Financial Reporting & Disclosure
There is no consensus on basic questions in the area such as (i) what are high quality earnings?; and (ii) what factors, within and outside the manager’s control, drive earnings quality? We conducted a field study published in a lead article published in the JAE to address these questions . CFOs believe that the hallmarks of earnings quality are sustainability, absence of one-time items, and backing by actual cash flows. CFOs believe that in any given period a remarkable 20% of firms intentionally distort earnings, even though they are adhering to generally accepted accounting principles. The economic magnitude of the misrepresentation is large, averaging about 10% of reported earnings. A prominent red flag pertains to the “human element" or the culture of the firm. Overall, CFOs have come to view financial reporting largely as a compliance activity rather than as a vehicle of innovation designed to inform stakeholders and lower the cost of capital.
This disconnect raises several important questions, in particular, how the FASB adds economic value to its constituents, especially the corporate sector? We investigate the cost effectiveness, from the shareholders’ perspective, of all of the significant accounting standards passed by the FASB during 1973-2007. Overall, there is little evidence of shareholder value creation for the FASB’s standard setting activities.
A couple of interesting papers on detecting reporting fraud or its milder version, earnings management are as follows:
Aggressive accounting spreads from offenders to other peer firms. Interestingly, such contagion falls right after the passage of SOX (2003-5) but resurfaces again in 2005-8 period.
After a major accounting restatement, firms remarkably invest in mending fences with stakeholders, other than capital providers.
We show that even when CEOs and CFOs are publicly accused of misreporting, around 40% of them come out financially ahead even after getting caught.
Earnings quality measures sold by a professional firm on Wall Street barely match the accrual based earnings management measures used by academic researchers.
Although not directly related to financial reporting, we study that the feeling of being in the hole encourages cheating by NYC cab drivers.
Understanding the efficacy of the audit function in mitigating earnings management is of obvious interest to accounting academics. In a paper forthcoming in Journal of Law and Economics, my co-authors and I show that class action lawsuits against auditors have fallen to single digits in recent times. In another paper, we show that the usual measures of audit quality used in the literature barely captures the audit deficiencies alleged by class action lawyers.