While hundreds of research papers discuss earnings quality, there is no agreed-upon definition. We take a unique perspective on the topic by focusing our efforts on the producers of earnings quality: Chief Financial Officers. In our paper, The Misrepresentation of Earnings, which was recently made publicly available on SSRN, we explore the definition, characteristics, and determinants of earnings quality, including the prevalence and identification of earnings misrepresentation. To do so, we conduct a large-scale survey of 375 CFOs on earnings quality. We supplement the survey with 12 in-depth interviews with CFOs from prominent firms.
Posts Tagged ‘Misreporting’
In our paper, Executives’ ‘Off-the-Job’ Behavior, Corporate Culture, and Financial Reporting Risk, forthcoming in the Journal of Financial Economics, we examine how and why two aspects of top executives’ behavior outside the workplace, as measured by their legal infractions and ownership of luxury goods, are related to the likelihood of future misstated financial statements, including fraud and unintentional material reporting errors. We investigate two potential channels through which executives’ outside behavior is linked to the probability of future misstatements: (1) the executive’s propensity to misreport (hereafter “propensity channel”); and (2) changes in corporate culture (hereafter “culture channel”).
The hedge fund industry has grown tremendously over the last two decades. While this growth is due to a number of factors, one explanation is that its performance-based compensation system creates incentives for managers to generate alpha. This incentive system, however, could also motivate some managers to manipulate net asset values or commit outright fraud. Due to the light regulatory environment hedge funds operate in and their secretive nature, monitoring managers is generally difficult for investors and regulators.
In response, recent research has attempted to infer malfeasance directly from the distribution of hedge fund returns. In particular, the finding of a pervasive discontinuity in the distribution of net returns around zero has been interpreted as evidence that hedge fund managers systematically manipulate the reporting of NAVs to minimize the frequency of losses. This literature, however, has not recognized that performance fees distort the pattern of net returns.
In our paper, Are Hedge Fund Managers Systematically Misreporting? Or Not?, forthcoming in the Journal of Financial Economics, we show that inferring misreporting based on a kink at zero can be misleading when ignoring incentive fees. Because these fees are applied asymmetrically to positive and negative returns, the distribution of net returns should display a natural discontinuity around zero. In other words, there is a mechanical explanation for the observed kink in the distribution of net returns. We demonstrate this effect by showing that funds without incentive fees have no discontinuity at zero until we add hypothetical incentive fees to their returns.
In our paper, Regulating the Timing of Disclosure: Insights from the Acceleration of 10-K Filing Deadlines, forthcoming in the Journal of Accounting and Public Policy, we examine how regulatory reforms that accelerate 10-K filing deadlines in 2003 affect the reliability of accounting information. The intended purpose of the new deadlines is to improve the efficiency of capital markets by making accounting information available to market participants more quickly. However, accelerating filing deadlines compresses the time available for firms and their auditors to prepare, review, and audit accounting reports, suggesting potential costs in the form of increased misstatements and lower reliability. We provide empirical evidence on the effects of accelerating deadlines by comparing the likelihood of restatement of 10-K filings before and after the rule change.
In Osram Sylvania Inc. v. Townsend Ventures, LLC, the Delaware Court of Chancery (VC Parsons) declined to dismiss claims by Osram Sylvania Inc. that, in connection with OSI’s purchase of stock of Encelium Holdings, Inc. from the company’s other stockholders (the “Sellers”), Encelium’s failure to meet sales forecasts and manipulation of financial results by the Sellers amounted to a material adverse effect (“MAE”). The decision was issued in the context of post-closing indemnity claims asserted by OSI against the Sellers and not a disputed closing condition.
OSI, a stockholder of Encelium, agreed to purchase the remaining capital stock of Encelium not held by OSI pursuant to a stock purchase agreement executed on the last day of the third quarter of 2011. The $47 million purchase price was agreed based on Encelium’s forecasted sales of $4 million for the third quarter of 2011, as well as Sellers’ representations concerning Encelium’s financial condition, operating results, income, revenue and expenses. Following the closing of the transaction in October 2011, OSI learned that Encelium’s third quarter results were approximately half of its forecast and alleged that Encelium and the Sellers knew about these sales results, but failed to disclose them at closing in violation of a provision in the agreement requiring them to disclose facts that amount to an MAE. OSI also alleged other misconduct by Encelium and the Sellers, including, among other things, that they had manipulated Encelium’s second quarter results to make its business appear more profitable.
In considering the Sellers’ motion to dismiss OSI’s contract and tort-based claims, the court held that:
In the paper, Measuring Intentional Manipulation: A Structural Approach, which was recently made publicly available on SSRN, I suggest a structural model of a manager’s manipulation decision that allows me to estimate his costs of manipulation and to infer the amount of undetected intentional manipulation for each executive in my sample. The model follows the economic approach to crime (Becker, 1968) and incorporates the costs and benefits of manipulation decisions. The model is a dynamic finite-horizon problem in which the risk-averse manager maximizes his terminal wealth. The manager’s total wealth depends on his equity holdings in the firm and his cash wealth. The model yields three predictions. First, according to the wealth effect, managers having greater wealth manipulate less. Second, according to the valuation effect, the current-period bias in net assets increases in the existing bias. Third, the manager’s risk aversion, the linearity of his terminal wealth in reported earnings, and the stochastic evolution of the firm’s intrinsic value produce income smoothing. Furthermore, the structural approach allows partial observability of manipulation decisions in the data; hence, I am able to estimate the probability of detection as well as the loss in the manager’s wealth using the data on detected misstatements (i.e., financial restatements).
A large body of prior literature examines the relation between managerial equity incentives and financial misreporting but reports mixed results. This literature argues that a manager whose wealth is more sensitive to changes in stock price has a greater incentive to misreport. However, if managers are risk-averse and misreporting increases both equity values and equity risk, managers face a risk/return tradeoff when making a misreporting decision. In this case, the sensitivity of the manager’s wealth to changes in stock price, or portfolio delta, will have two countervailing incentive effects: a positive “reward effect” and a negative “risk effect.” In contrast, the sensitivity of the manager’s equity portfolio to changes in risk, or portfolio vega, will have an unambiguously positive incentive effect. Accordingly, when managers are risk-averse, it is important to jointly consider both portfolio delta and portfolio vega when assessing the relation between equity incentives and misreporting.
In our paper, The Relation Between Equity Incentives and Misreporting: The Role of Risk-Taking Incentives, forthcoming in the Journal of Financial Economics, we show that jointly considering both portfolio delta and portfolio vega substantially alters inferences reported in the literature. Specifically, we find inferences in studies reporting either a positive relation or no relation between portfolio delta and misreporting are not robust to controlling for vega.
Recently, the SEC’s Enforcement Division has brought three matters focused on alleged flaws (and fraud) in connection with valuation issues. Together these actions make clear that the SEC is and will be looking hard at how public companies as well as financial firms make difficult and subjective valuation decisions. Specifically, the SEC will be looking to see whether firms, and individuals, followed proper processes and applied the correct inputs in reaching these judgments. These cases also make clear that, even in times of significant market disruption, firms cannot ignore or substantially discount market inputs in making valuation judgment.
In November 2012, the SEC filed and settled In The Matter of KCAP Financial, Inc. This was the first action in which the SEC alleged that a public company had violated the provisions of Financial Accounting Standard (FAS) 157 by failing to properly value certain assets. FAS 157 requires expanded disclosures and incorporates a strong preference for market inputs to determine fair value. According to FAS 157, “[e]ven in times of market dislocation, it is not appropriate to conclude that all market activity represents forced liquidations or distressed sales.”
I. High Quality, Independent Auditing is Critical to Our Economic Success.
As I have learned in this job, getting the accounting right is indeed not the same thing as getting the auditing right. My sense from accountants I talk to is that auditing is receiving well-deserved attention in its own right.
Our economic success depends on the confidence of the users of capital and the providers of capital alike. Corporate managers hire internal accountants — many of you here today — to ensure they have accurate and detailed information on which to base management decisions. Managers ignore opportunities to glean trends and insights from this data at their peril.
Mistakes in this information can send a company into a business line or market that squanders resources. We now know that the true cost of financial misstatement is much greater than stock market fallout, concomitant lawsuits and insurance claims.
In the paper, Mandatory Clawback Provisions, Information Disclosure, and the Regulation of Securities Markets, forthcoming in the Journal of Accounting and Economics, I discuss the potential pitfalls of mandating that compensation be recouped from the executives of firms that are found to have engaged in material accounting misstatements. My discussion is motivated by recent evidence in the literature that the voluntary adoption of such clawback provisions by firms is followed by a reduced incidence of accounting restatements, lower auditing fees and a reduced auditing lag, and stronger earnings response coefficients. It is tempting to conclude from this evidence that government attempts to mandate such provisions, most recently through Section 954 of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, will increase the accuracy of information disclosure by firms and thereby enhance the integrity of the capital market. I argue that such a conclusion is premature at best.