize the role that financial reporting for fair values, asset securitizations, derivatives, and loan loss provisioning played in contributing to the Financial Crisis. Because banks were at the center of the Financial Crisis, we focus our discussion and analysis on the effects of financial reporting by banks. We begin by discussing the objectives of financial reporting and bank regulation to help clarify that information standard setters require firms provide to the capital markets and information required by bank regulators for prudential supervision will not necessarily be the same. This distinction is important to understanding why financial reporting played a limited role in contributing to the Financial Crisis.

…continue reading: How Did Financial Reporting Contribute to the Financial Crisis?

In our paper, Are International Accounting Standards-Based and US GAAP-Based Accounting Amounts Comparable? which was recently made publicly available on SSRN, we seek to determine the extent to which application of International Financial Reporting Standards (IFRS) as applied by non-US firms (hereafter, IFRS firms) results in accounting amounts that are comparable to those resulting from application of US Generally Accepted Accounting Principles (GAAP) by US firms. We do this by addressing two questions. The first is whether comparability is higher after IFRS firms apply IFRS than when they applied non-US domestic standards. The second is whether after IFRS firms adopt IFRS comparability differs depending on whether a firm adopted IFRS mandatorily, depending on the legal origin of an IFRS firm’s country, and for more recent reporting years. Although there is a growing literature examining whether application of IFRS affects quality of accounting amounts and has economic implications in capital markets, no study directly examines the extent to which application of IFRS by IFRS firms results in accounting amounts that are comparable to those based on application of US GAAP by US firms.

…continue reading: Are International Accounting Standards-Based and US GAAP-Based Accounting Amounts Comparable?

The Securities and Exchange Commission recently filed its first civil enforcement action under Regulation G, alleging that a public company intentionally misclassified certain ordinary operating expenses as nonrecurring expenses in order to increase its earnings. SEC v. SafeNet, Inc., Litig. Rel. No. 21290 (Nov. 12, 2009). Regulation G provides that, if a public company discloses material information that includes a financial measure not calculated in conformity with generally accepted accounting principles (GAAP), the company must reconcile the non-GAAP financial measure to the most directly comparable GAAP financial measure. Regulation G also prohibits public companies from disseminating false or misleading non-GAAP financial measures or presenting non-GAAP financial measures in a manner that would mislead investors or obscure the company’s GAAP results.

The SEC alleged that the company failed to comply with Regulation G by making improper adjustments to the company’s expenses. The improper adjustments allegedly included reclassifying ordinary expenses as nonrecurring integration expenses, reducing accruals for professional fees and reducing inventory reserve accruals. According to the SEC’s complaint, these adjustments were made without factual support in order to inflate the company’s earnings, and the company provided false and misleading explanations to its independent auditors when the auditors questioned the adjustments. The SEC complaint also alleged that former corporate officers and internal accountants engaged in a fraudulent scheme to backdate stock option grants without recording the requisite compensation expense for the option grants and used improper accounting adjustments to achieve earnings targets.

…continue reading: SEC Brings First Regulation G Enforcement Action

(Editor’s Note: This post comes to us from Chih-Ying Chen of Singapore Management University.)

In my forthcoming Review of Accounting Studies paper entitled Do analysts and investors fully understand the persistence of the items excluded from Street earnings?, I investigate whether analysts and investors fully understand the persistence of the items excluded from Street earnings and whether their ability to understand it has improved since the adoption of Reg G. In the past, companies commonly presented their earnings on the basis of methodologies other than Generally Accepted Accounting Principles (GAAP) in their earnings releases. These non-GAAP earnings numbers, often referred to as pro forma earnings or core earnings, exclude certain items that managers claim to be nonrecurring. Analyst-tracking services also exclude nonrecurring items when they report analyst earnings forecasts and the actual earnings of firms (often referred to as Street earnings).

Due to the lack of an authoritative definition, pro forma or Street earnings could be measured in different ways at different times. Previous research has produced results that are consistent with the claim that items excluded from pro forma or Street earnings are recurring. Concerned that pro forma financial information may obscure GAAP results and mislead investors under certain circumstances, the U.S. Securities and Exchange Commission (SEC) introduced a new disclosure regulation, Regulation G (hereafter, Reg G), which came into effect on March 28, 2003. Reg G requires public companies that disclose non-GAAP earnings to also present GAAP earnings and a reconciliation of the two. Since the adoption of Reg G, there is some evidence that the probability of disclosing non-GAAP earnings and using non-GAAP earnings exclusions to meet or beat analyst forecasts has decreased.

Since my focus is on analyst and investor understanding, I begin by comparing the association between Street exclusions and future Street earnings with analyst and investor expectations of this association. Analyst expectations are measured by the association between Street exclusions and subsequent analyst earnings forecasts, and investor expectations are inferred from stock returns around the time of the subsequent earnings announcements. Street exclusions are classified into MBF exclusions and non-MBF exclusions, where MBF exclusions are those that allow a firm to meet or beat analyst earnings forecasts (that is, the GAAP earnings number is below the consensus forecast of analysts, but the Street earnings number is not).

My empirical results show that the difference in the levels of persistence between MBF and non-MBF exclusions declined after the adoption of Reg G. Analysts underestimate the persistence of non-MBF exclusions, but the degree of this underestimation is lower in the post-Reg G period. In contrast, there is little evidence to indicate that analysts underestimate the persistence of MBF exclusions in either time period. I also find strong (weak) evidence that investors underestimate the persistence of Street exclusions in the pre- (post-) Reg G period. As it is not possible for firms with excluded gains or without Street exclusions to meet or beat analyst forecasts using Street exclusions, I also analyze a restricted sample that comprises only the observations with excluded expenses. In this sample, I find that both MBF and non-MBF exclusions are less persistent and that analysts and investors are better able to understand these exclusions in the post-Reg G period. Further analyses show that only firms that had highly persistent Street exclusions in the pre-Reg G period had substantial declines in this persistence and improvements in the ability of analysts to understand it in the post-Reg G period.

Overall, my results suggest that Reg G constrained the practice of excluding recurring expenses from Street earnings to meet or beat analyst forecasts and helps analysts and investors to understand the persistence of Street exclusions.

The full paper is available for download here.

In our forthcoming The Accounting Review paper entitled “The Voluntary Adoption of Internationally Recognized Accounting Standards and Firm Internal Performance Evaluation”, we investigate whether the voluntary adoption of international accounting standards is associated with changes a firm’s internal performance evaluation process; in particular, is it associated with increases in the sensitivities of CEO turnover and employee layoffs to accounting earnings.

Our sample consists of firms from Continental Europe that voluntarily adopted IFRS or U.S. GAAP from 1988 to 2004. We require the adopting firms to have both pre- and post-adoption data, and as a result, exclude firms that report under IFRS/U.S. GAAP from the first year they enter into our sample. We classify firms into those following IFRS/U.S. GAAP accounting standards and those following local accounting standards. For the IFRS/U.S. GAAP adopting firms, the adoption year is treated as event year zero. The local standards firms (firms that follow local GAAP throughout our sample period) serve as the control sample in the various tests. Our final sample comprises 200 IFRS/U.S. GAAP adopting firms and 766 local standards firms.

We find that CEO turnover and employee layoffs are more sensitive to accounting earnings after IFRS/U.S. GAAP adoption. These findings support our hypothesis that accounting earnings play a greater role in firm internal performance evaluations after the adoption of international accounting standards. In addition, we investigate firms’ decisions to adopt international accounting standards and proxy for the performance evaluation demand with two variables: closely held shares and labor productivity. After controlling for various other factors, we find that greater performance evaluation demand (less closely held shares and lower labor productivity) are associated with a higher likelihood of IFRS/U.S. GAAP adoption.

The above evidence does not necessarily imply that the voluntary adoption of international accounting standards causes the changes in internal performance evaluations in terms of higher earnings performance sensitivities. Firms that voluntarily adopt IFRS/U.S. GAAP likely experience fundamental changes in their operations, financing, and corporate governance; and the adoption of international accounting standards can simply be an instrument for these profound changes. Our findings suggest that the greater reporting transparency through international accounting standards likely plays a role (which may not be strictly causal, but is important nonetheless) in improving firms’ internal performance evaluations. We document that IFRS/U.S. GAAP adoption is associated not only with changes in firms’ operating and information environment, but also with changes in corporate governance.

Our findings highlight the multitude of implications from the adoption of international accounting standards and add to our understanding of the complex changes experienced by the adopting firms.

The full paper is available for download here.