Michael Kirschenheiter

Can “Big Bath” and Earnings Smoothing Co‐exist as Equilibrium Financial Reporting Strategies?

We study a model of financial reporting where investors infer the precision of reported earnings. Reporting a larger earnings surprise reduces the inferred earnings precision, dampening the impact on firm value of reporting higher earnings, and providing a natural demand for smoother earnings. We show that for sufficiently “bad” news, the manager under‐reports earnings by the maximum, preferring to take a “big bath” in the current period in order to report higher future earnings. If the news is “good,” the manager smoothes earnings, with the amount of smoothing depending on the level of cashflows observed. He either over‐reports or partially under‐reports for slightly good news, and gradually increases his under‐reporting as the news gets better, until he is under‐reporting the maximum amount for sufficiently good news. This result holds both when investors are “naive” and ignore management’s ability to manipulate earnings, or “sophisticated” and correctly infer management’s disclosure strategy.

Information Quality and Correlated Signals

This paper assumes that there are two methods of estimating the value of a firms assets, called the historical cost (HC) and market value (MV) methods, respectively. It assumes that the true value of the assets and the two estimates are all random variables, jointly distributed as a multivariate normal. These methods are distinguished by their relevance (measured by the covariance of the estimate with the true asset value) their reliability (as measured by the estimates variance) and the direct costs of estimation and disclosure. Then, assuming there are a group of investors with negative exponential utilities, price equations are derived when a manager reports using a policy of reporting only HC, only MV, or both HC and MV (called full disclosure or FD). The choices among these disclosure policies are compared on both an ex-ante basis (before the realizations are observed) and an ex-post basis. Next a price equation is derived for the policy of reporting the lower of HC or MV (called LCOM). It is shown that this price equation equals the price equation for reporting HC or MV alone (whichever is announced) adjusted up by an imputed benefit for the undisclosed good news. Finally a price equation is derived for the policy of reporting the greater of HC or MV (called GCOM). This price equation is similar to the LCOM price equation except the addition of an imputed benefit is replaced by the subtraction of an imputed cost. This price equation is used to analyze questions concerning the imposition of market value accounting for financial assets owned by financial institutions.

The Aggregation and Valuation of Deferred Taxes

This paper clarifies some of the conflicting arguments about the value relevance of deferred taxes. We address two questions. First, does accounting aggregation hold, or in other words, are deferred tax expense and liability balances valued the same as operating earnings and asset balances, respectively? Second, what accounting method for deferred taxes preserves classical accounting relations, or should deferred taxes be recorded as equity, as debt, or as some combination of these categories? We answer these questions using a model of depreciable assets and cashflow dynamics identical to Feltham and Ohlson (1996). We find that aggregation does not hold; rather deferred taxes are valued less than earnings and book value. Deferred taxes add value because they represent the deferral of tax payments, so their value is the net present value of the tax benefits. We interpret this result to mean that the timing of the reversal of temporary differences does matter, consistent with recent empirical work. Our analysis shows that the deferred tax liability, as currently recorded in accordance with US GAAP, overstates the liability. Also, we find that the classical accounting relations hold only when deferred taxes are adjusted to their net present value. Further, the extent of this adjustment depends on whether or not the tax benefits are capitalized into the cost of the operating asset. If the benefits are reflected in the assets cost, deferred taxes should be adjusted down based on the ratio of the discount rate over the sum of the tax depreciation and discount rates. Otherwise, the entire balance should be treated as equity.

Discretionary Disclosures to Risk-Averse Traders: A Research Note†

Verrecchia (1983) investigates a manager’s incentives for costly, discretionary disclosure of his information to risk-averse traders when the functional form of prices is exogenously specified. We extend Verrecchia (1983) by deriving the endogenously determined functional form of prices that would arise when all traders have constant risk tolerance. We show that these endogenously determined prices are inconsistent with the assumed prices in Verrecchia (1983) when the manager elects to not disclose. We derive the manager’s disclosure strategy for our setting and extend the comparative static results in Verrecchia (1990) for risk-neutral traders to a setting where traders have constant risk tolerance and prices are endogenously derived. Further, in our setting, discretionary disclosure does not affect how traders price risk of different outcomes. Also, we offer a representation of risk-averse traders’ prices using risk-adjusted distributions. Finally, these results provide implications for empirical-archival discretionary disclosure studies.

Special issue on accounting and auditing

It is perhaps little known that accounting and mathematics have been connected for more than 500 years ago. In 1494, Luca Pacioli published his mathematics compendium Summa de Arithmetica, Geometria, Proportioni et Proportionalita consisting of 615 pages. “[T]he only significant part of the book that has ever been translated to English” was the 27-page treatise on bookkeeping,1 which defines the hour of birth of accounting. So to speak the study of double entry accounting was developed in concert with linear algebra.2 Beyond the joint development, which becomes apparent in Pacioli’s book, there are several reasons why accounting offers a very good application for mathematical techniques and mathematical knowledge. First, accounting phenomena cannot be understood best by just observing them. For generating predictions and interpretations [analytical] theory is required.3 Second, formalizing economic arguments by means of a mathematical model results in a more rigorous