Unregulated Corporate Financial Disclosure and Analysts’ Forecast Properties: The Case of Embedded Value Reporting by Life Insurers

This paper investigates the association between life insurers’ voluntary disclosure of embedded value (EV), an unregulated market-driven fair value measure, and analyst forecast accuracy and dispersion. EV is an estimate of the present value of future net cash flows from in-force life insurance business. Advocates of this disclosure believe that EV is a better measure of economic performance than traditional GAAP measures. Others argue that corporate management has discretion in estimating and reporting EV. Further, analysts may have access to information that allows the development of possibly more accurate estimation metrics in the absence of EV disclosure. It is then an empirical issue to determine whether EV disclosure has any incremental effect on analysts’ forecast properties. Using a multi-country setting, we find that EV disclosure is positively associated with analysts’ earnings forecast accuracy and negatively related to forecast dispersion. This result is consistent with the alternative hypothesis that disclosure of EV provides a richer information set that enriches analysts’ forecasts beyond their own in-house developed surrogates. As guidance for insurance accounting and disclosure evolves, our findings support the value of continuing to provide EV information to the public.

Do Corporate Site Visits Constrain Real Earnings Management?

This study investigates the relationship between corporate site visits (CSVs) and firms’ real earnings management. Using a unique dataset of site visits to Chinese firms listed on the Shenzhen Stock Exchange from 2009 to 2016, we find that such visits are negatively associated with firms’ real earnings management. The results are robust to using alternative CSV measures, controlling for alternative communication channels, and using the propensity score matching method. In cross-sectional analyses, we find that the negative association between site visits and real earnings management is stronger for more complex firms and firms with greater information asymmetry. In addition, we find that CSVs are negatively associated with both management and corporate misconduct but not with accrual-based earnings management or restatements.

Opportunistic Avoidance of Litigation Loss Accruals and the Mitigating Effects of Auditors

We find that firms with preliminary earnings that are expected to just meet analyst forecasts are more likely to only disclose (i.e., not accrue) litigation loss contingencies, claiming that the litigation event falls below the qualitative thresholds necessitating accrual. We also find that this opportunistic treatment of a subjective estimate is reduced when firms’ auditors have expertise in the defendant’s industry or have experience auditing litigation contingencies. Furthermore, we find that opportunistic disclosure usage increases when firms are more economically important to auditors’ client portfolios. Our results are robust to a series of additional tests. We provide evidence to support the Public Company Accounting Oversight Board’s (PCAOB) call for increased auditor professional skepticism toward management bias and opportunism when evaluating subjective estimates.

Valuation Issues, Auditor Fraud, and PCAOB Confirmation: Findings From an Analysis of Lawsuits Against Large Public Accounting Firms

In this article, we bridge the gap between academia and practice by analyzing and presenting the results of allegations in more than 200 lawsuits against the largest public accounting firms. Our findings are critical as the lawsuits damage the firms’ reputations, the credibility of the profession in general, and may result in large monetary losses and loss of clients. We find three key results not found in previous legal research. First, we find that Generally Accepted Accounting Principles (GAAP) issues, especially those focused on valuation, dominate Generally Accepted Auditing Standards (GAAS) issues in the allegations. Second, fraud allegations against the auditors themselves are a significant problem, although often ignored in the fraud literature. Third, the Public Company Accounting Oversight Board (PCAOB) reports on the accounting firms provide an unintended source of information for third parties in future legal allegations against those same firms.

Designing Efficient Stratified Mean-Per-Unit Sampling Applications in Accounting and Auditing

Despite technological advances in accounting systems and audit techniques, sampling remains a commonly used audit tool. For critical estimation applications involving low error rate populations, stratified mean-per-unit sampling (SMPU) has the unique advantage of producing trustworthy confidence intervals. However, SMPU is less efficient than other classical sampling techniques because it requires a larger sample size to achieve comparable precision. To address this weakness, we investigated how SMPU efficiency can be improved via three key design choices: (a) stratum boundary selection method, (b) number of sampling strata, and (c) minimum stratum sample size. Our tests disclosed that SMPU efficiency varies significantly with stratum boundary selection method. An iterative search-based method yielded the best efficiency, followed by the Dalenius–Hodges and Equal-Value-Per-Stratum methods. We also found that variations in Dalenius–Hodges implementation procedures yielded meaningful differences in efficiency. Regardless of boundary selection method, increasing the number of sampling strata beyond levels recommended in the professional literature yielded significant improvements in SMPU efficiency. Although a minor factor, smaller values of minimum stratum sample size were found to yield better SMPU efficiency. Based on these findings, suggestions for improving SMPU efficiency are provided. We also present the first known equations for planning the number of sampling strata given various application-specific parameters.

Spurious Correlation Due to Scaling

Scaling is common in empirical accounting research. It is often done to mitigate heteroscedasticity or the influence of firm size on parameter estimates. However, Barth and Clinch conclude that common diagnostic tools are ineffective in detecting various scale effects. Using analytic results and Monte Carlo simulations, we show that common forms of scaling, when misapplied, induce substantial spurious correlation via biased parameter estimates. Researchers, when uncertain about the exact functional form of scale effect, are typically better off dealing with both heteroscedasticity and the influence of larger firms using techniques other than scaling.

Price Reversals After Extreme Price Shocks: Impact of Earnings Information With Time Series Evidence From Emerging Market

The purpose of the article is to analyze the relevance of earnings fundamentals in predicting extreme price reversals of an emerging stock market. We collect monthly price data on six sector indices from Bombay Stock Exchange (BSE) of India for the period 2004–2019. The research decomposes industry stock returns into Potential Maximum Gains (PMG) and Potential Maximum Losses (PML) with price extremes at first and then tests price reversal behavior using Generalized AutoRegressive Conditional Heteroskedasticity (GARCH) and vector autoregressive (VAR) models. The study finds symmetry between PMG and PML in the banking, realty, and oil sectors, while the asymmetric reversal behavior is noted in the automobiles and capital goods industries. The presence of industry fundamentals in the models estimating the reversal behavior of share prices enhances their predictive power, which suggests the significance of value strategies in making gains from extreme price variations. The price reversal behavior is sector specific and found inconsistent in emerging market. Hence, the investors cannot overlook the relevance of the industry characteristics and earnings fundamentals while predicting the stock price behavior in emerging markets.

Auditor Choice and the Informativeness of 10-K Reports

This study provides new evidence on the influential role of external auditors in enhancing the informativeness of form 10-K annual reports to shareholders. Specifically, we find that the client’s choice of a Big 4 auditor (PwC, EY, KPMG, and Deloitte) versus a non-Big 4 auditor contributes to cross-sectional variations in 10-K disclosure volume. We also document that the benefit of enhanced disclosures provided by Big 4 auditors is more pronounced for audit clients with poorer accrual quality and those with higher information asymmetry. Furthermore, we introduce the portion of 10-K length unexplained by operating complexity and observable client characteristics as a new proxy for audit firm effort. Specifically, we find that abnormally long disclosures are associated with higher audit fees and longer audit report lag, which implies that an incremental level of audit effort can be inferred from the discretionary component of 10-K disclosures. As audit effort is costly, a greater volume of 10-K disclosures can be expected to be associated with an improvement in the quality of financial reporting. Overall, our findings show that auditors play more than a simple attestation role in the financial reporting process, and that the quality of financial reporting in a company’s 10-K annual report is a joint product of the effort and decisions of both a company’s managers and its auditors.

R&D Reporting Rule and Firm Efficiency

Critics opine that full expensing of research and development (R&D) depresses near-term profits and incentivizes myopic managers to under-invest in R&D, compromising firm efficiency. Advocates of the expensing rule argue that little rigorous research evidence supports the claimed adverse consequences. We examine the impact of the R&D expensing rule on firm efficiency by exploiting an exogenous shock: a shift in the accounting regime in Germany from full expensing to partial capitalization of R&D when it mandated International Financial Reporting Standard (IFRS) adoption in 2005. We employ Stochastic Frontier Analysis and Data Envelopment Analysis to estimate efficiency for the same German firms before and after the IFRS adoption. We find robust evidence of efficiency improvement in the post-period relative to the pre-period for German R&D firms that report R&D expenditures, and for both early adopters and timely adopters. We also document that financially constrained firms and firms experiencing rapid R&D growth prior to the IFRS adoption show greater efficiency improvement. Moreover, we conduct three falsification tests to make sure our results are not attributable to other accounting changes associated with the IFRS adoption, and find no efficiency improvement for the three control groups (German “no-R&D” sample, U.K. firms, and Australian firms), respectively. We conclude that the change in the R&D reporting rule is the likely catalyst for improvements in efficiency of German R&D firms.

Management Forecasting Ability and Predictive Ability of Dividend Changes for Future Earnings

We revisit the predictive ability of dividend changes for firms’ future earnings and extend the literature by examining the effect of management forecasting ability. Although prior studies have examined the relationship between dividend changes and future earnings, the empirical evidence is mixed. The belief that dividend changes have implications for future earnings depends on the assumption that managers can accurately assess future earnings prospects. In this regard, we posit that the predictive ability of dividends can vary with managers’ forecasting ability. Analyzing a large sample of Japanese dividend-paying firms, we find that dividend changes, particularly dividend increases, are positively associated with increases in future earnings. Consistent with our hypothesis, this positive association is more pronounced for firms with high-forecasting ability managers. Our findings support the signaling theory of dividend changes and indicate that management forecasting ability has a moderating effect on the linkage between firms’ dividend changes and future earnings.