Join us Tuesday, March 9 at 4pm when Scott Dyreng of Duke University discusses his recent research on the cost of violating covenants on private debt.  The key message of the paper is that firms are willing to pay extra taxes in order to avoid debt covenant violations.  The study uses a somewhat unfamiliar data set (Loan Pricing Corporation’s DealScan database), and has an interesting policy twist — it applies to private firms as well as public firms.  This is timely given the recent announcement of a Blue Ribbon Panel to address accounting standards for private companies. ( Congratulations to Teri Yohn, who is a member of the panel!)

FASRI Roundtables tend to be rather informal and broad affairs, so you can expect us to talk about some of Scott’s other research.  I’m hoping we will also find time to talk about a more unusual paper of Scott’s, written with Bill Mayew and Christopher Williams on religious norms and financial reporting. From the abstract:

Social norms have been shown to influence economic decisions in a variety of contexts. We investigate how social norms stemming from religious adherence surrounding a firm’s headquarters affect financial reporting choices. We hypothesize and find that religious social norms are negatively associated with financial reporting aggressiveness. Relative to counties exhibiting low levels of religious adherence, firms operating in counties with high levels of religious adherence (1) are less likely to meet or beat analyst forecasted quarterly earnings, (2) have higher accrual quality, (3) have lower risk of fraudulent accounting, and (4) are less likely to restate their financial statements. Corroborating these results, we find that capital market participants respond to reported good news earnings in manor consistent with investor acknowledgement of the role of religious social norms curbing aggressive financial reporting. Finally, we extend our inferences to tax planning and find that religious social norms are also inversely associated with tax avoidance, where cash effective tax rates and tax haven usage act as proxies.

Please join us for what promises to be a very interesting conversation.  Details on participating are here.

If HRC’s actual results fell short of expectations, Scrushy would tell HRC’s management to “fix it” by recording false earnings on HRC’s accounting records to make up the shortfall.
– SEC vs. HealthSouth Corporation[HRC]

You look back and think, ‘What was I thinking? Why didn’t I just do the right thing?’ But when you’re caught up in the heat of the battle, it didn’t seem so simple.
– Aaron Beam, Former CFO of HealthSouth

Our next Roundtable (Wednesday, February 17^th, at 11am ET) will feature Aaron Beam, who served four years in Federal prison for his role in HealthSouth’s massive accounting fraud, and is now sharing his thoughts and experience in his book Wagon to Disaster and in speaking engagements around the South.

The 2003 SEC complaint alleges a fairly straightforward fictitious entry:  HealthSouth would reduce a contra-revenue account called Contractual Adjustments, which would allow them to show higher net revenue in a way that would be less visible and harder to track than changing revenue directly.   HealthSouth balanced this entry with increases to a fixed asset account called AP Summary.  The relevant portions of the SEC complaint are provided below, and you can also see a summary here.

Accounting educators and researchers should find this a fascinating conversation for many reasons, and you might want to encourage your students to listen in.  But, you may be asking, how is this conversation relevant to research on financial reporting standards?  No doubt Mr. Beam has a great deal to say about auditing, but it is hard to see how blame for HealthSouth’s reporting problems can be laid at the feet of reporting standards.  Actually, I am hoping to get some insight into a couple of standard-setting issues.

First, what roles can financial reporting standards play in limiting the damage done by outright fraud?  Weld, Bergavin and Magrath have an interesting article in CPA Journal arguing that HealthSouth’s financial statements provided a number of clues that earnings were being managed.  Top-quality financial statements (including additional disclosure) can’t directly prevent firms from committing fraud and fooling their auditors, but they can provide investors with a last line of defense:  the ability to raise specific questions about management’s claims.  I would be very interested to hear Mr. Beam’s perspective on what features of the financial reporting environment allowed HealthSouth to avoid questions for so many years.

Second, much standard-setting research is influenced by the enormous literature on earnings management.  But I don’t think researchers yet have a very good handle on how earnings management actually occurs — whether fraudulent or not.  Large sample evidence makes me pretty confident that many firms manage their earnings through operational and accounting decisions in order to satisfy Wall Street and hit specific targets (like the average analyst estimate or a management forecast).  But we know very little about how top management’s intent to achieve earnings goals actually percolates through a large and complex organization.  For example, you might suspect that firms adjust research and development expenses in order to meet or beat analysts’ estimates.  But if this is to be accomplished through an actual reduction in spending (rather than an adjustment in accounting estimates), how does management accomplish this in short window between knowing the size of the reduction needed and the end of the quarter?  Does the CFO need to plan a series of spending cuts throughout the period, to be enacted depending on the resolution of uncertainty?  Given the great stress Mr. Beam’s boss (HealthSouth CEO Richard Scrushy) placed on satisfying Wall Street, I imagine we will get some interesting insights.

As a related point, more than a few academics have suggested that allowing more flexibility in reporting standards can improve communication, and also serve as a substitute for more costly operational forms of earnings management.  I wonder if Mr. Beam agrees, or whether he sees loose standards as easing the wagon’s way from earnings management to outright fraud.

Click here for details on how to attend the discussion.

The Accounting Scandal (from the SEC Complaint — see top of post for link)

25.  HRC’s accounting personnel designed the false journal entries to the income statement and balance sheet accounts in a manner calculated to avoid detection by the outside auditors. For example, instead of increasing the revenue account directly, HRC inflated earnings by decreasing the “contractual adjustment” account. Because the amounts booked to this account are estimated, there is a limited paper trail and the individual entries to this account are more difficult to verify than other revenue entries.

26.  Additionally, each inflation of earnings and corresponding increase in fixed assets were recorded through several intermediary journal entries in order to make the false inflation more difficult to trace.

27.  Furthermore, HRC increased the “AP Summary” line item at various facilities by different amounts because it knew that across the board increases of equal dollar amounts would raise suspicion.

28.  HRC also knew that its outside auditors only questioned additions to fixed assets at any particular facility if the additions exceeded a certain dollar threshold. Thus, when artificially increasing the “AP Summary” at a particular facility, HRC was careful not to exceed the threshold.

29.  HRC also created false documents to support its fictitious accounting entries. For example, during the audit of HRC’s 2000 financial statements, the auditors questioned an addition to fixed assets at one particular HRC facility. HRC accounting personnel, knowing that this addition was fictitious, altered an existing invoice (that reflected an actual purchase of an asset at another facility that approximated the dollar amount of the fictitious addition) to fraudulently indicate that the facility in question had actually purchased that asset. This altered invoice was then given to the auditors to support the recording of the fictitious asset in question. Also, when the auditors asked HRC for a fixed assets ledger for various facilities, HRC accounting personnel would re-generate the fixed asset ledger, replacing the “AP Summary” line item with the name of a specific fixed asset that did not exist at the facility, while leaving the dollar amount of the line item unchanged.

* Update: A video of this Roundtable, along with some follow-up comments can be seen here.

Although a substantial body of academic research is devoted to developing and testing risk proxies that detect or predict accounting irregularities, the academic literature has paid little attention to commercially developed risk measures. This is surprising given the general consensus that accruals-based risk proxies in the academic literature are very noisy (McNichols [2000]). We compare the commercially developed AGR risk proxy with proxies from the academic literature to determine which measure best detects and predicts accounting irregularities. We find that AGR outperforms academic risk measures in all head-to-head tests for detecting and most head-to-head tests for predicting Securities and Exchange Commission enforcement actions (AAERs), egregious accounting restatements, and shareholder lawsuits related to alleged accounting improprieties. Incorporating commercially developed risk proxies into future research may yield interesting insights beyond what academic proxies have provided to date.

This looks like a good paper, not only because of the comparison it performs, but also because it gives a good overview of the state of the art in risk measures, both commercially and academically. I’m looking forward to reading the rest of the paper.

The auditor’s response has been to highlight the fact that Koss is one of the companies that are not yet subject to Sarbox’s Section 404(b), which requires an auditor sign-off of internal controls. “The company did not engage Grant Thornton to conduct an audit or evaluation of internal controls over financial reporting,” says a spokesperson for the accounting firm. “Establishing and maintaining effective internal control is management’s and the board’s responsibility.”

This comes at a key time as congress is considering a law that would permanently exempt small filers from being subject to SOX 404(b) requirements. The article continues,

The Securities and Exchange Commission has allowed nonaccelerated filers — companies with market caps below $75 million — to only self-report on the effectiveness of their internal controls for the past two years. But the regulator has continually delayed the auditor-attestation portion of Section 404 for those filers. If there are no more delays or exemptions, companies like Koss will have to get their auditors to review their internal controls starting this summer, depending on their fiscal year-end.

However, the major regulatory-reform bill passed by the House in mid-December would permanently exempt small businesses from 404(b). Small-business proponents have pushed for the exemption, saying audits of internal controls over financial reporting are disproportionately costly and perhaps even unnecessary since, individually, small companies represent only minuscule blips of total market capitalization in the United States.

Still, it’s debatable whether small businesses will get the exemption after the Senate works on its version of the bill later this month. Investor advocates are hoping they won’t. “Investors believe that auditor’s expertise can provide management with additional perspective on the quality of its system of internal control, which can have a positive impact on the quality of a company’s financial reporting,” wrote four investor groups, including the CFA Centre for Financial Market Integrity, in a recent letter to House members. The Koss case could bolster such arguments against the exemption.

Although I haven’t been able to read the paper itself (so I cannot comment on the quality of the analysis or the conclusions), I am intrigued by the question and am interested in any evidence that describes how IFRS is applied in practice. My own experience with IFRS is that preparers often find themselves with little practical guidance on how to interpret or apply the vague principles within many IFRS standards.  For example, paragraph 13 of IAS 18 Revenue contains the only guidance in IFRS on multiple element arrangements. Many IFRS preparers simply look to US GAAP’s EITF 00-21 (now referred to as ASC 605-25 Multiple Element Arrangements) rather than create from scratch their own policy interpretation. One big benefit of this approach is that they know their international auditors are likely to be accepting of the EITF 00-21 approach too.

Because so many IFRS standards contain principles only with very little implementation guidance, and because these principles are often so loosely described, it seems relatively easy for countries and companies to argue that their own legacy GAAP is consistent with those principles. For those standards where this is the case, companies can conclude that they are following IFRS, but we still see inconsistent policies across countries (as the Kvaal and Nobes paper documents). Unless IFRS standards can become more concrete in their principles and provide a sufficient amount of authoritative implementation guidance to clarify those principles, I wonder whether IFRS can ever produce global comparability.

• What specific aspects of reporting quality drive improved investment decisions?  Like so many archival studies, this one uses very broad measures of financial reporting quality.  One uses the Dechow-Dichev metric on the association between income and previous, current and future cash flows; another uses Wycocki’s modification, yet another looks at the readability of the 10-K, a la Feng Li.  But none of those seem to capture the specific agency problems that distort investment.  What would be more targeted?
• To the extent that financial reporting improves firms’ investment decisions, should we think of this as satisfying a “stewardship” objective, rather than (or in addition to) decision-usefulness for investors?  Either way, how useful would (or should) the FASB find evidence associating financial reporting quality with the optimality of investment decisions?

We had time for plenty of other questions, and some interesting answers.  Hopefully we will see some of those raised in the comment thread.

This got me thinking– what sort of transactions/issues will become big financial reporting issues due to the financial crisis? Specifically, I expect the crisis to be the sort of “shock to the system” that allows researchers to examine issues that do not arise in times of prosperity or well functioning markets. In other words, it provides much more variation in some independent variables, and by exploiting the additional variation, researchers might design more powerful tests of important questions. Perhaps a discussion along these lines will help bloggers to frame some interesting questions.

The PWC report lists several issues that require heightened attention during a crisis. The ones I might have guessed are

• Bankruptcy reorganizations – additional reporting issues arise while the reporting entity undergoes bankruptcy. (The auditor also has to consider going concern issues, but this report is aimed at preparers.)
• Asset impairments – impairment triggers are more likely to be tripped in a downturn, and once the triggers trip, full impairment testing is required.
• Fair value measurement of financial instruments – when / how to assess fair value in distressed markets.
• Derivatives and hedging – assessing fair value and hedge effectiveness can be a challenge in a crisis. Also, the increased market volatility may lead to new hedging activity.
• Debt restructurings or repurchases – some borrowers are either refinancing their debt or bargaining for better terms; the amount of gain from settling or restructuring troubled debt can vary significantly depending on how the transaction is structured.
• Deferred income tax asset valuation allowances – if recent company performance is poor, the recoverability of deferred tax assets is called into question. 

The report had several other issues I would not have thought of are:

• Lease restructurings – what happens when a company modifies the terms of its leases?
• Private investment in public enterprises (PIPE) – I am not quite sure what this is, unless it is an infusion of capital into a public company from some private equity fund or other such sources. The report suggests that such financing usually comes with embedded derivatives and implications for earnings per share.

I can think of one category that is not in the report – how should a public company report its acceptance of government “bailout” funding? How does the reporting entity decide whether the credit side of the entry is debt, equity, or income?

The three page report is on cfodirect.pwc.com.  If the link above fails to open, then you might need to sign up for access  (I believe academics can sign up for free);  send me an email if it does not open.

On Wednesday, Sept 30th, 11 am ET, we will be joined by Kathy Petroni (Michigan State University).

Kathy will be talking about her paper, entitled “CFOs and CEOs:  Who Have the Most Influence on Earnings Management?”  The paper is forthcoming in the Journal of Financial Economics, and is co-authored with John (Xuefeng) Jiang and Isabel Yanyan Wang (also of Michigan State University).

The abstract of the paper reads:

This study examines the association between CFOs’ equity incentives and earnings management. CEOs’ equity incentives have been shown to be associated with accruals management, beating earnings benchmarks, and earnings restatements (Bergstresser and Philippon, 2006; Cheng and Warfield, 2005; McAnally et al. 2007; and Burns and Kedia, 2006). Given that CFOs’ primary responsibility is financial reporting, we argue that for a given level of equity incentives the CFO’s incentives should play a stronger role than those of the CEO. Consistent with this prediction, we find that the magnitude of discretionary accruals and the likelihood of beating benchmarks and earnings restatements are more sensitive to the CFOs’ equity incentives than to those of the CEO. Our evidence supports the SEC’s new disclosure requirement on CFO compensation.

While their study suggests that CFOs play a key role in understanding earnings management, a related study suggests that there might be clear and operational solution to the problem:  simply promote the CFO to CEO.  Then, as argued here by Steve Matsunaga and Eric Yeung, you will get higher quality financial disclosures (in the form of less aggressive/more conservative accounting policies and more precise earnings guidance) – perhaps the improvement in financial reporting quality comes because this group of CEOs (given their background) know how to watch out for shifty CFOs.

Be sure to join us on Wednesday for what promises to be an engaging and enlightening discussion!

Remember: You can attend Round Table Discussions in Second Life (instructions here) or on the web at our LIVE page.