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

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

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

The Impact of Brand Quality on Shareholder Wealth

This study examines the impact of brand quality on three components of shareholder wealth: stock returns, systematic risk, and idiosyncratic risk. The study finds that brand quality enhances shareholder wealth insofar as unanticipated changes in brand quality are positively associated with stock returns and negatively related to changes in idiosyncratic risk. However, unanticipated changes in brand quality can also erode shareholder wealth because they have a positive association with changes in systematic risk. The study introduces a contingency theory view to the marketing-finance interface by analyzing the moderating role of two factors that are widely followed by investors. The results show an unanticipated increase (decrease) in current-period earnings enhances (depletes) the positive impact of unanticipated changes in brand quality on stock returns and mitigates (enhances) their deleterious effects on changes in systematic risk. Similarly, brand quality is more valuable for firms facing increasing competition (i.e., unanticipated decreases in industry concentration). The results are robust to endogeneity concerns and across alternative models. The authors conclude by discussing the nuanced implications of their findings for shareholder wealth, reporting brand quality to investors, and its use in employee evaluation

Large-sample evidence on the debt covenant hypothesis

http://deepblue.lib.umich.edu/bitstream/2027.42/35558/2/b2037828.0001.001.pdfhttp://deepblue.lib.umich.edu/bitstream/2027.42/35558/1/b2037828.0001.001.tx