Posts Tagged ‘Kathy Petroni’

Fair Value Accounting for Financial Instruments

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Tuesday November 6, 2012 at 10:01 am
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Editor’s Note: The following post comes to us from Elizabeth Blankespoor of the Graduate School of Business at Stanford University; Thomas Linsmeier of the Financial Accounting Standards Board; Kathy Petroni, Professor of Accounting at Michigan State University; and Catherine Shakespeare of the Ross School of Business at the University of Michigan.

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

Governance Problems in Closely-Held Corporations

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Thursday January 21, 2010 at 9:01 am
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Editor’s Note: This post comes to us from Venky Nagar, Associate Professor of Accounting at the University of Michigan, Kathy Petroni, Professor of Accounting at Michigan State University, and Daniel Wolfenzon, Professor of Finance and Economics at Columbia Business School.

The notion of balance of power, as any schoolchild or immigration test-taker knows, was central to our Founding Fathers’ conception of effective governance. Their deep insight on human behavior not only shaped our political institutions, but also cleanly translated to the design of modern corporations. As Berle and Means have noted, owners of a corporation that separates ownership from control have to remain ever-vigilant about expropriation by the controlling party. One way to achieve balance of power is to share ownership across individuals, so that no individual can unilaterally expropriate. However, the benefits of shared ownership are difficult to assess in public firms for two reasons. First, the large number of owners implies that each owner free rides with respect to the monitoring efforts of other owners (the individual owner may also not have the relevant expertise). Second, the liquid market of a company’s shares enables ownership structures to evolve endogenously. In equilibrium, the ownership structure of firms depends on their specific conditions and, as a result, it is difficult for an outsider to disentangle the effect of ownership structure from the effect of other firm characteristics.

…continue reading: Governance Problems in Closely-Held Corporations

CFOs, CEOs and Earnings Management

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Wednesday September 2, 2009 at 9:18 am
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(Editor’s Note: This post comes from John (Xuefeng) Jiang, Kathy Petroni, and Isabel Wang of the Eli Broad College of Business, Michigan State University.)

In our paper, CFOs and CEOs: Who Have the Most Influence on Earnings Management?, which was recently accepted for publication in the Journal of Financial Economics, we investigate whether Chief Financial Officer (CFO) equity incentives are associated with earnings management. Extant research has primarily focused on how chief executive officer (CEO) equity incentives affect earnings management (Bergstresser and Philippon 2006; Cheng and Warfield 2005). However, both commentators and policymakers have expressed a concern that CFO equity-based compensation might also contribute to earnings management. As described by Katz (2006), during testimony before the Senate Finance Committee IRS Commissioner Mark Everson expressed that the temptations of stock appreciation demand “heroic” virtue to keep managers from wrongdoing. He suggested that CFOs who are in charge of “minding the cookie jars” should not be paid by stock options, but by “generous but fixed compensation for specified contract periods.” Echoing concerns over CFO compensation, the SEC recently amended its disclosure rules on executive compensation by requiring that firms report their CFO pay. One analyst claims that the mandatory disclosure of CFO compensation is “a major benefit” of the amended SEC disclosure rule (Harris 2007).

Because CFOs’ primary responsibility is financial reporting, we argue that CFO equity incentives should play a stronger role than those of the CEO in earnings management. We separately and jointly examine the association between CFO and CEO equity incentives and earnings management. We consider two settings (accrual management and the likelihood of beating analysts’ expectations) and utilize methodologies similar to those used in prior research that has documented an association between CEO equity incentives and earnings management. We find that the magnitude of accruals and the likelihood of beating analyst forecasts are more sensitive to CFO equity incentives than to those of the CEO. For example, our results suggest that if a CFO equity incentive moves from the first quartile to the third quartile of the distribution of our sample CFO equity incentives, the absolute total accruals as a percent of total assets would increase almost 75 percent more than the increase associated with a similar move of CEO equity incentives. Similarly, the change in odds ratio of beating analysts’ expectation is 5 percent more when CFO’ equity incentives increase from the first quartile to the third quartile than when CEO’ equity incentives have a similar move.

Our results suggest future research should consider compensation of CFOs when investigating incentives for earnings management. More importantly, our results confirm policymakers’ concerns over CFO compensation and thus provide indirect support for the SEC’s new requirement for disclosures of CFO compensation. The disclosure of CFO compensation should be useful for investors and analysts to assess the quality of firms’ financial reporting.

The full paper is available here.

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