stock price reactions as surrogates for the net cash flow effects of corporate policy decisions abstract this paper adopts a rational market structure to examine the link between the cash flow effects of management policy decisions and the resulting stock price reactions the focus is on testing cross sectional associations between cash flow effects and the underlying characteristics of affected firms we find that it is not possible to infer the sign of association between the stock price reaction and any characteristics of the firm that are observable before management announces its decision our methodological suggestions involve exploiting either a priori assumptions or sample information about the probability distribution of unobservable decision variables underlying the management decision process

the use of control groups in capital market research capital market researchers have used several different types of control groups in attempting to assess stock market reactions to accounting events in recent years the properties of various control groups have been examined to determine the sensitivity of experimental results to a particular control group gonedes 1975 1978 foster 1980 brown and warner 1980 beaver 1981 except for the brown and warner study these studies have been of an analytical nature the purpose of this study was to extend the brown and warner analysis to four alternative control groups using a particular accounting event study as an example the example involved an assessment of whether the stock market reacted to actual changes in accounting estimates the four types of control groups examined were those which have been used in previous capital market studies see section 3 one of brown and warner s main conclusions was that beyond a simple one factor market model there is no evidence that more complicated methodologies such as risk equivalent control portfolios convey any benefit our results which are based on a market setting typical of many information content studies lead to a potentially different conclusion brown and warner injected simulated market effects into randomized data and by replicating their analyses 250 times they were able to

stock price reactions to lifo adoptions the association between excess returns and lifo tax savings although long a topic of accounting research little is known about the motives for or effects of voluntary changes in accounting techniques among the motives which have been suggested are attempts by managers to smooth reported earnings gordon 1964 copeland 1968 cushing 1969 white 1972 and ronen and sadan 1981 to influence man agement compensation to reduce regulatory or political costs watts and zimmerman 1978 and to avoid bond covenant restrictions holthausen 1981 while some of these motives may be consistent with a market value rule they often fail to provide unambiguous accounting change predictions e g which accounting changes result in lower regulatory costs moreover empirical verification has been constrained by the unobservability of the variables to which the managers allegedly respond the stock price reaction which should be expected for a given account ing change depends not only on its implications for the valuation of securities but also on the extent to which the implications are already known or anticipated by investors 3 ultimately our ability to detect these stock price effects if any depends on the power of our tests previous studies of the effects of accounting changes have generally not found significant stock price reactions archibald 1972 ball 1972 kaplan and roll 1972 harrison 1977 and holthausen 1981 4 for the most part these studies dealt with accounting changes which had no direct cash flow effects in contrast changes in inventory costing methods especially those involving the last in first out lifo cost flow assumption can generate potentially large changes in a firm s cash flows due to their impact on taxable earnings these cash flow effects provide not only a motive for lifo changes5 which is consistent with the market value rule but also implications for associated stock price effects if investors react to lifo s cash flow implications rather than to its effects on reported earnings then positive stock price adjustments should be associated with lifo adjustments however the evidence from previous studies of stock price reactions to lifo adoptions is inconclusive ball 1972 sunder 1973 1975 abdel khalik and mckeown 1978 brown 1980 and ricks 1982 while several factors may account for these results see section 2 it can be noted that the previous studies have considered only a dichotomous variable whether or not a firm has adopted lifo yet because the cash flow consequences of a lifo adoption decision depend on a number of firm specific factors this approach ignores potentially large differences among firms in the economic consequences of lifo adoptions most firms switching to lifo now reveal in their financial statement disclosures the tax savings which have been realized this study uses these disclosures to examine the association between unsystematic re turns and the magnitudes of first year lifo tax savings for all nyse firms which adopted or extended their use of lifo during the period 1972 80 subject to data availability 6 the research design employs within group comparisons based on cumulative monthly unsystematic excess returns with appropriate controls for unexpected earnings per formance 7 this design avoids several methodological weaknesses inherent in the previous studies and allows more definitive tests of hypotheses relating investor reactions to the income and cash flow effects of lifo adoptions as reported more fully below results based on lifo adoptions made in 1974 are consistent with a positive association between cumulative excess stock returns and the magnitudes of lifo tax savings 8 the results also provide evidence that changes in systematic risk may accompany lifo adoptions however contrary to previous studies most of the sample firms exhibit downward rather than upward changes in systematic risk section 2 reviews the previous studies of stock price reactions to lifo adoptions and suggests explanations for their results section 3 discusses the alternative approach employed in this study while section 4 describes the test methodologies employed the data and data selection procedures are described in section 5 the results and a discussion are presented in section 6 section 7 offers some conclusions

belief based refinements in signalling games abstract there are many economic problems which when modelled as games of incomplete information give rise to many sequential equilibria severely limiting the usefulness of the model there has recently been a large literature devoted to refining the set of equilibria in order to reduce this multiplicity by restricting the set of admissible disequilibrium beliefs this paper argues that the logical foundations of some refinements and the equilibria they focus on are problematic and further proposes an alternative refinement that avoids the difficulties we also provide an existence theorem covering a broad class of signalling games often studied in economics journal of economic literature classification numbers c72 c70 d82

market based empirical research in accounting a review interpretation and extension a decade and a half of the most concerted and ambitious research effort in accounting history is evaluated here it is the search into the relationship between publicly disclosed accounting information and the consequences of the use of this information by the major group of usersequity investors as such consequences are reflected in characteristics of common stocks traded in major exchanges this research effort known as market based accounting research mbar obtained its impetus from major developments in finance theory during the late 1950s and early 1960s these were the portfolio selection theory and its offspring the capital asset pricing model capm and the concept of informationally efficient capital markets ecm subsequent developments in information economics agency theory and optimal incentive signaling models were quickly incorporated into mbar while the impetus to this line of research came from other disciplines accounting was not only a beneficiary but also to a modest extent a benefactor mbar is relevant to the study of capital market efficiency the capm information economics and regulation this contribution distinguishes mbar from most accounting areas whose contributions to other disciplines are negligible in

accounting for retail land sales analysis of a mandated change abstract this study assesses the stock market s reaction to a series of events leading up to a mandated change in accounting for retail land sales evidence is found to support the conclusion that the market reacted to some of these events in a manner consistent with the effects of the accounting change on debt annagement contracts a distinctive aspect of the analysis is the efficient use of security returns data to detect market reactions and to derive empirical distributions of test statistics employed the analysis is extended by a model for grouping regression equations known as seemingly unrelated regressions however the gains from this extension are modest

depreciation policy changes tax earnings management and investment opportunity incentives abstract contrary to previous studies we find managers change depreciation policies in predictable ways we identify three dimensions of depreciation policy changes whether it is a method change or an estimate revision whether it is income increasing or decreasing and whether it applies to new assets only or both new and existing assets this disaggregation leads to three findings first a 1981 tax law altered the frequency of estimate revisions and method changes second firms adopting income increasing method changes for all assets experience worse performance than those adopting such changes only for new assets finally non income increasing policy changes are associated with changes in investment opportunities

the impact of sfas no 8 on equity prices of early and late adopting firms abstract this study examines the economic consequences of statement of financial accounting standards no 8 sfas no 8 compared to a matched control group both early adopters and late adopters of sfas no 8 exhibited significantly negative excess returns in the exposure draft release period even after adjusting for a size effect in january weighted least squares and ordinary least squares cross sectional regressions were compared the late adopter regressions weakly support contracting and political cost theories

failure of stock prices to discipline managers in a rational expectations economy in this paper we show that even a strongly efficient stock market is by itself insufficient to discipline managers who may hold incorrect beliefs about investors behavior and their decision rules instead of disciplining the managers the stock market may generate prices that reinforce these incorrect beliefs when this happens the disciplining of managers must be accomplished through other mechanisms such as through markets for managerial labor mergers and takeovers the financial press and education these alternative mechanisms may produce slower disciplinary reactions than the stock market several important classes of accounting phenomena seem consistent with a failure of the stock market to discipline managers promptly we present in detail how the apparent failure of managers to make cashflow maximizing lifo fifo choices in a timely fashion is consistent with this theory our approach is also applicable to other financial reporting conundrums in which adverse managerial and stock market reactions were predicted in response to financial accounting standard no 2 accounting for research and development outlays standard no

the economic consequences of accounting choice implications of costly contracting and monitoring abstract in this paper we review research into the economic consequences of voluntary and mandatory choices of accounting techniques and standards we discuss how the predictions of extant economic consequence theories are driven by contracting and monitoring costs associated with management compensation contracts bond covenants regulation and or political visibility we review empirical tests of economic consequence theories categorize those tests and discuss their strengths and weaknesses the empirical tests reveal two systematic associations with accounting choice size a proxy for political visibility and leverage a proxy for contracting and monitoring costs of lending agreements interpretation of the results is difficult due to general limitations of the tests we conclude by suggesting some directions for future research based on our analysis of the potential payoffs associated with different types of empirical tests

the magnitudes of financial statement effects and accounting choice the case of the adoption of sfas 87 abstract we examine the accounting choice decision in the context of the timing of adoption of sfas 87 unlike most prior studies we consider interactions between firm characteristics and the magnitudes of the financial statement effects of an accounting decision we expect that including interactions will both enhance the ability to explain accounting choice and facilitate distinction between omitted variables ball and foster 1982 and hypothesized relations results are consistent with these expectations

evidence on the effect of bond covenants and management compensation contracts on the choice of accounting techniques the case of the depreciation switch back abstract provisions of bond indenture agreements and management compensation contracts are examined to derive testable implications concerning management s incentives to choose among alternative accounting techniques the hypotheses are subjected to empirical examination by investigating the voluntary change from accelerated to straight line depreciation for financial reporting purposes only the methodology utilized incorporates an expectations model of accounting earnings in an attempt to separate out of the effects of earnings announcements from accounting change announcements which are often concurrent the evidence from both price and non price data is not consistent with the general hypothesis that bond covenants and management compensation contracts are important determinants of the decision to change depreciation techniques five potential explanations for the results are offered

negotiated accounting rules in private financial contracts abstract this paper explores how private contracts tailor gaap and whether tailoring reflects the characteristics of the contracting parties the analysis reveals that contracts of bank and insurance lenders are different with bank agreements closer to public debt tailoring is one of several characteristics associated with insurance lending agreements the extensive tailoring of gaap income in insurance contracts enforces dividend and payout restrictions that are consistent with the interest of long term insurance lenders in contrast bank lenders deal with borrowers default risk by negotiating shorter maturities security sinking funds and loan syndication

aggregation of test statistics an evaluation of the evidence on contracting and size hypotheses abstract more powerful tests of a theory of choice of accounting methods and the effect of changes in these choices on equity values are provided the power increase comes from efficiently aggregating results across studies one conclusion is that at least six variables common to more than one study have explanatory power these variables are managerial compensation leverage size risk and constraints on interest coverage and dividends another conclusion is that the posterior probability that the theory taken as a whole has explanatory power is close to one this conclusion includes the effect of variables that only appear in one study

relation between market model prediction errors and omitted variables a methodological note a number of accounting studies have examined market model prediction errors to evaluate the share price effects of various events such as voluntary or mandatory accounting changes a common approach is to examine the prediction errors around the event date of a portfolio of potentially affected firms this approach has been extended recently through the use of cross sectional regressions e g leftwich 1981 holthausen 1981 collins rozeff and dhaliwal 1981 sepe 1982 and chow 1983 in which prediction errors or raw returns are regressed on firm specific variables such as size the purpose of this paper is to examine the implications of some recent findings in finance for the various finance based empirical accounting studies in general two types of omitted variables from the standard capital assets pricing model have been identified first several studies have reported that certain firm specific variables such as size banz 1981 and reinganum 1981 earnings yield basu 1975 1983 and dividend payout ratio litzenberger and ramaswamy 1979 may be omitted variables from the standard capm in addition other studies have found some special time series characteristics of stock returns such

accounting conservatism and managerial risk taking corporate acquisitions abstract watts 2003 and ball and shivakumar 2005 argue that accounting conservatism decreases managerial incentives to make negative net present value investments i develop and test a new hypothesis that accounting conservatism is associated with managers making less risky investments i find that under more conservative accounting managers make less risky acquisitions and that firms with accounting based debt covenants drive this association this result is consistent with conservative firms avoiding risky investments because of the potential for large losses to trigger debt covenants conservatism reducing risk shifting can in part explain debt holders demand for conservative accounting

misspecification of capital asset pricing this study documents empirical anomalies which suggest that either the simple one period capital asset pricing model capm is misspecified or that capital markets are inefficient in particular portfolios based on firm size or earnings price e p ratios experience average returns systematically different from those predicted by the capm furthermore the abnormal returns persist for at least two years this persistence reduces the likelihood that these results are being generated by a market inefficiency rather the evidence seems to indicate that the equilibrium pricing model is misspecified however the data also reveals that an e p effect does not emerge after returns are controlled for the firm size effect the firm size effect largely subsumes the e p effect thus while the e p anomaly and value anomaly exist when each variable is considered separately the two anomalies seem to be related to the same set of missing factors and these factors appear to be more closely associated with firm size than e p ratios

determinants of the corporate decision to capitalize interest abstract until 1974 firms could choose within gaap to capitalize or expense interest costs associated with capital expenditures the predominant practice had been to treat interest as a period expense however in 1974 the securities and exchange commission imposed a moratorium on further adoption of interest capitalization by non regulated firms this study empirically examines economic factors potentially influencing firms decisions to expense or capitalize interest prior to the sec moratorium we hypothesize that the choice may be affected by 1 the existence of management compensation agreements tied to reported earnings 2 debt covenant constraints and 3 the political costs for some firms of reporting higher earnings when compared to the control group our findings are that 1 the frequency of explicit management compensation packages was not greater for the interest capitalization group 2 firms with financial ratios closer to likely debt agreement constraints on dividends interest coverage and leverage tended to elect interest capitalization and 3 other than the largest firms in the politically sensitive petroleum refining industry the larger firms were more likely to capitalize interest

accounting information in financial contracting the incomplete contract theory perspective this paper reviews theoretical and empirical work on financial contracting that is relevant to accounting researchers its primary objective is to discuss how the use of accounting information in contracts enhances contracting efficiency and to suggest avenues for future research we argue that incomplete contract theory broadens our understanding of both the role accounting information plays in contracting and the mechanisms through which efficiency gains are achieved by discussing its rich theoretical implications we expect incomplete contract theory to prove useful in motivating future research and in offering directions to advance our knowledge of how accounting information affects contract efficiency

cross sectional association between abnormal returns and firm specific variables abstract abnormal returns market model prediction errors are the subject of many event studies in accounting and finance literature conditional on the event of interest researchers have recently used cross sectional regressions to examine relations between abnormal returns and firm specific variables this paper demostrates that non constant variences and covariances in market model residuals across firms introduced bias in the estimated slope coefficients of the independent variables i e the expected signs of the estimated slope coefficients can be predicted a priori a method is develope to removed the bias in the estimated slope coefficiets and is found to be effective this method explicitly takes the dependence among abnormal returns across firms into account methods that assume abnormal returns across firms to be independent do not control for such bias

on cross sectional analysis in accounting research abstract this paper examines cross sectional analysis procedures common to many market based accounting research papers both the economic and econometric properties of levels and returns studies are discussed topics covered include the relations between the accounting studies and cash flow valuation models the role of expectations of accounting variables deflators spurious inference risk adjustment and its relation to growth size and leverage residual dependence dependence among explanatory variables and the effect of scale differences across firms major conclusions are that market value is the correct deflator in returns studies and that levels and returns studies are economically but not econometrically equivalent

mandated accounting changes and debt covenants the case of oil and gas accounting abstract the relationships among mandated accounting changes bond covenants and security prices has been the focus of several studies these studies have provided mixed evidence on the existence of a bond covenant effect on security prices this paper suggests that inconclusive prior results are a consequence of inappropriately measuring the default risk of debt using an option pricing framework it is shown that the debt to equity alone is not an adequate measure of default risk in particular both the debt to equity ratio and the total risk of the firm are necessary to adequately model the bond covenant effects of an accounting change these theoretical propositions are supported by the empirical analysis of the security market reaction to changes in oil and gas accounting

the effects of debt covenants and political costs on the choice of accounting methods the case of accounting for r d costs abstract until 1974 firms could capitalize or expense all or part of their research and development r d costs managerial choice between these two alternatives is hypothesized to be affected by the existence of debt covenants which employ accounting numbers relating to leverage interest coverage and ability to pay dividends in addition the use of public versus private debt is hypothesized to affect the accounting choice due to differential renegotiation costs lastly a political cost hypothesis is tested this study uses a multivariate statistical technique the generalized jackknife the results suggest that firms which capitalized r d costs were more highly levered used more public debt were closer to dividend restrictions and were smaller than firms which expensed r d costs

evidence of the impact of mandatory changes in accounting principles on corporate loan agreements abstract the theory in this paper predicts that mandatory changes in accounting princples can affect the measurement rules defined in restrictive covenants in firms lending agreements consequently those mandatory changes can have an impact on the value of a firm s equity even if the changes appear to be merely cosmetic this contracting cost theory is tested by examining of both event related and cross sectional abnormal performance of the equity of a sample of firms when the accounting princples board changes accounting princples for business combinations the theory provides at best in incomplete explanation of the observed abnormal performance

the effect of owner versus management control on the choice of accounting methods abstract this paper examines the relationship between the ownership control status of firms and the accounting methods they adopt the arguments of watts and zimmerman s positive theory are integrated with those of managerial economists to generate the prediction that management controlled firms are more likely than owner controlled firms to adopt accounting methods which increase reported earnings this prediction is inconsistent with fama s hypothesis that the market for managerial talent will prevent management controlled firms from acting differently than owner controlled firms this paper compares the depreciation methods used by a sample of management and owner controlled firms for financial reporting purposes the comparison considers and controls for the factors of firm size leverage and the depreciation method used for tax reporting purposes the comparison reveals that there is a significant difference in the depreciation methods adopted by management controlled and owner controlled firms for financial reporting purposes

economic consequences of firms depreciation method choice evidence from capital investments abstract this study identifies several interrelated reasons why firms depreciation method choice is likely to influence managers capital investment decisions we find that firms that use accelerated depreciation make significantly larger capital investments than firms that use straight line depreciation further we find that there has been a migration away from accelerated depreciation to straight line depreciation over the past two decades firms that make such accounting changes make smaller capital investments in the post change periods than in the pre change periods these results suggest that a choice made for external financial reporting purposes influences managers capital investment decisions

the efficiency of the forward exchange market in this note we test the efficiency of the forward market for foreign exchange for the uk pound us dollar exchange rate using residuals from the lus class we show that previous rejections of efficiency in the forward market have not been due to the use of residuals from the ols class

debt covenants and accounting choice abstract in this issue duke and hunt and press and weintrop show that leverage is significantly related to the existence of and closeness to accounting based debt covenants alternative rationales for this relation are presented the theory requires more rigorous specification to define closeness to covenants and determine which measure of leverage produces a more appropriate proxy for closeness to covenants then healy and palepu investigate a sample of firms close to their dividend restriction and find in general they are no more likely than other firms to change accounting methods their sample selection criteria reduces the generalizability of their results

an approach to statistical inference in cross sectional models with security abnormal returns as dependent variable several recent event studies test hypotheses about the association between event related abnormal security returns and firm characteristics using a three step procedure first forecast model parameters are estimated usually parameters of a market model second prediction errors or residuals are computed over an event period third prediction errors are regressed cross sectionally on firm characteristics hypothesized to influence the impact of the event on share values results of these regressions are used to draw inferences about the relation between abnormal returns and firm characteristics researchers who employ three step procedures acknowledge that crosssectional ols regressions lead to valid inferences if the disturbances are iid normal in cross section see for example leftwich 1981 p 23 and lustgarten 1982 p 138 while sufficient assumptions to draw valid inferences from ols regressions are clear these assumptions are violated if there is cross correlation and cross sectional heteroscedasticity in the firm return processes from which the prediction errors are estimated assumptions about the processes generating these prediction

taxes and firm size abstract firm size has been used as a proxy for the firm s political costs and hence managers proclivity to choose income reducing accounting procedures this study provides additional evidence on this topic by examining the association between firm size and effective corporate tax rates the latter are one component of a firm s political costs the roughly fifty largest u s exchange listed firms in particular oil and gas companies and manufacturing firms have significantly higher worldwide tax rates than other firms these higher tax rates are observed primarily after the implementation of the u s 1969 tax reform act and after the opec countries raised their tax rates on u s oil producers the findings which are insensitive to alternative sources of data alternative measures of firm size and alternative measures of effective tax rates are consistent with the use in previous studies of firm size as a proxy for the firm s political costs

the effect of accounting procedure changes on ceos cash salary and bonus compensation abstract this paper examines the effect of accounting procedure changes on cash salary and bonus compensation to ceos we estimate whether there is an adjustment to the statistical relation between compensation and corporate earnings following changes that lower earnings fifo to lifo inventory valuation and that raise earnings accelerated to straight line depreciation the results indicate that 1 subsequent to these changes salary and bonus payments are based on reported earnings rather than earnings under the original accounting method and 2 the potential compensation effect of the changes is small compared to the effect of economy or industry wide changes in compensation

an income strategy approach to the positive theory of accounting standard setting choice abstract this paper is designed to provide additional evidence on the positive theory of accounting policy choice by combining individual accounting principles into firm income strategies these strategies were the dependent variable in a probit analysis where the independent variables were size management compensation industry concentration ratio systematic risk capital intensity and the total debt to total asset ratio the results indicate that four of these factors size management compensation concentration ratio and the total debt to total asset ratio have a significant association with the choice of a firm s income strategy this test provides strong evidence consistent with the positive theory of accounting standard setting choice we also present evidence that smaller firms and or firms in less concentrated industries do not appear to make accounting policy choice decisions that are consistent with this theory

the economic determinants of the market reaction to proposed mandatory accounting changes in the oil and gas industry a cross sectional analysis abstract this paper examines the economic reasons for the observed negative abnormal common stock performance of firms whose reported earnings and stockholders equity were negatively affected by the proposed elimination of full cost accounting in the oil and gas industry four explanations of the market effects of this mandatory accounting change are examined 1 naive investor theory 2 modified naive investor theory 3 contracting cost theory and 4 estimation risk theory these hypotheses are developed in detail and used to generate variables for a cross sectional model which explains observed return behavior the effect of the accounting change on total stockholder s equity the existence of financial contracts denominated in terms of accounting numbers and to a lesser extent firm size are shown to be important explanatory variables the importance of these variables is consistent with both the contracting cost and estimation risk theories

does it pay to change your company s name a stock market perspective a company s name is commonly considered to be an integral part of its image just like the quality of its products or the quality of its technical services changing a company s name is a major policy decision contemplated by many firms and actually implemented by some each year this paper attempts to examine albeit indirectly whether a name change can improve the profit performance of a firm and what type of firm is more likely to succeed in doing so we use the event study methodology developed in finance to examine the above questions with respect to 58 corporations that changed their names in 1981 1985 our findings are that for most of the firms name changes are associated with improved performance and that the greatest improvement tends to occur in firms that produce industrial goods and whose performance prior to the change was relatively poor evidence that industrial good producers are also heavy users of corporate advertising lends further credence to this finding our findings do not support however the contention that the new name per se will enhance demand for the firm s products rather it seems that the act of a name change serves as a signal that other measures to improve performance such as changes in product offerings and organizational changes will be seriously and successfully undertaken the rationale behind why such a signal is sent and why it is believed is discussed

the sec reversal of fasb statement no 19 an investigation of information effects it has become popular in recent years to assess the economic consequences of new financial reporting standards and disclosure requirements as reflected in stock price behavior while the motivation for such studies seems to be generally accepted there are serious problems both in designing studies to assess the capital market reaction to new accounting rules and in subsequently interpreting the results for policymaking the difficulties are largely due to the lack of tight models of how new financial accounting standards board fasb standards and securities and exchange commission sec releases should impact investor decisions within the context of efficient markets this generally leads the researchers to test for average abnormal stock returns upon the announcement of a new accounting rule across a sample of firms subject to the rule this empirical approach is exposed to two major dangers first the intrusion of confounding events can easily lead to rejection of the null hypothesis of no price response due to both the very general nature of the alternate hypothesis of average abnormal returns and the single event date