We survey commercial bank lenders to better understand how they evaluate and react to variation in financial statement quality and how they view recent changes in accounting standards. A unique aspect of this study is that our respondents focus on medium-size loans to private companies. In fact, more than 90 percent of the survey respondents primarily make credit decisions on loans between $250 thousand and $50 million. This is in contrast to prior archival research, which focuses primarily on very large loans to public firms or very small loans to private firms. We find that lenders in our sample distinguish among financial statements in terms of quality, including conservatism, primarily on the basis of accrual patterns and restatements. While this general result holds throughout our sample, financial statement quality is substantially more important for lenders making larger loans (over $10 million) as compared to very small loans (under $1 million). In addition, bank lenders are much more likely to respond to low quality reporting with collateral and guarantee requirements than with an increase in the interest rate charged. This finding is consistent for lenders making both larger and smaller loans. Finally, despite concerns in the academic literature, bank lenders in our sample actually hold a neutral-to-positive view of recent changes in accounting standards. In addition, most do not support current efforts to exempt private companies from some accounting standards.
Borrowing base restrictions are common debt contractual features which limit the amount available to the borrower based on its working capital assets. The lender determines the availability of credit to the borrower based on the success of borrowing base assets. Identifying the unique setting of borrowing base restrictions, I examine whether financial reporting quality affects the choice of monitoring mechanisms that lenders use in debt contracts. I find that borrowers with low quality financial statements are more likely to access borrowing base lines of credit, as they face high adverse selection costs in non-borrowing base lines of credit. Accordingly, I show that the effect of financial reporting quality on the cost of debt is diminished in borrowing base lines of credit as compared to non-borrowing base lines of credit. These results are robust to several financial reporting quality measures such as accrual model based proxies, internal control weakness disclosures and big auditors. Moreover, based on the number of assets and advance ratios charged to these assets, I construct a borrowing base restriction strictness index and find that the effect of financial reporting quality on the cost of debt is decreasing with the index, supporting the substitution effect between contractual monitoring mechanisms and borrower's financial reporting quality. I also generate an alternative monitoring intensity measure through a hand-collected sample of borrowing base loan contracts using textual analysis, and find similar results.
This review lays out a research perspective on earnings quality. We provide an overview of alternative definitions and measures of earnings quality and a discussion of research design choices encountered in earnings quality research. Throughout, we focus on a capital markets setting, as opposed, for example, to a contracting or stewardship setting. Our reason for this choice stems from the view that the capital market uses of accounting information are fundamental, in the sense of providing a basis for other uses, such as stewardship. Because resource allocations are ex ante decisions while contracting/stewardship assessments are ex post evaluations of outcomes, evidence on whether, how and to what degree earnings quality influences capital market resource allocation decisions is fundamental to understanding why and how accounting matters to investors and others, including those charged with stewardship responsibilities. Demonstrating a link between earnings quality and, for example, the costs of equity and debt capital implies a basic economic role in capital allocation decisions for accounting information; this role has only recently been documented in the accounting literature. We focus on how the precision of financial information in capturing one or more underlying valuation-relevant constructs affects the assessment and use of that information by capital market participants. We emphasize that the choice of constructs to be measured is typically contextual. Our main focus is on the precision of earnings, which we view as a summary indicator of the overall quality of financial reporting. Our intent in discussing research that evaluates the capital market effects of earnings quality is both to stimulate further research in this area and to encourage research on related topics, including, for example, the role of earnings quality in contracting and stewardship.
Recent research proposes that financial reporting is actually shaped by debt markets instead of by equity markets. As noted by Baker, Greenwood and Wurgler (2003), "Relative to the literature on equity financing patterns, and relative to the actual importance of debt finance in the U.S. economy, the literature on debt financing patterns is surprisingly underdeveloped". Hence, the interface between financial reporting and debt financing has recently emerged as a fruitful idea for research. In fact, because of their asymmetric payoff function and fixed claims on corporate assets, creditors have stronger incentives than equity investors to demand high quality financial reporting. In this dissertation, I build up alternative arguments for conservatism that can be applied to the public bond market and cannot be generalized to the private debt market or the equity market. For instance, Merton's (1974) theoretical bond pricing model indicates that equity holders and bondholders value a firm's operating volatility in different ways. Thus, bond and equity investors could have different expectations and needs regarding what they consider to be useful financial reporting. In that regard, recent evidence on the interface between financial reporting quality and debt markets largely focuses on private bank loan contracting. However, in terms of providing capital to corporations, public debt markets are as large as private debt markets, with substantial differences in terms of monitoring efficiency, private information availability, seniority in liquidation, and re-contracting flexibility. Hence, public bondholders can value financial reporting quality in a way that differs from private debt holders' perspective. Using accounting conservatism and internal control effectiveness as proxies for financial reporting quality, I investigate two sets of research questions that relate to the effects of financial reporting quality on corporate bond financing. I consider both conditional and unconditional conservatism. Conditional conservatism depends upon future economic circumstances and reflects the writing down of book values under sufficiently adverse circumstances while not allowing their writing up under favorable circumstances (e.g., lower of cost or market for inventories). Unconditional conservatism reflects the consistent application of Generally Accepted Accounting Principles (GAAP) that reduces earnings independent of future economic events, resulting in the book value of net assets being understated due to predetermined aspects of the accounting process (e.g., immediate expensing of R & D expenditures according to U.S. GAAP). First, I investigate the main effect of accounting conservatism and the moderating effect of internal control effectiveness on the yield spread of new corporate bond issues. Second, I assess the main effect of accounting conservatism and internal control effectiveness on the underpricing of newly issued corporate bonds. Both yield spreads and underpricing reflect different market realities. While the yield spread of new corporate bond issues is determined through negotiations among bond issuers, investment bankers and large institutional investors the underpricing of newly issued corporate bonds reflects the responses of all bond investors based on their assessment of the available information. My main empirical findings are: (1) conditional conservative reporting relates to higher yield spreads in new corporate bond issues; (2) unconditional conservative reporting relates to lower yield spreads in new corporate bond issues; (3) ineffective internal controls enhance the effect of conditional conservative reporting to raise the yield spread; (4) both conditional and unconditional conservative reporting relate to the underpricing of newly issued corporate bonds. However, internal control effectiveness does not seem to matter in the underpricing. This dissertation mainly contributes to the existing literature in two ways. First, this study extends the conservatism literature by linking conservative reporting to corporate bond financing patterns. With theoretical arguments and empirical evidence that are inconsistent with the debt contracting efficiency view of conservatism, my study casts some doubt as to how generalizable is the traditional debt contracting efficiency argument regarding the interface between conservatism and the cost of debt. Second, research on Sarbanes-Oxley Act's internal control provisions needs to go beyond the equity holders' and private debt holders' perspectives, and consider other financial stakeholders who contract on the basis of financial statements. This dissertation fills the void in the internal control literature by providing initial empirical evidence as to how internal control effectiveness affects corporate bond financing.
Using a hand-collected sample of private debt contracts between U.S. publicly traded firms and financial institutions, I examine the role of accounting in the renegotiation of debt contracts following a positive shock to the borrower's credit quality. I find that, following a positive shock to their credit quality, firms with more timely reporting of good news are more likely to renegotiate their loan contracts and they do so sooner than firms with less timely good news reporting. Further, these effects are more pronounced for firms whose positive shocks can be more credibly communicated through financial reporting. My paper contributes to the literature on the role of accounting information in debt contract renegotiations.
Line-Item Analysis of Earnings Quality provides a comprehensive summary and analysis of the specific earnings quality issues pertaining to key line item components of the financial statements. After providing an overview of earnings quality and earnings management, Line-Item Analysis of Earnings Quality analyzes key line items from the financial statements. For each key line item, the authors: review accounting principles; discuss implications for earnings quality; evaluate the susceptibility of the item to manipulation; describe analyses and red flags which may inform on the item's quality. Line-Item Analysis of Earnings Quality will prove useful in conducting fundamental and contextual analyses through its analysis and evaluations.
The updated, real-world guide to interpreting and unpacking GAAP and non-GAAP financial statements In Financial Statement Analysis, 5th Edition, leading investment authority Martin Fridson returns with Fernando Alvarez to provide the analytical framework you need to scrutinize financial statements, whether you’re evaluating a company’s stock price or determining valuations for a merger or acquisition. Rather than taking financial statements at face value, you’ll learn practical and straightforward analytical techniques for uncovering the reality behind the numbers. This fully revised and up-to-date 5th Edition offers fresh information that will help you to evaluate financial statements in today’s volatile markets and uncertain economy. The declining connection between GAAP earnings and stock prices has introduced a need to discriminate between instructive and misleading non-GAAP alternatives. This book integrates the alternatives and provides guidance on understanding the extent to which non-GAAP reports, particularly from US companies, may be biased. Understanding financial statements is an essential skill for business professionals and investors. Most books on the subject proceed from the questionable premise that companies' objective is to present a true picture of their financial condition. A safer assumption is that they seek to minimize the cost of raising capital by portraying themselves in the most favorable light possible. Financial Statement Analysis teaches readers the tricks that companies use to mislead, so readers can more clearly interpret statements. Learn how to read and understand financial statements prepared according to GAAP and non-GAAP standards Compare CFROI, EVA, Valens, and other non-GAAP methodologies to determine how accurate companies’ reports are Improve your business decision making, stock valuations, or merger and acquisition strategy Develop the essential skill of quickly and accurately gathering and assessing information from financial statements of all types Professional analysts, investors, and students will gain valuable knowledge from this updated edition of the popular guide. Filled with real-life examples and expert advice, Financial Statement Analysis, 5th Edition, will help you interpret and unpack financial statements.
This paper provides new theoretical and empirical evidence suggesting that the quality of credit information may be a key element in explaining the maturity structure of corporate debt around the world. In markets with poor credit information and hence a high degree of uncertainty about borrower quality, the authors find suboptimal equilibria in which short-term contracts are preferred either as a hedge against uncertainty to limit losses in bad states (in the symmetric information case) or as a screening device to learn about borrower credit quality in the course of a repeated lending relationship (in the asymmetric information case). The results of the model are supported by the econometric analysis of panel data from both industrial and developing economies. The authors find that countries with better quality of credit information (for example, as a result of improvements in credit reporting systems or accounting standards) are characterized by a higher share of long-term debt as a proportion of total corporate debt ceteris paribus. The findings suggest that promoting institutions and policies to improve the quality of credit information is an important prerequisite for increasing access of firms to long-term finance.
Earnings Management, Conservatism, and Earnings Quality reviews and illustrates earnings management, conservatism, and their effects on earnings quality in an economic modeling framework. Both earnings management and conservative accounting introduce biases to financial reports. The fundamental issue addressed is what economic effects these biases have on earnings quality or financial reporting quality. Earnings Management, Conservatism, and Earnings Quality reviews analytical models of earnings management and conservatism and shows that both can have beneficial or detrimental economic effects, so a differentiated view is appropriate. Earnings management can provide additional information via the financial reporting communication channel, but it can also be used to misrepresent the firm's position. What the authors find is that similar to earnings management, conservatism can reduce the information content of financial reports if it suppresses relevant information, but it can be a desirable feature that improves economic efficiency. The approach to study earnings management, conservatism, and earnings quality is based on the information economics literature. A variety of analytical models are reviewed that capture the effects and subtle interactions of managers' incentives and rational expectations of users. The benefit of analytical models is to make precise these, often highly complex, strategic effects. They offer a rigorous explanation for the phenomena and show that sometimes conventional wisdom does not apply. The monograph is organized around a few basic model settings, which are presented in simple versions first and then in extensions to elicit the main insights most clearly. Chapter 2 presents the basic rational expectations equilibrium model with earnings management and rational inferences by the capital market. Chapter 3 is devoted to earnings quality and earnings quality metrics used in many studies. Chapter 4 studies conservatism in accounting. Finally, the authors examine the interaction between conservatism and earnings management. Each chapter ends with a section containing a summary of the main findings and conclusions.
