Ken V. Peasnell

The characteristics of firms subject to adverse rulings by the Financial Reporting Review Panel

Abstract This study presents evidence on the characteristics of firms judged by the Financial Reporting Review Panel (FRRP) as having published defective financial statements. Relative to a pairwise-matched control sample, FRRP firms are associated with weak performance in the defect year. In contrast, their performance in the post-defect period is indistinguishable from that of the control sample, suggesting that rather than being perennial underachieves, FRRP firms are average performers suffering temporary performance difficulties. FRRP firms are also less likely to have a Big Five auditor. Weaker evidence is also presented that FRRP firms are less likely to have an audit committee and a high proportion of outside directors. In contrast, their remaining governance characteristics are largely indistinguishable from those of the control sample. Moreover, there is no evidence that public censure by the FRRP leads to a higher incidence of executive turnover in subsequent years.

The determinants of the UK Big Firm premium

Abstract Our study attempts to determine whether, and if so why, the large auditing firms are able to earn a premium on their audit work in the UK. We start by confirming the apparent existence of a Big Firm premium during the period 1985-2002. We examine industry specialisation, non-audit service fee and monopoly pricing explanations for the premium. The results of our tests of industry specialisation are mixed. There is little evidence that this premium is associated with industry specialisation when specialists are defined at the national level. Significant premia are observed if specialisation is defined at the city level, particularly if the auditor is the industry leader. However, when appropriate allowance is made for endogeneity. by modelling both audit and non-audit fees in a simultaneous equations framework, the Big Firm premium disappears. We find evidence to suggest that non-audit fees earned by auditors from their audit clients are positively related to the size of the audit fee and vice versa. Finally, when the sample is stratified by the size of audit client, we find no systematic evidence of anti-competitive pricing.

Fixed Asset Revaluation and Equity Depletion in the UK

UK GAAP has traditionally allowed the write-off of purchased goodwill directly to reserves, resulting in the widespread depletion of book equity. Companies have also been permitted to revalue fixed assets at managements discretion. This study examines whether upward revaluations have been associated with the depletion of book equity and with other costly contracting explanations identified in prior research. Our results provide strong support for the equity depletion hypothesis, both with regard to the decision to revalue and the timing of the revaluations. Indebtedness, liquidity, size and fixed asset intensity are also consistently associated with upward revaluation. Copyright Blackwell Publishers Ltd 2000.

Are Asset Securitizations Sales or Loans

This study addresses whether asset securitizations are really asset sales or a form of secured borrowing, by estimating cross-sectional equity valuation regressions to assess whether the stock market treats securitized assets and liabilities held by a special purpose entity (SPE) as assets and liabilities of the sponsor-originator (S-O). Overall, we find that the market views the SPE assets and liabilities as belonging to the S-O, i.e., the risk and rewards of ownership of the transferred assets reside with the S-O and not the SPE. Results from a boot-strapping simulation that controls for scale by randomly assigning SPE assets and liabilities from one S-O to another provide evidence that scale bias is an unlikely explanation for finding the market views SPE assets and liabilities as belonging to the S-O. Findings from specifications in which we permit coefficients to differ for S-O firms with high and low relative levels of retained interest indicate that whereas the market views asset securitizations by low retained interest S-O firms as sales, i.e., risk transfer has taken place, it views asset securitizations by high retained interest S-O firms as secured borrowings, i.e., risk transfer is incomplete. We also show that although the market views securitizations by regulated and unregulated S-Os as secured borrowing, there is suggestive evidence that regulated firms have greater incentives to use securitizations to achieve off-balance sheet financing. .

The effect of large audit firm mergers on audit pricing in the UK

Abstract This paper examines the effects on UK audit market concentration and pricing of mergers between the large audit firms and the demise of Andersen. Based on data over the period 1985–2002, it appears that mergers contributed to a rise in concentration ratios to levels that suggest concern about the potential for monopoly pricing. The high concentration ratios have not improved the level of price competition in the UK audit market. Our pooled models suggest that concentration ratios are associated with higher audit fees. The evidence suggests that the effects of mergers between big firms on brand name fee premium and on price competition vary depending on the particular circumstances. The brand name premium is strongest for the largest quartile of companies prior to the mergers. After the Big Six mergers, the premium increases for average‐sized companies but falls for the smallest and largest companies. Following the PricewaterhouseCoopers merger, the premium increases for below median‐sized clients but decreases for above‐median sized clients. For the Deloitte‐Andersen transaction, the premium falls for the smallest and largest companies but increases for those in the second quartile. Our results provide evidence that auditees are likely to pay higher fees if their auditor merges with a larger counterpart. We attribute merger‐related fee hikes to product differentiation, rather than anti‐competitive pricing.

Have Changes in Pension Accounting Changed Pension Provision? A Review of the Evidence

Abstract The present paper reviews the research evidence on the impact of changes in pension accounting methods on pension provision. We show that decisions to freeze, terminate or convert defined benefit (DB) plans have been driven primarily by a desire to limit contributions, though financial reporting has played a part as well. The introduction of accrual accounting requirements for post‐retirement health care benefits in the US similar in character to those required for DB pension liabilities appear to have motivated some firms to curtail health care provision. Changes in accounting for DB schemes have affected how firms allocate pension plan assets. We conclude that accounting matters, though perhaps not as much as is sometimes claimed. Increased costs of providing DB pensions, coupled with the greater volatility of employers’ cash contributions, have undoubtedly played the major part in the decline of DB schemes.

The Use of The R2 as a Measure of Firm-Specific Information: A Cross-Country Critique

Recent research uses the degree of stock returns co-movement as a measure of the quality of a country’s information environment. It has been argued that stronger property rights, better corporate governance regimes and more efficient enforcement mechanisms lead to prices incorporating more firm-specific information and, therefore, co-moving less with the market. In this paper, we use a much more comprehensive international data set than in prior research, encompassing forty countries over twenty years, to evaluate the reliability of this approach in a crosscountry setting and to analyse the behaviour of the measure used. Our results demonstrate severe limitations in the use of co-movement as measure of information quality. We highlight the instability of the measure and show that it can produce results that are often difficult to reconcile with such an informational explanation.

The Basu Measure as an Indicator of Conditional Conservatism: Evidence from UK Earnings Components

Following the work of Basu in 1997, the excess of the sensitivity of accounting earnings to negative share return over its sensitivity to positive share return (the Basu coefficient) has been interpreted as an indicator of conditional accounting conservatism. Although this interpretation is supported by substantial evidence that the Basu coefficient is associated with likely demands for conservatism, concerns have arisen that it may reflect factors not directly related to conservatism, and that this may adversely affect its validity as an indicator of that phenomenon. We argue that evidence on the validity of the Basu coefficient as an indicator of conditional conservatism can be obtained by disaggregating earnings into components, classifying those components by whether or not they are likely to be affected by conditional conservatism, and examining whether the Basu coefficient arises primarily from components likely to be affected by conditional conservatism. We implement this procedure for UK firms reporting under FRS 3: Reporting Financial Performance from 1992 to 2004. Although a substantial proportion of the Basu coefficient emanates from cash flow from operating and investing activities (CFOI), which cannot directly reflect accounting conservatism, its incidence across other components of earnings is predominantly within those components likely to be affected by conditional conservatism. Also, although the bias documented by Patatoukas and Thomas in 2009 is present in all of our aggregate earnings measures, it is heavily concentrated in the CFOI component of earnings and largely absent from components classified as likely to be affected by conditional conservatism. With the important caveat that researchers should test the robustness of their results to the exclusion of the element of the Basu coefficient due to cash flows, our findings are consistent with the conditional conservatism interpretation of the coefficient.

Do Investors Understand Really Dirty Surplus

This study addresses whether firms’ share prices correctly reflect two accounting measures, dirty surplus and really dirty surplus. Dirty surplus is readily observable from the financial statements, but really dirty surplus, which arises from recognizing equity transactions such as employee stock option exercises at other than fair market value, is not. Findings show that dirty surplus and really dirty surplus are irrelevant for forecasting abnormal comprehensive income. However, findings also indicate that investors appear to undervalue really dirty surplus. Hedge returns are insignificant when portfolios are formed based on dirty surplus, but are significantly positive based on really dirty surplus. Really dirty surplus positive hedge returns are robust to a variety of sensitivity tests. Taken together, the findings are consistent with either investors overvaluing firms that have large negative really dirty surplus or really dirty surplus being correlated with an unmodeled risk factor.

Performance Reporting – The IASB's Proposed Formats of Financial Statements in the Exposure Draft of IAS 1

ABSTRACT This paper is a response to the exposure draft of proposed amendments to IAS 1 Presentation of Financial Statements published by the International Accounting Standards Board (IASB) in March 2006. The objective is to bring to the standard setters attention research that is relevant to the issues raised in the exposure draft. We review analytic, empirical and experimental research that addresses the presentation of income and the format of the income statement. Overall, there is some support for a single statement of (total) recognised income and expense. However, net income is on average more relevant than comprehensive income, which may favour a two-statement approach. While this result is in line with the IASBs option of the two formats, it does not support the IASBs preference for a single statement.