Financial Reporting Choices: Empirical Archival Research

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Financial Reporting ChoicesEmpirical Archival
Research

• Mary Lea McAnally
• Texas AM University
• March 2004

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Tentative plan for the hour

• Defining accounting choice
• The WHAT, WHY, and HOW of accounting choice a
  conversation
• Some examples of my research
• Hodder Kohlbeck McAnally CAR 2002
• Hodder McAnally Weaver TAR 2003
• Hodder Mayew McAnally Weaver wp 2004
• Turning challenges into opportunity

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Defining accounting choice

• An accounting choice is any decision whose
  primary purpose is to influence (either in form
  or substance) the output of the accounting system
  in a particular way, including not only financial
  statements published in accordance with GAAP, but
  also tax returns and regulatory filings.
• (Fields Lys and Vincent JAE 2001)

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Defining accounting choice

• implementation that impairs an element of
  decision usefulness or implementation that is
  inconsistent with the intent of the standard.
• (Schipper 1999)

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Defining accounting choice

• managers use judgment in financial reporting and
  in structuring transactions to alter financial
  reports to either mislead some stakeholders about
  the underlying economic performance of the
  company, or to influence contractual outcomes
  that depend on reported accounting numbers.
• (Healy and Wahlen Accounting Horizons 1999)

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Research Challenges a preview

• Managerial goals (incentives) unclear
• Competing goals
• Goal success untested - Costs v. benefits
• Accounting choices one versus multiple
• Measuring choice is complicated
• Endogeneity
• Methodology is weak

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WHAT financial statement numbers do firms seek to
manage?

• Earnings
• Hit earnings target (net income and EPS)
• Avoid losses
• Report more than last year
• Meet or beat analysts forecasts
• Be in line with peer / industry group
• Clear other contractual hurdles
• Smooth earnings interperiod allocation
• Decrease earnings

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WHAT financial statement numbers do firms seek to
manage?

• Debt levels
• Reduce debt
• Move debt off balance sheet
• Cash flow
• Improve cash flow
• Other balance sheet and income stmt items
• Inventory, Marketable securities
• Current ratio, ROA, ROE
• Interest expense

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WHAT financial statement numbers do firms seek to
manage?

• Taxes
• Minimize PV of all taxes
• Trade-off explicit and implicit taxes
• Regulatory concerns
• Manage non-GAAP accounting numbers
• Other disclosures
• Segment
• SEC market risk disclosures
• Stock option disclosures

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HOW do firms manage financial statement numbers?

• Real economic actions (substance)
• Operating, investing, financing transactions
• Structure transactions purposefully
• Choose accounting methods (form)
• hard accounting choices among alternate GAAP
  methods
• Change accounting methods
• Choice of year-end, changing year-end

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HOW do firms manage financial statement numbers?

• Implement accounting methods
• soft accounting choices
• Estimates and judgments
• Discretionary accruals dollar amounts
• Allocation of assets (IPRD v goodwill)
• Estimates (A/R, depn, pension, stock options)
• Inputs to the models (model assumptions)
• Model selection
• Adoption timing

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HOW do firms manage financial statement numbers?

• Manage disclosure (implementation)
• Amount and nature of disclosure
• Voluntary disclosure
• Recognition v. disclosure
• Level of aggregation (what is material?)
• Display (F/S geography)
• Classification of items
• Framing of events and past outcomes

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WHY do firms manage financial statement numbers?

• Fields et al. taxonomy
• Agency costs (internal contracts)
• Compensation contracts
• Debt contracts
• Asset pricing
• Stock price
• Stock volatility
• External contracts
• Regulators
• Taxes

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Hodder Kohlbeck McAnally CAR 2002

• Did banks choose when and how to adopt FAS 115 to
  avoid regulatory risk?
• 93Q4 94Q1 95Q4 96Q1 98Q4
• Two stage approach
• Stage 1 estimate optimal targets 96Q1 98Q4
• Stage 2 predict optimal behavior at adoption
  and compare to actual (i.e. calculate deviations
  from optimal)
• Relate deviations to regulatory risk
• Use deviations to explore behavior at amnesty

Estimation period
Adoption period
Amnesty
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Hodder McAnally Weaver TAR 2003

• Do tax and non-tax factors explain banks
  conversion to S-Corp after the 1996 tax law
  change (SBJPA) ?
• 1993 1994 1995 1996 1997 1998 1999
• Measure tax and non-tax factors before law change
  (ex ante)
• Explain choice in terms of ex ante factors
• NOTE Converting to S-Corp is an economic choice

Estimate ex ante factors
Explain S-corp conversions
SBJPA
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Hodder Mayew McAnally Weaver wp 2004
Do firms exercise choices when reporting
employee stock option numbers?
Black-Scholes outputs (ESO fair value)
Black-Scholes inputs (volatility, dividend
yield, risk-free rate, option life)
Black-Scholes Model
Primary focus Taken as given Some focus
(black box !)
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Choices re Black-Scholes model inputs

• RISK FREE RATE ? OPTION VALUE ?
• DIVIDEND YIELD ? OPTION VALUE ?
• EXPECTED LIFE ? OPTION VALUE ?
• VOLATILITY ? OPTION VALUE ?

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How do we test for choices?

• Compare Historic, Reported and eX post inputs
• 
  
• 1993 1994 1995 1996 1997 1998 1999 2000 2001
• compare R to H (VOL, DIV)
• compare X to R (VOL, DIV)
• compare R to Industry (VOL, DIV, RATE, LIFE)

H
X
R
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Turning challenge into opportunity

• Specify managerial goals as clearly as possible
• - Consider alternate incentives
• - Consider simultaneous equations approach
• Compare costs and benefits of each choice
• Consider multiple choices
• - individual accounts v. aggregate approach
• - institutional knowledge
• - industry specific analyses
• Control for endogeneity use prior research to
  identify omitted variables
• Develop alternate methodologies (e.g. field
  studies)

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Identifying opportunities for empirical archival
studies

• Rule changes (GAAP or tax or SEC)
• - timing, that is, WHEN do firms adopt
• - choice of method
• - disclosure v. recognition
• Economic conditions change
• Specific transactions lead to clear incentives
• Theory other disciplines such as psych,
  sociology, finance, economics