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Accounting conservatism, cost of capital, and fraudulent financial reporting
ACCOUNTING CONSERVATISM, COST OF CAPITAL, AND FRAUDULENT FINANCIAL REPORTING A dissertation submitted to the Kent State University Graduate School of Management In partial fulfillment of the requirements for the degree of Doctor of Philosophy by Karin A. Petruska June 2008 3316841 3316841 2008 ii Dissertation written by Karin A. Petruska B.S.B.A., Youngstown State University, 1989 M.B.A., Youngstown State University, 1993 Ph.D., Kent State University, 2008 Approved by _____________________________ Chair, Doctoral Dissertation Committee Dr. Pervaiz Alam _____________________________ Members, Doctoral Dissertation Committee Dr. Kevin Dow _____________________________ Dr. Wei Li _____________________________ Dr. David Booth Accepted by _____________________________ Interim Doctoral Director, Graduate School of Dr. Michael Hu Management _____________________________ Dean, Graduate School of Management Dr. Frederick Schroath iii ACKNOWLEDGEMENT I would like to thank above all else, God, for blessing me and truly giving me the faith, courage, inspiration, and steadfastness to continue on this journey in my life. He has always been there whenever I needed him the most. I would like to thank my dissertation chair, Dr. Pervaiz Alam, who has continuously provided me with meaningful advice during many hours of discussion. I feel very fortunate to have been able to work with Dr. Alam over the years. He has mentored me throughout my entire Ph.D. program and has shared his experiences, wisdom, and knowledge as a researcher, for which I am very grateful. He has shaped my doctoral experience and provided me with the necessary skills to be successful in my academic career. Without his unwavering help and guidance, this journey would not have been possible. I would also like to thank the other members of my dissertation committee, Dr. Kevin Dow, Dr. Wei Li, and Dr. David Booth for their guidance, support, advice, and helpful comments. My appreciation is also extended to Dr. Michael Hu and Dr. John Thornton for their gracious efforts in presiding at my dissertation defense. I would like to thank my parents, Robert and Ethel, who have always encouraged me and have taught me to dream big, to never give up on those dreams, and to believe in what you do. They have always kept my spirits soaring and showed me the importance of remaining positive and providing help to those who need it. I dedicate this dissertation to them for providing love, understanding, and encouragement during the pursuit of this degree. To my sisters, Melissa and Heidi, I thank them for their caring, concern, and understanding. While there are many other people who have contributed to my success in completing this final degree, I am thankful to Jan Winchell for her computational assistance and to my fellow Ph.D. students who have always made the days seem brighter and have always made me smile. iv TABLE OF CONTENTS Page CHAPTER 1 INTRODUCTION 1.1 Background and Purpose……………………………………………………… 1 1.2 Litigation Risk………………………………………………………………………. 5 1.3 Regulation and Standard Setting……………………………………………………. 7 1.3.1 The Private Securities Litigation Reform Act (PSLRA) of 1995………………… 8 1.3.2 The Sarbanes-Oxley Act (SOX) of 2002…………………………………………… 9 1.3.3 Standard Setting…………………………………………………………………… 11 1.4 Cost of Capital………………………………………………………………………. 13 1.5 Purpose……………………………………………………………………………… 14 1.6 Motivation for Study………………………………………………………………… 16 1.7 Research Contribution……………………………………………………………… 19 1.8 Research Expectations and Methodology……………………………………………. 21 1.9 Sample Selection…………………………………………………………………… 24 1.10 Organization of the Study……………………………………………………………. 26 CHAPTER 2 LITERATURE REVIEW 2.1 Background and Purpose…………………………………………………………… 27 2.2 Definition and Relevance of Earnings Quality………………………………………. 27 2.3 Definitions of Accounting Conservatism……………………………………………. 29 2.4 Research Studies on Accounting Conservatism…………………………………… 31 2.4.1 Circularity Issue Relating to Accounting Conservatism…………………………… 38 2.5 Determinants of Fraud……………………………………………………………… 38 2.6 Limitations of Prior Research Methods……………………………………………… 41 2.6.1 Accruals……………………………………………………………………………… 41 2.6.2 Frequency Distributions……………………………………………………………… 42 2.7 Extensions of the Basu (1997) Model and Alternate Measures……………… ……. 42 2.7.1 Real Activities Manipulations……….……………………………………………… 44 2.8 Cost of Equity Capital………………….…………………………………………… 45 CHAPTER 3 HYPOTHESES AND RESEARCH DESIGN 3.1 Hypotheses Development……………………………………………………………. 48 3.2 Methodology…………………………………………………………………………. 58 3.2.1 Univariate Descriptive Statistics…………………………………………………… 58 3.2.2 Measures of Conservatism…………………………………………………………… 59 v TABLE OF CONTENTS (continued) 3.2.2.1 The Basu (1997) Model……………………………………………………………… 59 3.2.2.2 Earnings Persistence………………………………………………………………… 62 3.2.2.3 Conservatism and the Sarbanes-Oxley (SOX)Period…………………………………. 63 3.2.3 Alternate Accounting Conservatism Measures………………………………………. 64 3.2.3.1 Accruals Adjusted for Asymmetrical Timeliness……………………………………. 64 3.2.3.2 Q-Score……………………………………………………………………………… 67 3.2.3.3 Earnings Variability and Earnings Smoothness……………………….……………… 68 3.2.3.4 Nonoperating Accruals…………………… ……………………………………… 69 3.2.3.5 Skewness of Earnings……….…… ………………………………………………… 70 3.2.4 Cross-Sectional Variation of Accounting Conservatism…………………………… 70 3.2.5 Measures of Standard Setting………………………………………………………… 72 3.2.6 Measures of Cost of Equity Capital………………………………………………… 74 3.2.7 Cross-Sectional Variation of Cost of Equity Capital Estimates……………………… 77 3.3 Sample Selection and Data Sources………………………………………………… 79 CHAPTER 4 EMPIRICAL RESULTS 4.1 Introduction………………………………………………………………………… 82 4.2 Sample Identification………………………………………………………………… 83 4.3 The Matched Control Sample……………………………………………………… 84 4.3.1 Sample Selection and Distributions……….………… …………………………… 85 4.4 Econometric Issues…… …………………………………………………………… 90 4.5 The Basu (1997) Model of Aggregate Asymmetric Timeliness……………………… 94 4.5.1 The Basu (1997) Model of Aggregate Asymmetric Timeliness of Earnings in the Year of the Fraud Manipulation ……………………………………………………… 94 4.5.2 The Basu (1997) Model of Aggregate Asymmetric Timeliness of Earnings Surrounding the Year of Fraud Manipulation………… ………………………… …. 98 4.5.3 Pooled, Cross-Sectional, Time Series Basu (1997) Regression Model………… 101 4.5.4 Asymmetric Timeliness of Operating Accruals, Cash Flows and Earnings……… … 104 4.5.5 Pooled, Cross-Sectional, Time Series Persistent Versus Transitory Earnings… 107 4.6 Sensitivity Tests………………………………………………………………………. 109 4.6.1 Asymmetric Timeliness of Earnings Using Fraud as a Dummy Variable Indicator…. 109 4.6.2 Fama-Macbeth (1973) Statistics.…………………………… ………………………. 110 4.6.3 The Basu (1997) Model of Aggregate Asymmetric Timeliness of Earnings after Extraordinary Items and Discontinued Operations…………………………………… 111 4.6.4 Market-Adjusted Returns………………………………………………………… 112 4.6.5 Alternate Matching of Nonfraud Firms………………………………………………. 113 4.6.6 Controlling for Large Corporate Scandals……………………………………………. 113 4.7 Asymmetric Timeliness and the Sarbanes-Oxley Act (SOX) of 2002……… ……… 114 vi TABLE OF CONTENTS (continued) 4.7.1 Asymmetric Timeliness of Earnings and the SOX Act of 2002 Partitioned by Alleged Fraud and Nonfraud Firms……………………… ………………………… 114 4.7.2 Sensitivity Test of Asymmetric Timeliness of Earnings and the Sarbanes-Oxley Act (SOX) of 2002 for All Firms…………………………………………………… 115 4.7.3 Alternate Sarbanes-Oxley (SOX) Timing Date………………………………………. 117 4.8 Asymmetric Timeliness for Firms Reporting Goodwill Impairment……………… 117 4.8.1 Asymmetric Timeliness of Earnings for Firms Reporting Goodwill Impairment……. 118 4.8.2 Sensitivity Test of Asymmetric Timeliness of Earnings for All Firms Reporting Goodwill Impairment…………………………………………………… 119 4.9 Firm-Specific Measures of Accounting Conservatism……………………………… 120 4.9.1 Introduction…………………………………………………………………………… 121 4.9.2 Descriptive Statistics and Correlation Coefficients………………………………… 122 4.9.3 Control Variables…………………………………………………………………… 123 4.9.4 Financial Statement Measures of Variables Representing Accounting Conservatism 125 4.9.5 Sensitivity Tests for Financial Statement Variable Measures of Accounting Conservatism Relating to the Market-to-Book Ratio…………………………………. 128 4.9.6 Sensitivity Tests for Other Additional Financial Statement Variable Measures of Accounting Conservatism…………………………………………………………… 130 4.10 Accruals-Based Measures of Variables Representing Accounting Conservatism……. 131 4.10.1 Income-Decreasing Discretionary Accruals Models…………………………………. 132 4.10.2 Sensitivity Tests for Firm-Specific Accrual Measures of Accounting Conservatism 135 4.11 Firm-Specific Measure of Accounting Conservatism and the Post-SOX Period…… 138 4.11.1 Financial Statement Measures of Variables Representing Accounting Conservatism and the Post-SOX Period…………………………………………………………… 138 4.11.2 Accruals-Based Measures of Variables Representing Accounting Conservatism and the Post-SOX Period……………………… ………………………………………… 139 4.12 Summary……………………………………………………………………… ……. 141 4.13 Cost of Equity, Conservatism, and Fraudulent Financial Reporting………………… 142 4.13.1 Introduction………………………………………………………………………… 142 4.13.2 Empirical Results……………………………………………………………………. 144 4.13.3 Cost of Equity and Financial Statement Measures of Accounting Conservatism…… 145 4.13.4 Cost of Equity and Financial Statement Measures of Accounting Conservatism Surrounding the SOX Act…………………………………………………………… 149 4.13.5 Sensitivity Test for Multiple Disclosure…………………………………………… 150 4.14 Additional Insights into Accounting Conservatism by Alleged Fraud Firms……… 151 4.14.1 Agency Theory and Earnings Management…………………………………………. 152 4.14.2 Earnings Management and Disclosure………………………………………………. 153 4.14.3 Accounting Conservatism and Information Asymmetry…………………………… 153 4.14.4 Theoretical Models of Accounting Conservatism……………………………………. 155 4.14.5 Accounting Conservatism and Alleged Fraud Firms……………………………… 158 4.14.6 Conservatism and Earnings Management……………………………………………. 159 4.14.7 Additional Sensitivity Tests………………………………………………………… 160 vii TABLE OF CONTENTS (continued) 4.14.8 Alternate Specification of Litigation Risk…………………………………………… 162 4.15 Industry Effects………………………………………………………………… 163 4.16 Controls for Endogeneity/Self-Selection Bias……………………………………… 164 CHAPTER 5 SUMMARY AND CONCLUSIONS, LIMITATIONS, FUTURE RESEARCH 5.1 Introduction………………………………………………………………………… 172 5.2 Summary and Conclusions…….…………………………………………………… 172 5.3 Limitations……………….………………………………………………………… 181 5.4 Future Research……………………………………………………………… 182 APPENDIX A Additional Measures of Earnings Quality……………… ………….…… 184 APPENDIX B Additional Cost of Capital Models………………… …………………… 187 REFERENCES………………………………………………………………………………. 196 [...]... information asymmetries (Guay and Verrecchia, 2007) and should lead to a lower cost of capital effect Barth et al (2005) found that firms with more transparent financial statements benefited from a lower cost of equity capital Financial reporting of low quality earnings increases the risk of inefficient resource allocation and could increase the cost of capital The incidence of earnings manipulation by... Statement of Financial Accounting Standards (SFAS) No 144, Accounting for the Impairment or Disposal of Long-Lived Assets, reflects the demise of the pooling -of- interests method of accounting for business combinations and specific assets or asset groups It also avoids amortization, replacing it with a two-step impairment test Overall, these two standards require the estimation of non-verifiable and non-contractible... Results of Controlling for Self-Selection Bias………………………………… 270 TABLE 32: Results of Controlling for Self-Selection Bias and the Ex Ante Cost of Capital on Risk Proxies, Fraud, and Measures of Accounting Conservatism…………… 272 x CHAPTER 1 INTRODUCTION 1.1 Background and Purpose The lack of availability of reliable and verifiable estimates between managers and investors can cause uncertainty and information... complexity of financial reporting The concept of conservatism affects all of the underlying assumptions in the financial statements (Krishnan, 2005) If accounting earnings are non-verifiable, the quality of other information is also suspect Ball et al (2000) and Watts (2003b) state that a feature of accounting conservatism is that it facilitates the effective monitoring of managers and contracts The accounting. .. conservatism, regulations and standards, and increases or decreases in cost of equity capital compared to a non-fraud control sample I examine if accounting conservatism and the cost of equity capital increases surrounding the relative alleged fraud manipulation date Although there have been numerous studies measuring the cost of capital of firms in general, and the construction of several alternate specification... increase The standard relating to SFAS No 142, Goodwill and Other Intangible Assets is expected to produce the opposite results contrary to the SOX Act 13 1.4 Cost of Capital Cost of capital is one of the most important benchmarks to evaluate the ability of firms to invest their funds and to evaluate the quality of their existing investments (Habib, 2006) A firm’s cost of capital is of interest to... Accrual Measures of Accounting Conservatism………………… 253 TABLE 24: Firm Specific Financial Measures of Accounting Conservatism and the SOX Act……………………………………………………………………………… 255 TABLE 25: Firm Specific Accrual Measures of Accounting Conservatism and the SOX Act……………………………………………………………………………… 257 TABLE 26: Descriptive Statistics of Cost of Equity Capital Variables……………………… 259 TABLE 27: Pearson and Spearman... information payoffs such that overstating firm assets should more likely generate litigation costs for the firm Other theories offered for the emergence of conservatism have been attributed to the use of financial statements in debt and compensation contracts (the 7 In Statement of Financial Accounting Concepts No 2, Qualitative Characteristics of Accounting (FASB, 1980), relevance and reliability... Correlation Coefficients for Cost of Capital and Independent Variables………………………………………………………… 260 TABLE 28: Ex Ante Cost of Equity on Risk Proxies, Fraud, and Measures of Accounting Conservatism …………………………………………………………………… 262 TABLE 29: Logistic Regression of the Likelihood of Fraudulent Financial Statement Manipulation…………………………………………………………………… 267 TABLE 30: Asymmetric Timeliness of Earnings for Firms in... sample as consisting of firms that have income/revenue overstatements and higher levels of total accruals than their nonfraud counterparts While earnings management (e.g., one-time “big bath” restructuring charges, cookie jar reserves, creative acquisition accounting, excessive charges and write-offs, and abandoning of unprofitable operations) could produce some of the evidence on conservatism, it is . Results……………………………………………………………………. 144 4.13.3 Cost of Equity and Financial Statement Measures of Accounting Conservatism…… 145 4.13.4 Cost of Equity and Financial Statement Measures of Accounting Conservatism Surrounding. ACCOUNTING CONSERVATISM, COST OF CAPITAL, AND FRAUDULENT FINANCIAL REPORTING A dissertation submitted to the Kent State University Graduate School of. reserves, creative acquisition accounting, excessive charges and write-offs, and abandoning of unprofitable operations) could produce some of the evidence on conservatism, it is not thought