Papers
What should GAAP look like?
S.P. Kothari, Karthik Ramanna, Douglas J. Skinner
We develop an economic theory of GAAP under the assumption that GAAP’s objective is to facilitate efficient capital allocation within an economy. The theory predicts that the GAAP as shaped by the economic forces of demand for and supply of financial information would focus on performance measurement and control through the income statement and balance sheet. In addition, the theory allows us to compare and contrast extant GAAP, as produced in a regulated setting, with a GAAP that might arise endogenously as a result of market forces. We conclude that verifiability and conservatism, while detracting accounting from a valuation objective, are critical features of an economic GAAP. We recognize the advantage of using fair values in circumstances where these are based on observable prices in liquid secondary markets, but caution against expanding fair values to areas such as intangibles where its opportunistic use is predictable. We conclude that the convergence project between the FASB and IASB should be dismantled and that competition between the two bodies would be the most practical means of achieving an economic GAAP.
Returns to Buying Earnings and Book Value: Accounting for Growth
Stephen H. Penman and Francesco Regginai
This paper provides an explanation of how the earnings yield and book-to-price combine to indicate required equity returns, along with empirical support. Earnings yields predict returns, consistent with standard formulas that show that the earnings yield equals the required return when there is no expected earnings growth beyond that from retention. With growth, those same formulas show that the earnings yield is increasing in the required return but decreasing in the growth, and that growth can be accommodated in inferring the required return. However, if growth is risky and so requires a higher return, growth has both an increasing and decreasing effect on the earnings yield, making the determination of the required return from a given earnings yield problematical. The paper shows that book-to-price facilitates the determination: for a given earnings yield, book-to-price indicates additional return associated with expected growth. This finding provides a rationalization of the well-documented book-to-price effect in stock returns: book-to-price indicates the risk in buying earnings and earnings growth. Book-to-price is positively associated with earnings yields (that indicate expected returns) but, in addition, book-to-price indicates risky growth that adds to expected returns. Growth identified by a high book-to-price as yielding a higher return is quite different, however, from “growth” typically attributed to a low book-to-price as yielding a lower return. Accordingly, the notion of “growth” versus “value” is redefined.
Relevance of Past Performance Measures in Chief Executive Compensation
Rajiv D. Banker, Rong Huang, Jose M. Plehn-Dujowich
Prior research has examined the relationship between executive compensation and measures of contemporaneous performance. In contrast, we focus on measures of past performance as signals on the agent’s ability in optimal compensation contracts. We present a simple analytical model emphasizing the principal’s adverse selection problem to derive empirically testable hypotheses and support them with an analysis of compensation and performance data on 8,476 existing CEO-year observations and 155 new CEO-year observations during the period 1993-2006. We find that salary, the fixed component of CEO compensation, is positively related to past performance for both existing CEOs and newly hired CEOs. Consistent with a theoretical prediction when an empirical researcher cannot observe some information available for contracting, we also find that salary is correlated with subsequent performance. In a moral hazard setting, measures of past performance are useful as benchmarks to filter out the noise when incentive pay is based on contemporaneous performance. Consistent with this prediction, we find that bonus, the contingent part of total compensation, is negatively related to past performance when performance measures are serially correlated. Our results indicate that it is necessary to consider both contemporaneous performance and past performance and to investigate fixed pay separately from contingent pay in order to understand pay-for-performance sensitivity.
Investigating the Impact of Job Complexity and Performance on CFO Compensation
Steven Balsam, Afshad Irani, Jennifer Yin
This study investigates the impact of job complexity and firm as well as CFO-specific performance on CFO compensation. Job complexity is measured in terms of the intricacies of a firm’s operations as well as whether the CFO serves on the Board of Directors. Accounting and stock market rates of return measure overall firm performance while the magnitude and success of the CFO’s interactions with financial analysts along with CFO’s use of accounting discretion to achieve earnings targets proxy for CFO-specific performance. We find that, consistent with our theory, job complexity and performance (firm and CFO-specific) affect contemporaneous CFO compensation.
Transparency, Liquidity, and Valuation: International Evidence
Mark Lang, Karl Lins, and Mark Maffett.
We examine the relation between transparency, stock market liquidity, and valuation for a global sample of firms. Following the prior literature, we argue that transaction costs will be higher and investors will be less willing to transact if they perceive significant issues with respect to transparency, particularly in international settings where potential information effects are more pronounced Consistent with expectations, we document lower transaction costs and greater liquidity (as measured by lower bid-ask spreads and fewer zero return days) when transparency is likely to be higher (as measured by less evidence of earnings management, better accounting standards, higher quality auditors, more analyst following and more accurate analyst forecasts). We also find evidence that the relation between transparency and liquidity is more pronounced when country-level investor protections and disclosure requirements are poor, suggesting that firm-level transparency matters most when country-level institutions are weak. Finally, we provide evidence that increased liquidity is associated with lower implied cost of capital based on an analyst-forecast-based valuation model, and with higher valuation as measured by Tobin’s Q. Magnitudes are substantial, with an interquartile increase in transparency in a low investor protection country associated with a decrease in bid-ask spread from 1.9% to 0.9% and a decrease in cost of capital of 62 basis points.