On the Balance Sheet-Based Model of Financial Reporting

The FASB adopted a balance sheet-based model of financial reporting about 30 years ago, and this model has been gradually expanded and solidified to become the required norm around the world today. Currently, the FASB and the IASB are re-considering their Conceptual Framework, and this is the right time to have a much-needed debate about the proper conceptual foundations of accounting. This paper argues that the balance sheet orientation of accounting standard-setting is flawed, for the following reasons: 1. Accounting is supposed to reflect business reality, and thus the essential features of the financial reporting model need to reflect the essential features of the underlying business model. However, the balance sheet orientation of financial reporting is at odds with the economic process of advancing expenses to earn revenues, which governs how most businesses create value, and which represents how managers and investors view most firms. 2. The adoption of the balance sheet approach was driven by conceptual considerations; standard setters argued that the concept of assets is more fundamental and logically prior to the concept of income. However, this paper argues that the concept of income is clearer and practically more useful than the concept of assets, especially with the recent proliferation of intangible assets. 3. Earnings is the single most important output of the accounting system. Thus, intuitively, improved financial reporting should lead to improved usefulness of earnings. However, the continual expansion of the balance sheet approach is gradually destroying the forward-looking usefulness of earnings, mainly through the effect of various asset re-valuations, which manifest as noise in the process of generating normal operating earnings. During the last 40 years, the volatility of reported earnings has doubled and the persistence of earnings has gone down by about a third, while there is little change in the properties of the underlying business fundamentals. 4. The balance sheet approach has pushed accounting into incorporating more and more valuation estimates into financial reports, creating tautological and dangerous feedback loops between financial markets and the real economy. The paper concludes with two suggestions about a "good" model of financial reporting. The first suggestion is that accounting needs to make a sharp theoretical and practical distinction between operating and financing-type activities and assets, and this distinction needs to be reflected in all financial statements. The second suggestion is that for most firms the accounting for operating activities needs a renewed emphasis on the principle of matching of expenses to revenues

Discussion of “The Differential Persistence of Accruals and Cash Flows for Future Operating Income versus Future Profitability”

Fairfield et al. (2003a, this issue) suggests that the accrual effect in Sloan (1996) is at least partly due to the fact that accruals signify an increase in (less-productive) net operating assets. Thus, the paper is a useful and thought-provoking reminder that accruals have both earnings and balance sheet effects. However, the impact of the empirical results is diminished by the lack of a convincing story that ties and grounds these results to other knowledge in the area.Peer Reviewedhttp://deepblue.lib.umich.edu/bitstream/2027.42/47736/1/11142_2004_Article_5127178.pd

News or Noise?

This study investigates the quality of the U.S. News annual ranking of national universities and liberal arts colleges. The main finding is that current rankings changes have a strong tendency to revert over the following two rankings. Using a simple model, this study estimates that about 70 to 80 percent of the variation in rankings changes is transitory and reversible. Thus, most of the “news” in the annual rankings is essentially meaningless noise. An analysis of possible explanations suggests that the noise in annual ranking changes is most likely due to various measurement, estimation, and other information processing errors in the rankings' underlying components.Peer Reviewedhttp://deepblue.lib.umich.edu/bitstream/2027.42/43624/1/11162_2004_Article_297322.pd

Default Risk and Equity Returns: A Comparison of the Bank-Based German and the U.S. Financial System

In this paper, we address the question whether the impact of default risk on equity returns depends on the financial system firms operate in. Using an implementation of Merton's option-pricing model for the value of equity to estimate firms' default risk, we construct a factor that measures the excess return of firms with low default risk over firms with high default risk. We then compare results from asset pricing tests for the German and the U.S. stock markets. Since Germany is the prime example of a bank-based financial system, where debt is supposedly a major instrument of corporate governance, we expect that a systematic default risk effect on equity returns should be more pronounced for German rather than U.S. firms. Our evidence suggests that a higher firm default risk systematically leads to lower returns in both capital markets. This contradicts some previous results for the U.S. by Vassalou/Xing (2004), but we show that their default risk factor looses its explanatory power if one includes a default risk factor measured as a factor mimicking portfolio. It further turns out that the composition of corporate debt affects equity returns in Germany. Firms' default risk sensitivities are attenuated the more a firm depends on bank debt financing

In search of dermatophytes – frequency and etiology of fungal infections in patients with and without diabetes mellitus

Introduction: Onychomycosis is a frequent nail disorder, accounting for up to 50% of all nail problems. Treatment of onychomycosis is expensive and requires a long time of antifungal medications. Consequently, a proper and faster diagnosis is necessary. Especially for those patients with diabetes mellitus, where onychomycosis is among the most significant predictors of foot ulcer and possible severe complications.Aim: To compare the sensitivity, specificity, and turnaround time between direct microscopy, culture, histology, and real-time PCR. In addition, to compare the frequency and etiology of onychomycosis in patients with and without DM.Materials and methods: This study included 102 patients, divided into two groups. One group consisted of patients with diabetes mellitus and the other – without diabetes. Nail samples were collected and examined by direct KOH microscopic examination, culture, histology, and real-time PCR.Results: From the 102 patients with clinical onychomycosis, positive KOH was found in 38 (37.3%). Culture – 82 out of 102 samples (80.4%) were positive for dermatophytes, yeasts, and/or NDM. Positive histology samples were 32 (41.6%). The PCR was positive in 57 (55.9%) out of the 102. We discovered that there is no significant statistical difference in the etiology of the fungal infections between the two groups.Conclusions: All mycological investigations have their place in the diagnosis of onychomycosis. Direct microscopy, culture, and histology are useful methods for clinicians to diagnose and follow up the post-treatment period. The advantages of RT-PCR include obtaining results faster and accurately identifying fungi, thus becoming more valued in the diagnosis of OM

Where do firms manage earnings?

Despite decades of research on how, why, and when companies manage earnings, there is a paucity of evidence about the geographic location of earnings management within multinational firms. In this study, we examine where companies manage earnings using a sample of 2,067 U.S. multinational firms from 1994 to 2009. We predict and find that firms with extensive foreign operations in weak rule of law countries have more foreign earnings management than companies with subsidiaries in locations where the rule of law is strong. We also find some evidence that profitable firms with extensive tax haven subsidiaries manage earnings more than other firms and that the earnings management is concentrated in foreign income. Apart from these results, we find that most earnings management takes place in domestic income, not foreign income.Arthur Andersen (Firm) (Arthur Andersen Faculty Fund

Default risk, state ownership and the cross-section of stock returns: evidence from China

We apply a structural model to estimate firm-level default risk in China and investigate the stock return predictability of default risk and the moderating effects of state ownership for the sample period from 2003 to 2015. We show unique evidence that in China, default risk is positively associated with expected stock returns and state ownership matters considerably to the return predictability of default risk. We find investors of state-owned enterprises (SOEs) are not compensated appropriately in China despite of their higher default risk exposure. Our empirical evidence supports the conjecture on shareholder advantages and suggests that a strong bargaining power of equity holders would have a negative impact on stock returns

Corporate boards and performance pricing in private debt contracts

This paper investigates the effects of corporate governance on the use of performance pricing in debt contracts on a sample of newly syndicated loans in the U.S. private debt market. While cross-sectional results provide no evidence for the predicted relation between corporate governance quality and the likelihood of using performance pricing in debt contracts, there is evidence for the predicted positive relation between corporate governance quality and the use of interest-increasing performance pricing provisions. Evidence also provides support for the predicted negative relation between corporate governance quality and the use of financial ratio as the measure of performance underlying the provisions. Overall, empirical evidence supports the hypothesis that debt-holders perceive aspects of corporate governance to be beneficial and factor them in their contracting decisions