Paul M. Healy

Information Asymmetry, Corporate Disclosure and the Capital Markets: A Review of the Empirical Disclosure Literature

Corporate disclosure is critical for the functioning of an efficient capital market. Firms provide disclosure through regulated financial reports, including the financial statements, footnotes, management discussion and analysis, and other regulatory filings. In addition, some firms engage in voluntary communication, such as management forecasts, analysts? presentations and conference calls, press releases, internet sites, and other corporate reports. Finally, there are disclosures about firms by information intermediaries, such as financial analysts, industry experts, and the financial press.

THE EFFECT OF BONUS SCHEMES ON ACCOUNTING DECISIONS

Studies examining managerial accounting decisions postulate that executives rewarded by earnings-based bonuses select accounting procedures that increase their compensation. The empirical results of these studies are conflicting. This paper analyzes the format of typical bonus contracts, providing a more complete characterization of their accounting incentive effects than earlier studies. The test results suggest that (1) accrual policies of managers are related to income-reporting incentives of their bonus contracts, and (2) changes in accounting procedures by managers are associated with adoption or modification of their bonus plan.

The Fall of Enron

The financial reporting and disclosure problems at Enron, as well as the high market valuations for its stock raise troubling questions about the functioning of capital market intermediaries, regulators and governance experts whose are supposed to ensure the effective functioning of the stock market. This paper examines the functions of key capital market intermediaries and analyzes how their own governance and incentive problems may have contributed to Enrons rise and fall. We conclude by proposing system modifications to resolve the observed problems.

The effect of accounting procedure changes on CEOs' cash salary and bonus compensation

Abstract This paper examines the effect of accounting procedure changes on cash salary and bonus compensation to CEOs. We estimate whether there is an adjustment to the statistical relation between compensation and corporate earnings following changes that lower earnings (FIFO to LIFO inventory valuation) and that raise earnings (accelerated to straight-line depreciation). The results indicate that (1) subsequent to these changes salary and bonus payments are based on reported earnings, rather than earnings under the original accounting method, and (2) the potential compensation effect of the changes is small compared to the effect of economy- or industry-wide changes in compensation.

Discussion of a market-based evaluation of discretionary accrual models

The use of accrual models has been pervasive in accounting research in the past ten years. This literature has sought to examine whether and why managers use discretion in financial reporting. The findings suggest that managers use their discretion for a wide range of reasons, including to increase their own compensation and protect their job security, to communicate their expectations of long-term firm performance with investors, and to create stockholder wealth at the expense of other stakeholders (such as debtholders, taxpayers, and regulatory bodies). Of course, the power and internal validity of these tests depend critically on whether the models of accruals used in the studies are well specified. Guay, Kothari, and Wattss (henceforth GKW) paper attempts to provide evidence on this question by modeling the relation between stock returns, and discretionary accruals and nondiscretionary earnings. GKW then examine whether the five most popular accrual models used in the literature produce discretionary accruals and nondiscretionary earnings that conform to their modeling predictions. The findings suggest that even the most effective models, the Jones and modified Jones models, do only a modest job of parsing earnings into discretionary and nondiscretionary components. Taken at face value the findings of the GKW paper have serious consequences for how readers should interpret the findings of earlier earnings management studies. However, such strong conclusions are

The challenges of investor communication The case of CUC International, Inc

We examine investor communication issues faced by public corporations using the experience of CUC International. CUC had difficulty convincing investors that its new product marketing outlays were profitable investments, leading to stock mis-valution over an extended period. To resolve this problem, it adopted a series of accounting and financial policy measures, including a leveraged recapitalization, accelerated debt repayments, and a stock repurchase. CUCs experience suggests that accounting is not always effective in facilitating credible and timely communication. While financial signals are more effective, their impact is not as immediate as predicted by prior research. The CUC case suggests that investor communications is a rich area for future research.

Auditor changes following big eight mergers with non-big eight audit firms

Abstract This paper examines the reaction of clients of “non-Big Eight” audit firms to mergers of their auditors with “Big Eight” firms. We postulate that a non-Big Eight audit firms clients will retain a Big Eight acquirer following a merger if they benefit from the Big Eight firms specialized services and/or reputation. Clients that do not have these economic incentives to retain the Big Eight firm are more likely to change to another non-Big Eight audit firm following the merger. Empirical tests of the characteristics of clients that remain with a Big Eight acquirer or change to another smaller auditor following an audit merger generally support our hypotheses.

Buy-Side vs. Sell-Side Analysts' Earnings Forecasts

The study reported here is a comparison of the earnings-forecasting performance of analysts at a large buy-side firm with the performance of sell-side analysts in the 1997–2004 period. The tests show that the buy-side analysts made more optimistic and less accurate forecasts than their counterparts on the sell side. The performance differences appear to be partially explained by the buy-side firm’s greater retention of poorly performing analysts and by differences in the performance benchmarks used to evaluate buy-side and sell-side analysts. The 2003 Global Settlement of Conflicts of Interest between Research and Investment Banking raised fundamental questions about the integrity and quality of sell-side research. Regulators had alleged that investment banking fees used to support research induced sell-side analysts to be overly optimistic about the stocks they covered. By limiting the investment banking benefits from sell-side research, an (unintended) consequence of the Global Settlement has been to reduce sell-side research budgets at leading investment banks and to encourage the growth of buy-side research. Buy-side research, which is privately produced and funded, is used only by fund managers at the producing investment firm. As a result, buy-side analysts do not face the potential conflicts of working for investment banking firms and the need to generate commissions encountered by the sell side. Yet, to our knowledge, because of a lack of data on buy-side research, no public investigation of the performance of buy-side analysts has been carried out. We examined analyst earnings forecast optimism and accuracy for buy-side analysts at a large, reputable money management firm relative to the optimism and accuracy of sell-side analysts in the 1997–2004 period. The sample buy-side firm is a top 10–rated money management firm for which fundamental research is an essential part of the stock selection process. From analyst reports provided by the firm for the period July 1997 through December 2004, we collected annual earnings forecasts for each company covered. For sell-side analysts, earnings forecasts came from Thomson Financial’s I/B/E/S database. Our findings indicate that analysts at the buy-side firm made more optimistic and less accurate forecasts than their counterparts on the sell side. As a percentage of actual earnings, the mean (median) buy-side forecasts in the study period are 8–16 percent (3–12 percent) higher than those for the sell side; the mean (median) absolute forecast errors for buy-side analysts are 11–15 percent (4–11 percent) higher than for the sell side. The significant differences in forecast optimism and absolute errors held for all forecast horizons and after controlling for differences in analyst experience, industry specialization, coverage, and firm size. Several factors appear to at least partially explain these findings. First, sell-side firms are less likely than the buy-side firm to retain analysts with weak prior-year earnings forecast accuracy. This factor explains roughly one-third of the buy-side analysts’ relative forecast optimism and one-fifth of their absolute errors. Second, until recently, the buy-side firm did not measure its analysts against the sell side. In contrast, sell-side analysts are regularly measured against each other. Finally, we found a sharp decline in buy-side relative forecast optimism and a decrease in relative forecast accuracy after the enactment of Regulation Fair Disclosure, which is consistent with sell-side analysts’ access to company information being curtailed by the new regulation. We are cautious in interpreting these findings, however, because many other factors affected analysts’ performance during this period. Follow-up tests ruled out several other plausible explanations for the findings. The results were unchanged when we compared the buy-side analysts’ performance with that of analysts at sell-side firms having a comparable number of analysts and breadth of industry coverage, which suggests that the findings are not driven by differences in the buy- and sell-side analysts’ scope of coverage. Moreover, the buy-side analyst forecasts were relatively optimistic, even for newly covered stocks, which indicates that the findings do not simply reflect that coverage of poorly performing companies was stopped by buy-side analysts. Tests of the quality of analysts hired by the buy-side firm from the sell side indicate that the buy-side firm did not hire low-quality sell-side analysts but that the performance of the new analysts deteriorated after they joined the firm. Finally, we found no evidence that the sample investment firm was a poor performer, which could have explained the performance of its analysts. Our findings raise several questions for researchers and practitioners. First, although we have no reason to believe that the sample firm is anything but a strong performer within the industry, a replication of the tests on a broader sample would be interesting. Second, our findings raise questions about the quality of other buy-side research metrics, such as stock recommendations. Finally, it will be interesting to assess whether (and how) services that benchmark buy-side analysts’ research performance to that of analysts at other buy-side firms and to the sell-side affect the quality of buy-side research.

The Stock Selection and Performance of Buy-Side Analysts

Prior research on equity analysts focuses almost exclusively on those employed by sell-side investment banks and brokerage houses. Yet investment firms undertake their own buy-side research and their analysts face different stock selection and recommendation incentives than their sell-side peers. We examine the selection and performance of stocks recommended by analysts at a large investment firm relative to those of sell-side analysts from mid-1997 to 2004. We find that the buy-side firm’s analysts issue less optimistic recommendations for stocks with larger market capitalizations and lower return volatility than their sell-side peers, consistent with their facing fewer conflicts of interest and having a preference for liquid stocks. Tests with no controls for these effects indicate that annualized buy-side Strong Buy/Buy recommendations underperform those for sell-side peers by 5.9% using market-adjusted returns and by 3.8% using four-factor model abnormal returns. However, these findings are driven by differences in the stocks recommended and their market capitalization. After controlling for these selection effects, we find no difference in the performance of the buy- and sell-side analysts’ Strong Buy/Buy recommendations.

Discussion of earnings-based bonus plans and earnings management by business unit managers

Abstract Guidry, Leone, and Rock use business unit data from a multinational conglomerate to reexamine whether earnings-based bonus plans are associated with earnings management. By focusing on business unit compensation, the authors increase the power of the tests and control for earnings management incentives provided by stock-based compensation. Questions raised by the study include the generalizability of the findings beyond the sample firm, the economic significance of earnings management, the effect of earnings management on bonus awards, and how group-level incentives to manage earnings interact with incentives at the business unit level.