Joshua Ronen

To Fair Value or Not to Fair Value: A Broader Perspective

Fair value is considered here with respect to the two primary objectives of financial statements proposed in the joint conceptual framework that is under development by the FASB and the IASB, namely (a) informativeness—to assist providers of capital in predicting, evaluating, and comparing the amounts, timing and uncertainty of future cash flows, and (b) stewardship—to assist in evaluating how efficient and effective managers have been in enhancing shareholders’ value. More specifically, a comprehensive set of accounting measures and a set of corporate governance reforms intended to align corporate insiders’ and auditors’ behaviour and decisions with the interests of investors is outlined. Suggested reforms show how to present a mix of effectively historical quantifications, exit values, and the discounted values of future cash flows expected from the particularized use of combinations of assets within the firm. Additionally, the article describes how markets can be reformed in order to align the interests of the officers who prepare such accounts, and the auditors who certify them, with those of investors. These market-based reforms would require auditors to insure misrepresentations, and managers to take equity to induce truthful reporting. Also included is a radical extension to earlier proposals by the author, requiring an officer of the company to make the market in shares in a way that would place limits upon the value of the insiders private information.

The Declining Value Relevance of Accounting Information and Non Information-Based Trading: An Empirical Analysis

Recently, a growing body of literature has suggested that financial statements have lost their value relevance because of a shift from a traditional capital-intensive economy to a high-technology, service-oriented economy. These conclusions are based on studies that find a temporal decline in the association between stock prices and accounting information (earnings and book values). This paper empirically tests a theoretical prediction arising from the Noisy Rational Expectations Equilibrium model that suggests that the decline could be driven by non-information-based (NIB) trading activity, because such trading reduces the ability of stock prices to reflect accounting information. Specifically, Dontoh et al. (2004) show that when NIB trading increases, the R-squares of a regression of stock price on accounting information declines. Our empirical tests confirm this prediction; i.e., the decline in the association between stock prices and accounting information as measured by R-squares is driven by an increase in NIB trading.

Opportunity Costs-An Experimental Approach

Normative economic models typically do not differentiate between opportunity costs (hereafter OC) and outlay costs (hereafter OL). OC are defined as benefits foregone as a result of rejecting the next best alternative action.1 OL, on the other hand, reflect the resources committed to an action as quantified through actual transactions. Although OL and OC in some cases may be identical, they can differ. In economics, only OC (properly defined) are considered relevant, whereas accounting reports only OL. For example, accounting does not consider the cost of capital in the quantification of investments, except to the extent that actual interest transactions occur. Accounting reports the salary paid to a firms manager but not the benefit foregone by not using him in his next best employment. Depreciation costs of equipment utilized in the firms manufacturing activity are reported but not the foregone profit that could have been realized (e.g., by renting the equipment). An important question for accountants is whether information about OC should be provided by the accounting process. To answer this question at least partially, it is beneficial to determine whether OC are used in actual decision making. It is difficult to investigate this issue in a real situation since decision makers may be using OC obtained from nonaccounting sources about which we have little or no knowledge. As a first step, we chose instead to investigate whether individuals in an experimental situation would rely on OC if information about them was provided.

`Managerialism', `ownerism' and risk

Abstract This paper proposes that managers, having the value of their human capital dependent on the performance of the firm they manage, and being unable to diversify away this risk, are expected to attempt to reduce their employment risk internally by project selection or by income smoothing, intended to stabilize the firms income stream. An empirical investigation shows that manager-controlled firms exercise ‘income smoothing’ to a greater extent than owner-controlled firms, have relatively lower unsystematic risk and perhaps lower systematic risk.

Legal Liabilities and the Market for Auditing Services

The ever-expanding scope of accountants’ liability and its alleged dire consequences have become the “talk of the town” within the accounting and legal communities. A perception of a “crisis” in the market for auditors’ malpractice insurance is also widespread. Many attribute this crisis to the seemingly persistent erosion in the privity doctrine formalized in Ultramares v. Touche, Niven and Co.’ Under this privity standard, accountants were liable to third parties who had relied on audited financial statements only if the injured parties could prove fraud. Writing for the majority in Ultramares, Judge Benjamin Nathan Cardozo noted:

Effects of some probability displays on choices

Abstract This research deals with deviations from the EV model. Ss in two experiments were required to select one of two mutually exclusive actions characterized by an identical probability of success. Each action, however, consisted of two sequential steps. The probability of success at the first step of one action was greater than the probability of success at the first step of the alternative action. Ss were made aware of the individual probabilities of success for each step as well as the joint probability of success. The EV model would predict that individuals would be indifferent in their selection of alternative actions. However, Ss were not indifferent; they systematically preferred actions in which the probability of success in the first step was higher. This preference for initial probability of success generally persisted with some exception throughout variations in experimental conditions designed to test for the stability of the effect.

On R&D capitalization and value relevance: a commentary

Abstract Studies that explore the empirical association between accounting numbers and price-based measures cannot, by themselves, lead to inferences regarding the usefulness of alternative accounting policies. The Boone and Raman (2001) paper is one among many studies that employ a “value-relevance” methodology (finding associations between prices or measures derived wherefrom and accounting numbers based on alternative treatments) in an attempt to derive implications for accounting policy formulation. This paper dwells on the reasons why no such implications can be drawn from association studies, and why, under the best of circumstances, such studies can illuminate only one corner of the black box: does the market behave as if it both (1) believes and (2) attaches some weight to information provided to it?

On the Rationality of the Post-Announcement Drift

This paper demonstrates that a post-announcement earnings drift, which is often advanced as an example of market irrationality, can arise even if traders act rationally on their information. Specifically, we show that in the presence of share supply variations which are unrelated to information, there is a positive correlation between the unexpected component of current public signals and future price changes. Such a correlation arises from the fact that while prices reveal private information that cannot be found in public signals, non-information based trading distorts the information content of prices relative to the implications of both private and public information. Under these circumstances, markets may appear semi-strong inefficient and slow to respond to earnings announcements even though information is processed in a timely and efficient manner. Our findings correspond well with previously documented empirical evidence and suggest that the robustness of earnings-based “anomalies” may be rational outcomes of varying uncertain share supply.

The Predictive Value of Accruals and Consequences for Market Anomalies

In this article, the authors revisit the role of the cash and accrual components of accounting earnings in predicting future cash flows using out-of-sample predictions and market value of equity as a proxy for all future cash flows. They find that, on average, accruals improve upon current cash flow from operations (CFO) in predicting future cash flows. In the cross-section, accruals’ contribution is positively associated with proxies for quality of accruals and governance. Next, the authors investigate the implications of accruals’ predictive value for accrual-based market anomalies. They find that portfolios formed on stock return predictions using information from current CFO and accruals yield significantly positive returns on average, as opposed to CFO alone. They also find that Sloan’s accrual anomaly is related to our accrual contribution anomaly. Indeed, when accruals’ contribution to future cash flow prediction is the highest, the accrual anomaly vanishes. Collectively, the results suggest that the predictive value of accruals and market participants’ ability to process it are a significant driver of accrual-based anomalies.

The Role of Transfer Price for Coordination and Control within a Firm

This paper explores the role of transfer prices as coordinating mechanisms within a firm. Three cases (full information; pure adverse selection; adverse selection and moral hazard) are analyzed and compared to show how quantity and effort are affected as assumptions on observability are progrssively relaxed. The analysis of the second case, having two observable variables, identifies the necessary and sufficient condition under which “the local approach” can be applied. The third case is reinterpreted as transfer prices in a direct delegation setting. The main results are: First, the optimal transfer price is standard average cost plus. Second, it is not necessarily decreasing in quantity unlike the downward sloping demand function.