Faculty & Departments

Accountancy Research

Accounting Books #1


Brad A. Badertscher, University of Notre Dame

Badertscher, B.A., Phillips, J., Pincus, M., Rego, S.

Earnings Management Strategies and the Trade-Off between Tax Benefits and Detection Risk: To Conform or Not to Conform? (Forthcoming)

The Accounting Review  

Prior research has separately examined pretax earnings management activities that have current taxable income consequences (book-tax ‘conforming earnings management’) and those that do not have current taxable income consequences (book-tax ‘nonconforming earnings management’).  Our study documents the prevalence of, and then investigates the firm-specific characteristics that impact the choice between, these earnings management strategies.  We utilize a sample of firms that restated their earnings downward due to accounting irregularities and thus can be presumed to have managed earnings upward.  We find that nonconforming earnings management is more prevalent and that firms trade off the net present value of tax benefits against the net expected detection costs associated with nonconforming earnings management.  In particular, firms having NOL carry forwards, using a high quality auditor, or engaging in the most egregious misstatements rely less on nonconforming earnings management strategies.  We also find that book-tax differences are useful in predicting restatements.

Jeffrey J. Burks, University of Notre Dame

Acito, A. A.,  Burks, J. J., Johnson, W. B.

Materiality Decisions and the Correction of Accounting Errors (Forthcoming)

The Accounting Review, 84(3), May 2009

We test conjectures about the determinants of materiality judgments by examining a financial reporting choice made by firms that depends on an underlying materiality assessment. Specifically, from late 2004 to mid 2006, over 250 firms were required to correct errors in their accounting for operating leases. The method chosen to correct the errors reflects the assessed materiality of the errors, as restatements are required to correct material errors while catch-up adjustments can be used to correct immaterial errors. We test the role of materiality considerations outlined in authoritative guidance as well as factors outside the guidance in explaining the correction method chosen. We find that quantitative and qualitative materiality considerations cited in authoritative guidance explain a large portion of the variation in firms' error correction decisions. We also find that firms base their decisions on those of other firms.

Burks, J. J.

Disciplinary Measures in Response to Restatements After Sarbanes-Oxley 

Journal of Accounting and Public Policy (Forthcoming) 

 This study examines whether boards discipline CEOs and CFOs more severely for accounting restatements after passage of the Sarbanes-Oxley Act (SOX). The disciplinary actions I focus on are job termination and reductions in bonus payouts. Boards have incentive to take the highly visible action of terminating a manager to satisfy demands by outsiders for more vigilant corporate governance after SOX. However, terminating an executive entails the risk of hiring an inferior replacement and other costs. Imposing these costs on the firm and shareholders may not be justified after SOX because the severity of the restatements declines significantly. Despite the pressure on boards to appear vigilant, I find that when disciplining CEOs after SOX, boards gravitate away from termination and toward bonus penalties, a development commensurate with the less severe restatements of the post-SOX period. In contrast, boards appear to strengthen disciplinary action against CFOs after SOX despite the decline in restatement severity.

Peter D. Easton, University of Notre Dame

Easton, P., Sommers, G.

Effect of Analysts' Optimism on Estimates of the Expected Rate of Return Implied by Earnings Forecasts 

Journal of Accounting Research, 45 Vol. 5, December 2007, p. 983-1016, 2007

Recent literature has used analysts' earnings forecasts, which are known to be optimistic, to estimate implied expected rates of return; yielding upwardly biased estimates. We estimate that the bias, computed as the difference between the estimates of the implied expected rate of return based on analysts' earnings forecasts and estimates based on current earnings realizations, is 2.84 percent. The importance of this bias is illustrated by the fact that several extant studies estimate an equity premium in the vicinity of 3 percent, which would be eliminated by the removal of the bias. We illustrate the point that cross-sample differences in the bias may lead to the erroneous conclusion that cost of capital differs across these samples by showing that analysts' optimism and, hence, bias in the implied estimates of the expected rate of return, differs with firm size and with analysts' recommendation. As an important aside, we show that the bias in a value-weighted estimate of the implied equity premium is 1.60 percent and that the unbiased value-weighted estimate of this premium is 4.43 percent.

Easton, P., Monahan, S., Vasvari, F.

Initial Evidence on the Role of Earnings in the Bond Market 

Journal of Accounting Research 

We document that: (1) the incidence of bond trade increases during the days surrounding earnings announcements, (2) there is a bond-price reaction to the announcement of earnings, and (3) there is a positive association between annual bond returns and both annual changes in earnings and annual analysts' forecast errors. All of these effects are larger when earnings convey bad news or when the underlying bond is more risky. Taken together, our results suggest that the nonlinear payoff structure of bond securities affects the role of accounting earnings in the bond market.

Easton, P., Monahan, S.

An Evaluation of Accounting Based Measures of Expected Returns 

The Accounting Review, 501-538, 2005

We develop an empirical method that allows us to evaluate the reliability of an expected return proxy via its association with returns even if realized returns are biased and noisy measures of expected returns. We use our approach to examine seven accounting-based proxies that are imputed from prices and contemporaneous analysts' earnings forecasts. Our results suggest that, for the entire cross-section of firms, the proxies are unreliable. None of them has a positive association with realized returns, even after controlling for the bias and noise in realized returns attributable to contemporaneous information surprises. Moreover, the simplest proxy, which is based on the least reasonable assumptions, contains no more measurement error than the remaining proxies. These results remain even after we attempt to purge the proxies of their measurement error via the use of instrumental variables and grouping. We provide additional evidence, however, that demonstrates that some proxies are reliable when the consensus long-term growth forecasts are low and/or when analysts forecast accuracy is high.

Chao-shin liu, University of Notre Dame

Ho, L. J., Liu, C., Schaefer, T. F.

Analysts’ Forecast Revisions and Firms’ Research and Development Expenses 

Review of Quantitative Accounting and Finance, 307-326, (2007)

This study examines whether reported values for firms’ research and development (R&D) affect analysts’ annual earnings forecast revisions following quarterly earnings announcements. Because R&D introduces uncertainty into earnings forecasts, analysts may benefit from additional information searches in an effort to increase forecast accuracy. Also, accounting standards mandate an immediate expensing of R&D, in essence projecting a zero value for the R&D. To the extent that R&D will produce future payoffs, the expense treatment reduces the informativeness of reported earnings for forecasting future earnings. Thus, the marginal benefit of analysts’ efforts to produce more information may increase with the magnitude of the R&D component of earnings announcements and trigger additional forecast revisions.  Alternatively, if the cost of information searches exceeds the benefit, analysts’ forecast revisions may decrease.

Our results show a positive relation between R&D expenses and analysts’ forecast revision activity. We also find a positive and significant association between the level of R&D expenses and the magnitude of analysts’ forecast revisions following quarterly announcements. These results point to a greater amount of analyst scrutiny when reported earnings are accompanied by high levels of R&D expenses.

Jeffrey S. Miller, University of Notre Dame

Unintended Effects of Preannouncements on Investor Reactions to Earnings News 

Contemporary Accounting Research, 23(4), 1073-1103, 2006

This study uses an experiment to examine three alternative theoretical explanations for the unintended effects of preannouncements on investor reactions to earnings news: cue consistency, recency effects, and diminishing marginal reactions.  The experiment varies the amount of a management preannouncement at five different levels while holding constant consensus analyst expectations prior to the preannouncement and the subsequent earnings announcement.  Participants provide preliminary forecasts of current and next period earnings per share (EPS) prior to the preannouncement, after the preannouncement, and after the earnings announcement.  The pattern of participants’ final next year EPS forecasts and the results of follow-up analyses appear most consistent with the predictions of diminishing marginal reactions and, to a somewhat lesser extent, cue consistency, suggesting both mechanisms may play a role in determining the effects of preannouncements.  There is little evidence supporting recency effects.  Finally, supplemental evidence indicates that participants are unaware that preannouncements influence their reactions to earnings news, suggesting that the effects are unintended. This study has implications for managers who make preannouncement disclosure decisions and for academics who wish to understand and interpret prior research on earnings preannouncements.

Jim A. Seida, University of Notre Dame

Seida, J. A., Randolph, D., Salamon, G.

Quantifying the Costs of Intertemporal Income Shifting:  Theory and Evidence from the Property & Casualty Insurance Industry 

The Accounting Review, American Accounting Association, 80(1), 315-348, 2005

This paper presents a model of optimal tax-motivated intertemporal income shifting given a quadratic cost function that relates the costs associated with shifting income to the amount of income shifted. By formally modeling the income shifting decision, we: (1) show how parameter estimates of the income-shifting cost function can be extracted from a linear regression where a proxy for income shifted is the dependent variable, (2) provide insight about prior tax-motivated income shifting research, and (3) clarify the interpretation of independent variables that capture the interaction between tax incentives and non-tax costs. We then provide an empirical application of our method for quantifying the costs to shift federal taxable income by investigating the income shifting behavior of firms in the property and casualty (P&C) insurance industry  following the Tax Reform Act of 1986. Our results suggest that the parameters of the cost function are negatively related to firm size, the cost to shift a significant amount of income are nontrivial, and the marginal cost to shift income increase as more income is shifted.

Sandra c. Vera-munoz, university of notre dame

with M. B. Shackell-Dowell and M. Buehner, M.

Accountants' Usage of Causal Business Models in the Presence of Benchmark Data: A Note (2007)

Contemporary Accounting Research, 24(3), 1015-1038

We address the question: Does articulation of a business model as a cause-and-effect theory enhance an accountant’s evaluation of benchmark data that require implicit cause-and-effect covariation assessments? We develop an experiment where accountants recommend how best to allocate a fixed budget between two mutually exclusive programs. We prompt (or do not prompt) accountants with a causal business model, and with benchmark data that either support or do not support the causal model. To allocate resources optimally, accountants must determine implicitly, from the benchmark data provided, the level of covariation between each program and profits. We find that providing a causal model leads accountants to spend more resources on the program that offers higher future benefits when the benchmark data support the model than when the data do not support the model. Furthermore, prompting accountants with a causal model and with benchmark data that do not support the model does not mislead them into spending more resources on the program that offers lower future benefits. The results of our study contribute to the emerging research that addresses accountants’ ability to identify and interpret direct and indirect causal links and to infer time-lagged causal relations from data.