Richard Leftwich

The economic consequences of accounting choice implications of costly contracting and monitoring

Abstract In this paper, we review research into the economic consequences of voluntary and mandatory choices of accounting techniques and standards. We discuss how the predictions of extant economic consequence theories are driven by contracting and monitoring costs associated with management compensation contracts, bond covenants, regulation, and/or political visibility. We review empirical tests of economic consequence theories, categorize those tests, and discuss their strengths and weaknesses. The empirical tests reveal two systematic associations with accounting choice: size, a proxy for political visibility, and leverage, a proxy for contracting and monitoring costs of lending agreements. Interpretation of the results is difficult, due to general limitations of the tests. We conclude by suggesting some directions for future research, based on our analysis of the potential payoffs associated with different types of empirical tests.

The effect of bond rating changes on common stock prices

Abstract The evidence in this paper suggests that downgrades by both Moodys and Standard and Poors are associated with negative abnormal stock returns in the two-day window beginning the day of the press release by the rating agency. Significant negative abnormal performance can still be detected after eliminating observations containing obvious concurrent (potentially contaminating) news releases. There is little evidence of abnormal performance on announcement of an upgrade. Significant abnormal returns are associated with announcements of additions to the Standard and Poors Credit Watch List, if either a potential downgrade or a potential upgrade is indicated.

The effect of large block transactions on security prices: A cross-sectional analysis

Abstract This paper documents the effects of large (block) transactions on the prices of common stocks traded on the New York Stock Exchange. We examine whether mean temporary and permanent price effects associated with large and small transactions differ and whether the price effects vary cross-sectionally according to the size of the block. Alternative definitions of block size are investigated – percentage of the equity traded, block volume in relation to normal trading volume, and dollar value of the block. The results suggest that price effects are predominantly temporary for seller-initiated transactions and permanent for buyer-initiated transactions.

Large-block transactions, the speed of response, and temporary and permanent stock-price effects

Abstract The paper investigates how quickly prices attain new equilibrium levels after large-block transactions, and measures the associated temporary and permanent price effects. We find that prices adjust within at most three trades, with most of the adjustment occurring in the first trade. The temporary price effect for seller-initiated transactions is related to block size, but the temporary price effect observed for buyer-initiated transactions is no larger than that observed in 100 share trades. Most of the price effect associated with block trades is permanent and is related to block size, regardless of the initiating party.

Abnormal stock returns associated with media disclosures of ‘subject to’ qualified audit opinions

Abstract This paper contains evidence of a significant negative stock price reaction to media disclosures of ‘subject to’ qualified audit opinions. Disclosures of qualifications in the financial news media (the Wall Street Journal and the Broad Tape) are rare relative to the frequency of audit qualifications. Other studies do not detect an impact of qualified opinions on stock prices. None of the explanations for the difference in the results between this study and prior studies is consistent with the data. We are unable to draw strong inferences because we cannot identify the selection process that produces the sample of media disclosures.

Qualified audit opinions and stock prices: Information content, announcement dates, and concurrent disclosures☆

Abstract We investigate whether announcements of ‘subject to’ audit opinions and disclaimers of opinions affect stock prices. The results indicate that many firms experience negative abnormal performance prior to the release of qualified opinions, and that the magnitude of prior abnormal performance differs across types of qualifications. However, there is little evidence of a stock price effect when qualifications are disclosed publicly. It is difficult to construct powerful tests of the announcement effect of a qualified opinion for three reasons. First, the announcement date of the qualification is not easily identified. Second, measuring the unanticipated component of the announcement requires a model of market expectations. Third, controls must be employed for concurrent disclosures. The problems concerning event date identification have ramifications for other accounting event studies, particularly studies of disclosures typically contained in the annual report or 10-K.

Evidence of the impact of mandatory changes in accounting principles on corporate loan agreements

Abstract The Theory in this paper predicts that mandatory changes in accounting princples can affect the measurement rules defined in restrictive covenants in firms lending agreements. Consequently, those mandatory changes can have an impact on the value of a firms equity, even if the changes appear to be merely ‘cosmetic’. This contracting cost theory is tested by examining of both event-related and cross-sectional abnormal performance of the equity of a sample of firms when the Accounting Princples Board changes accounting princples for business combinations. The theory provides, at best, in incomplete explanation of the observed abnormal performance.

Market failure fallacies and accounting information

Abstract Proponents of increased regulation of accounting maintain that there are failures in the private market for accounting information. In this paper, it is argued that market failure theories contain a logical fallacy. The optima identified in those theories are not optima because they are defined independently of institutional arrangements necessary to attain them. Existing institutional arrangements, such as markets, should not be condemned until it can be shown that there is an alternative regime which can produce socially superior output. The paper examines theories which explicitly allege that there are failures in the private market for accounting information. In addition, early criticisms of accounting information are restated in economic terms, and it is revealed that those criticisms implicitly assume that private production of accounting information suffers from market failures. The paper concludes by suggesting that, if accounting research is to contribute to public policy formulation, researchers should focus on evaluating the type of information that can be produced by feasible regimes such as markets or government agencies.

Contemporaneous Announcements of Dividends and Earnings

The information content of dividends is well documented in the literature. The marginal information content of dividends in the presence of contemporaneous earnings announcements, however, is ambiguous empirically and theoretically. This paper documents that quarterly dividend announcements convey information beyond that contained in contemporaneous quarterly earnings announcements. Earnings provide information beyond that provided by dividends regardless of the type of information in the dividend announcement, but especially when dividends and earnings provide consistent information or when dividends provide no information. The marginal information content of dividends, however, appears to be a result from the subsample of observations for which earnings indicate “favorable” news about the firm and dividends contemporaneously indicate “unfavorable” news. Dividends convey little, if any, information that is not already conveyed in contemporaneous earnings for other subsamples of firms.

Aggregation of test statistics: Statistics vs. economics

Abstract In the preceding paper Christie provides three tests to facilitate formal inferences in survey papers that examine related empirical studies. Those tests reinforce the view that accounting technique choice is related to variables that may proxy for contracting and monitoring costs in the market and political processes. However, the contribution of the tests is limited because the fundamental question of the relation between the empirical regularities and the theory remains unexamined.