Sugata Roychowdhury

Asymmetric Timeliness of Earnings, Market-to-Book and Conservatism in Financial Reporting

In a regression of earnings on returns, the coefficient on returns is higher when returns are negative. This is referred to as asymmetric timeliness of earnings, and has recently been used extensively as a measure of conservatism in financial reporting. The ratio of market value of equity to book value of equity, or market-to-book, is another commonly used proxy for conservatism. We use the theory of accounting conservatism to explain why and how the book value of equity differs from its market value. Further, our analysis provides insights into the relation between the two proxies for conservatism, asymmetric timeliness and the market-to-book ratio. We hypothesize and find that the sign and magnitude of the correlation between the two measures depends on (a) the horizon over which asymmetric timeliness is measured and (b) the timing of the measurement horizon relative to market-to-book. This version: 10/27/2004 Preliminary and incomplete Comments welcome ∗ Corresponding author Sloan School of Management, MIT E52-325,50 Memorial Drive, Cambridge, MA02142 Email: sugatarc@mit.edu Phone: 617-253-4903 This paper has benefited immensely from the comments of the seminar participants at MIT Sloan School. All remaining errors are ours.

Managerial Ownership and Accounting Conservatism

In this paper we examine the effect of managerial ownership on financial reporting conservatism. Separation of ownership and control gives rise to agency problems between managers and shareholders. Financial reporting conservatism is one potential mechanism to address these agency problems. We hypothesize that, as managerial ownership declines, the severity of agency problem increases, increasing the demand for conservatism. Consistent with our hypothesis, we find that conservatism as measured by the asymmetric timeliness of earnings declines with managerial ownership. The negative association between managerial ownership and asymmetric timeliness of earnings is robust to various controls, in particular, for the investment opportunity set. We thus provide evidence of a demand for conservatism from the firms shareholders.

Discussion of “The ‘Numbers Game’ in the Pre- and Post-Sarbanes-Oxley Eras”

Eli Bartov and Daniel Cohen (2009) test whether there has been a decline in the extent to which managers engage in opportunistic activities to meet or beat analyst benchmarks after the passage of the Sar-banes-Oxley Act (SOX) in response to the well-publicized corporate scandals of 2001 and 2002. They document a decline in the proportion of firms just meeting or beating analyst expectations (JMB firms) in the Post-SOX period. Focusing on the specific strategic actions taken by JMB firms, they find evidence of a shift away from expectations management and earnings management via accruals, towards earnings management via real activities. The research setting is intuitively appealing, and the results documented in the paper are very interesting. However, there appear to be multiple inferences that can be drawn from these results. In particular, the patterns documented in the paper raise questions about whether the effects of regulation (in this case, SOX) are indeed beneficial for capital markets, an issue that is clearly an interesting topic for further examination.

Does Litigation Encourage or Deter Real Earnings Management

In this paper, we rely on an exogenous shock to examine the impact of litigation risk on real earnings management (REM). We conduct differences-in-differences tests centered on an unanticipated court ruling that reduced litigation risk for firms headquartered in the Ninth Circuit. REM increases significantly following the ruling for Ninth-Circuit firms relative to other firms, consistent with litigation risk deterring REM. Additional analyses reveal that REM rises more following the ruling when firms issue more optimistic disclosures. The evidence is consistent with litigation deterring REM by constraining managers’ ability to issue optimistic and misleading disclosures that can conceal the myopic and opportunistic motives underlying REM. We further document that an increase in REM in response to a decline in litigation risk is more pronounced when managers have higher incentives to manipulate earnings and governance mechanisms are weaker.

In Alignment or Conflict? The Role of Shareholder Heterogeneity in the Relation Between Shareholders and Debtholders in Near-Insolvent Firms

The 1991 Delaware court ruling involving Credit Lyonnais expanded the fiduciary duties of managers towards debtholders when a firm is close to insolvency. The ruling arguably increased shareholders’ and managers’ aversion to near-insolvency situations; we examine the possibility that this led to a re-orientation of focus at Delaware firms towards long-term competitiveness rather than short-term goals. Using a differences-in-differences approach that exploits the exogenous shock, we find that the 1991 ruling induced managers of Delaware firms to place a greater emphasis on investments that foster long-term innovation, and a reduced focus on achieving myopic earnings goals. Further, we find a shift away from transient to dedicated institutional ownership after the court ruling. In other words, the shareholder base adjusts to the re-orientation of Delaware firms towards the longer term.

Increased Creditor Rights, Institutional Investors and Corporate Myopia

The 1991 Delaware court ruling involving Credit Lyonnais expanded the fiduciary duties of managers towards debtholders when a firm is close to insolvency. The ruling arguably increased shareholders’ and managers’ aversion to near-insolvency situations; we examine the possibility that this led to a re-orientation of focus at Delaware firms towards long-term competitiveness rather than short-term goals. Using a differences-in-differences approach that exploits the exogenous shock, we find that the 1991 ruling induced managers of Delaware firms to place a greater emphasis on investments that foster long-term innovation, and a reduced focus on achieving myopic earnings goals. Further, we find a shift away from transient to dedicated institutional ownership after the court ruling. In other words, the shareholder base adjusts to the re-orientation of Delaware firms towards the longer term.

Agency Environment, Innovation and Managers’ Long-Term versus Short-Term Focus

The 1991 Delaware court ruling involving Credit Lyonnais expanded the fiduciary duties of managers towards debtholders when a firm is close to insolvency. The ruling arguably increased shareholders’ and managers’ aversion to near-insolvency situations; we examine the possibility that this led to a re-orientation of focus at Delaware firms towards long-term competitiveness rather than short-term goals. Using a differences-in-differences approach that exploits the exogenous shock, we find that the 1991 ruling induced managers of Delaware firms to place a greater emphasis on investments that foster long-term innovation, and a reduced focus on achieving myopic earnings goals. Further, we find a shift away from transient to dedicated institutional ownership after the court ruling. In other words, the shareholder base adjusts to the re-orientation of Delaware firms towards the longer term.