Financial Accounting Research Financial Accounting Reporting Section FARS Meeting

1. Financial Accounting ResearchFinancial Accounting & Reporting Section (FARS) Meeting  Dan S. Dhaliwal The University of Arizona January 2009

2. 2 Introductory Comments Caution Research is about learning. Publishing is about teaching and sharing your knowledge.

3. 3 Magnitude, Timing and Uncertainty of Future Cash Flows What information is needed How that information is produced and disseminated

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7. Recognition Vs. Disclosure Recognized items meet several criteria, subject to cost-benefit and materiality considerations, and have the best combination of relevance and reliability Items that meet the definitions of financial statement elements but fail one or more of the recognition criteria should be disclosed Implication: Disclosure less reliable. 7

8. 8 Do managers recognize more reliably measured items? Investors perception of the reliability of disclosed vs. recognized items. Do auditors require the same precision in a disclosed item as in a recognized item?

9. 9 Accounting Information,Information Risk and Valuation of Securities (Cost of Capital, Expected Returns, and Yield) Barry and Brown (JFQA, 1985) Easley and O’Hara (JF, 2004) Lambert, Leuz, and Verrecchia (JAR, 2007) Bhattacharya, Ecker, Olsson, and Schipper (WP, 2007) Lambert, Leuz, and Verrecchia (WP, 2008)

10. Easley and O’Hara (2004) examine the link between information and CoC and find that CoC is (1) increasing in the fraction of private information in information set. (2) decreasing in the quality and quantity of information. 10

11. Hughes, Liu and Liu (2006) show CoC increases in information asymmetry because information asymmetry increases factor risk premiums. Information asymmetry, however, does not affect betas in price space although it does affect betas in return space. So, no cost of capital effect in the cross-section after controlling for betas. Our study is inter-temporal and the above conclusion is not a concern for us. 11

12. Lambert, Leuz and Verrecchia (2006) show CoC is determined by the firm’s assessed covariances with other firms’ cash flows, which is non-diversifiable. Regulations mandating higher quality accounting information and disclosures unambiguously lower CoC by reducing the assessed covariances. A regulation that transfers private signals into public signals (i.e., reducing information asymmetry) increases quality of disclosures and thus reduces CoC. So, Lambert et al. (2006) imply that a decrease in information asymmetry resulting from mandated disclosure lowers CoC. 12

13. 13 Cost of Equity Capital

14. 14 Cost of Equity Capital (b) Decreasing (increasing) in the aggregate risk tolerance of the market, Nt, when the expected cash flow and covariance of that cash flow with the market have the same (different) sign;

15. 15 Cost of Equity Capital

16. 16 Cost of Equity Capital (e) The ratio of the expected future cash flow to the covariance of the firm’s cash flow with the sum of all cash flows in the market is a key determinant of the cost of capital.

17. 17 Direct Effects Agency Cost Effect Investment Effect

18. Lambert, Leuz, and Verrecchia (WP, 2008) Average precision: the quality of investors’ information about firms’ cash flows on average. Information asymmetry: the differences in the quality, or precision, in information across investors. The average of investors’ precisions is a primary determinant of cost of capital. No other attribute of investors’ information is relevant to firms’ cost of capital. In particular, once one controls for average precision, the extent of information asymmetry in the economy has no effect on the cost of capital. 18

19. Reducing information asymmetry can appear to lower cost of capital in some situations by providing less informed investors access to information previously available only to better informed investors. However, the cost of capital decreases because the average precision of investors’ information increases, not because information asymmetry decreases. The communication of more information to more investors, not the reduction of information asymmetry, lowers cost of capital. 19

20. Taken together, these theory papers suggest that CoC (1) increases in the fraction of private information or information asymmetry. (2) decreases in quality and quantity of information. 20

21. Example Reg FD prohibits selective disclosure of material information to a subset of market participants. The SEC was concerned that selective disclosure enables a privileged few to profit at the expense of the investing public and this unequal access to information will inevitably lead to individual investors’ loss of confidence in the integrity of capital markets. By curtailing selective disclosure, the SEC believed that Reg FD would increase investor confidence in market integrity and “encourage continued widespread investor participation in our markets, enhancing market efficiency and liquidity, and more effective capital raising” (SEC 2000) i.e., SEC believed that Reg FD could ultimately reduce CoC. 21

22. Recent theory papers (Easley and O’Hara 2004; Hughes et al. 2006; Lambert et al. 2006) show that CoC (1) increases in information asymmetry or the fraction of private information in information set ) decreases in quality and quantity of information Thus, if Reg FD curtails selective disclosure and reduces information asymmetry, theory predicts a decrease in CoC post Reg FD, ceteris paribus. 22

23. 23 Assessing Quality: Value Relevance R2 from a regression of returns on earnings and change in earnings: Alford et al. (JAR, 1993) High R2 suggests accounting captures earnings in a relatively timely manner R2 from regression of price on earnings and book value: Harris, Lang, and Moeller (JAR, 1994) High R2 suggests that accounting captures attributes the market values

24. 24 Basu loss coefficient Regress: EPS = a + b1Ret + b2LossDum + b3LossDum*Ret Where Ret is return and Loss Dum =1 if Ret < 0 Focus is b3 All “bad news” ultimately find its way into earnings Could happen in a timely manner b3 will be large Could happen with a lag b3 will be small

25. 25 Problem with these approaches What does an association test tell you? Is the market “learning” from accounting data? Especially difficult to identify information releases internationally Rougher earnings can be “higher quality,” i.e. without manipulation Not much power Very sensitive to data

26. 26 Other measures Less evidence of smoothing Less evidence of managing toward targets More timely recognition of losses Ratio of absolute value of accruals to absolute value of cash flows

27. 27 Factors Related to Quality of Earnings Accounting standards Enforcement Attestation Litigation Private firms Capital structure Contracts Unions

28. 28 E.g., Countries with larger debt markets exhibit more conservatism (Ball et al (RAS, 2008). Does it hold within countries. Examine within countries IFRS

29. 29 Measures of C.C. Different measures produce different results. No theory to assess the relative validity of the models.

30. Earnings Management in General(Beaver 2002) Evidence: Researchers and market participants appear to detect earnings management. Questions What are the firm’s incentives? Are firms successful? Is earnings management a result of contracting in incomplete markets? Earning management proxies (e.g. discretionary accruals) may simply capture some firm-specific economic information 30

31. 31 Factors to Consider Mispricing: Market anomalies, Price Momentum and Price Reversals Forecast Properties

32. 32 Quality of Analyst Forecasts (CC Models Input) Implication of various deficiencies in analyst forecasts. Analyst Incentives- Link between analyst forecast and financial reporting environment What non-accounting information is included in analyst forecasts? Information reflected in stock prices and forecasts Analysis of forecast error and degree of mispricing

33. 33 Corporate Governance, SOX, Reg FD and Accounting Information Quality Different corporate governance structures optimal for different groups of firms. Does the information environment affect the price of information risk?

34. 34 Cost of Debt/Debt Markets One of the largest securities markets in the world Pricing of bonds is relatively well defined Different information environment Information intermediaries and institutional investors Lender concerned with downside risk Different Information needs?

35. 35 Credit Rate Changes and Drift in Stock and Bond Prices Odders-White and Ready (RFS, 2006) level of adverse selection in equity market and credit rating Regulating may affect the flow of information differently to debt markets.

36. 36 Syndicated Loan Market Both primary loans market and active secondary market Wide range of private debt contracts

37. Other Issues Accounting Information Quality and Efficiency of Contracts Implications of Behavioral Finance Valuation of Loss Firms Taxes and Valuation of Earnings Recognition versus Disclosure Detailed Analysis of SEC Filings, etc. 37

38. 38 Cost of Debt/Debt Markets One of the largest securities markets in the world Pricing of bonds is relatively well defined Different information environment Information intermediaries and institutional investors Lender concerned with downside risk Different Information needs?

39. Implicit Taxes Implicit taxes arise because the before-tax investment returns available on tax-favored assets are less than those available on tax-disfavored assets. The reduced yield available on tax-exempt municipal bonds in the U.S. relative to taxable corporate bonds of equal risk. If U.S. individual investors are the marginal holders of stock, we would expect (1) stocks to bear implicit taxes relative to bonds and (2) low-dividend-paying stocks to bear more implicit taxes than high-dividend-paying stocks. 39

40. Dividend Taxes and Implied Costof Equity Capital Dan Dhaliwal, Linda Krull, Oliver Zhen Li, and William Moser Journal of Accounting Research, 2005

41. Research Question Does the tax rate differential between capital gains and dividends effect the cost of capital? Does the cost of capital vary with cross-sectional difference in marginal investors’ tax rates? 41

42. Empirical Model ri,t - rft: the firm’s equity premium yield: Expected dividend yield penalty: inst: Institutional ownership as a proxy for the relative taxation of dividends and capital gains of the marginal investor. Prediction: a4 > 0 for H1 a6 < 0 for H2 42

43. Findings The relation between cost of equity and dividend yield is increasing in the dividend tax penalty. While tax-penalized dividend increase the cost of equity, tax-advantaged marginal investors reduce this positive relation. 43

44. Taxes, Leverage, and the Cost of Equity Capital Dan Dhaliwal, Shane Heizman, and Oliver Zhen Li Journal of Accounting Research, 2006

45. Research Question Whether leverage and corporate and investor level taxes affect the cost of equity capital? 45

46. Theory and Hypothesis Development When investor level taxes are introduced (Miller, 1977), where tps is the personal level tax rate on equity income tpb is the personal level tax rate on debt income 46

47. Empirical Model 47

48. Findings Cost of equity increases in leverage (M&M (1958)). Leverage-induced risk premium decreases in before financing corporate marginal tax rate (M&M (1963)). Some evidence that leverage-induced risk premium increases in the personal tax penalty of debt income (Miller (1977)). 48

49. Incremental Financing Decisions and Time-Series Variation in Personal Taxes on Equity Income Dan Dhaliwal, Merle Erickson, and Linda Krull The Journal of the American Taxation Association, 2007

50. Tax Effect on Financing Decision Tax rules influence the financing decisions of firms through their effect on the cost of financing the firms’ activities. The cost of issuing a capital structure instrument depends on the tax treatment it is accorded, which depends on Whether the instrument is debt, equity, or a hybrid; Whether the instrument is issued to an employee, a customer, a related party, a bank, or a number of other special classes of suppliers of capital; and Whether the instrument is issued by a corporation, partnership, or some other legal organizational form. The tax jurisdiction in which the capital structure instrument is issued. 50

51. The Tax Legislation (the 1997 and 2003 Tax Acts) The Taxpayer Relief Act of 1997 (the 1997 Tax Act) decreased the maximum tax rate on capital gains from 28% to 20% and left the tax rate on ordinary income unchanged. The Jobs and Growth Tax Relief Reconciliation Act of 2003 (the 2003 Tax Act) decreased the tax rate on dividend income from 38.6% to 15%, the tax rate on capital gains from 20% to 15%, and the tax rate on interest income from 38.6% to 35%. These Tax Acts decreased the tax rate on equity income relative to the tax rate on interest income, and the corporate tax rate was not changed. It is expected for firms to be less likely to issue debt relative to equity after the enactment of each tax act. 51

52. Empirical Model Estimate the following probit model separately for the 1997 Tax Act and the 2003 Tax Act samples: Type = 1 for debt issues and 0 for equity issues TRD = 1 after the effective date of the tax legislation and zero before Yield = the annualized amount of the last regular dividend in t-1/year t-1 market value of equity Inst = % of outstanding shares held by institutions Prediction: a1 and a2 < 0 a5 > 0 and a6 < 0 52

53. The Influence of Regulation Fair Disclosure on Firm Financing Decisions Susan Albring Syracuse University Monica Banyi University of Virginia, McIntire School of Commerce Dan Dhaliwal University of Arizona Raynolde Pereira University of Missouri 53

54. Research Questions Do changes in the firm’s information environment around Regulation FD affect managerial financing decisions? Narrow questions: If Regulation FD improves a firm’s information environment is there a positive impact on the probability of equity financing? If Regulation FD deteriorates a firm’s information environment is the positive impact of Regulation FD on firm use of equity financing attenuated? 54 The broadest umbrella question our research relates to is how managers respond to a change in information environment. The medium level question we address is whether changes to the firm’s information environment around Regulation FD affect managerial financing decisions. The narrow questions we address in this paper are if Regulation FD improves a firm’s information environment is there a positive impact on the probability of equity financing and if Regulation FD deteriorates a firm’s information environment is the positive impact of Regulation FD on equity financing attenuated for these firms? The broadest umbrella question our research relates to is how managers respond to a change in information environment. The medium level question we address is whether changes to the firm’s information environment around Regulation FD affect managerial financing decisions. The narrow questions we address in this paper are if Regulation FD improves a firm’s information environment is there a positive impact on the probability of equity financing and if Regulation FD deteriorates a firm’s information environment is the positive impact of Regulation FD on equity financing attenuated for these firms?

55. - RegFD On average, Regulation FD contributes to an increased preference for equity financing. Our results are consistent with prior research that finds a reduction in the cost of equity capital post Regulation FD (Chen et al. 2006). + Higher proprietary costs * RegFD Results suggest that the effects of Regulation FD are not uniform and suggest that Regulation FD had an adverse effect on the information environment of firms who confront higher proprietary costs of public disclosure. 55 On average, we find Regulation FD contributes to an increased preference for equity financing. Our finding on the impact of Regulation FD on firm financing decisions is consistent with prior research that finds a reduction in the cost of equity capital post Regulation FD (Chen et al. 2006). Our results suggest that the effects of Regulation FD are not uniform and suggest that Regulation FD had an adverse effect on the information environment of firms who confront higher proprietary costs of public disclosure. Our finding that firms with higher costs of public disclosure are more likely to issue debt in the post Regulation FD environment is consistent with the contention that firms which confront higher costs of widely disseminating firm specific information will exploit the advantage of selective disclosure which is allowed in debt markets. On average, we find Regulation FD contributes to an increased preference for equity financing. Our finding on the impact of Regulation FD on firm financing decisions is consistent with prior research that finds a reduction in the cost of equity capital post Regulation FD (Chen et al. 2006). Our results suggest that the effects of Regulation FD are not uniform and suggest that Regulation FD had an adverse effect on the information environment of firms who confront higher proprietary costs of public disclosure. Our finding that firms with higher costs of public disclosure are more likely to issue debt in the post Regulation FD environment is consistent with the contention that firms which confront higher costs of widely disseminating firm specific information will exploit the advantage of selective disclosure which is allowed in debt markets.

56. Biddle, Hilary, and Verdi (WP, 2008) This study investigates the relation between financial reporting quality and capital investment efficiency. Whether higher quality financial reporting enhances investment efficiency by reducing over- and/or under-investment, and what is its net effect? 56

57. Hypothesis Development Information asymmetries between firms and suppliers of capital can reduce capital investment efficiency by giving rise to frictions such as moral hazard and adverse selection that can each lead to produce over- and under-investment. Higher quality financial reporting enhances capital investment efficiency by mitigating information asymmetries (Leuz and Verrecchia (2000); Bushman and Smith (2001); Verrecchia (2001)) 57

58. Hypothesis H1A: Financial reporting quality is negatively associated with over-investment. H1B: Financial reporting quality is negatively associated with under-investment. 58

59. Findings Higher financial reporting quality can improve investment efficiency by reducing the information asymmetry that causes frictions such as moral hazard and adverse selection. Firms with high financial reporting quality invest less in years when the aggregate investment is high and more in year when the aggregate investment level is low. Financial reporting quality reduces under-investment by facilitating investment for constrained firms and mitigates over-investment by curbing investment for firms that are more likely to over-invest. Firms with higher quality financial reporting invest less and choose investments that are more profitable. 59