My first thought when I saw this title was that the more readable the financial reports and disclosures, the more analysts would want to follow the firm. But on second thought (and as the paper’s results bear out), I wondered whether analysts choose to follow firms whose financial reports are less readable because that is where they can add value. It turns out that, even though analysts take a longer time to revise their forecasts for firms with poor readability (suggesting that low readability is tough on analysts too, not just your average investors), there are more analysts following such firms than firms with high readability. Apparently, demand for interpretive services is sufficient to pay for more analysts when financial statement readability is relatively low.

After reading this paper, I wondered what a financial reporting standard setter would conclude. If the readability of financial reports is somehow the result of standard setting, perhaps the FASB, the IASB, and/or the SEC should focus more on making disclosures more readable. But then I had a more sinister thought occur to me. When standard setters ask for input from sophisticated users of financial reports (such as analysts), should they take the input with a grain of salt?  If analysts have an incentive to seek out companies or industries where they can add value by interpreting the low-readability reports, perhaps analysts have little incentive to seek for better disclosures (let alone readability). If you made lots of money helping people interpret financial reports because those reports are hard to understand, would you want standard setters and regulators to make financial reports more readable?

Of course, this paper is not specifically about standards and regulations that cause low readability, nor is it about standard setters reliance on input from analysts. So you should take my comments here with a grain of salt too. But if readability of disclosures somehow varies across different disclosure topics (for example, if pension disclosures tend to have lower Fog index scores than stock compensation disclosures), and standard setters are wondering what sophisticated investors think about a particular disclosure, they may want to think twice about the input they get from analysts.

By the way, I should add this caveat in defense of analysts—every analyst I ever met with in my work at the FASB seemed earnest in their desire to improve financial reporting. So, I do not mean to call into question the integrity of analysts. I am only drawing attention to the incentives some analysts may face when their bread and butter comes from interpreting hard to read financial reports.

One final thought: I wonder if the readability of my posts is associated with people’s willingness to comment on my posts. Hmmmm…

Considering the disturbing lack of skepticism we continue to see, and because of the fundamental importance of independence to the performance of quality audit work, the Board is prepared to consider all possible methods of addressing the problem of audit quality — including whether mandatory audit firm rotation would help address the inherent conflict created because the auditor is paid by the client.

The idea of a regulatory limit on auditor tenure is not new. Over the years, it has been considered by a variety of commentators and organizations. Through this public debate, the basic arguments both for and against mandatory term limits have been fairly well described. …

Based on this work, I believe it is incumbent on the PCAOB to take up the debate about firm tenure and examine it, with rigorous analysis and the weight of evidence in support and against. …

As such, the Board plans to issue another concept release to explore whether there are other approaches we could take that could more systematically insulate auditors from the forces that pull them away from the necessary mindset.

If this is a topic of interest to you, now might be a good time to take a look at the existing research and see what could be added to it.

Food for thought: An audit firm picked up a new client. The client had been with a different auditor for a few years, but due to a mandatory rotation requirement was forced to change auditors. Due to the size of the client, the new audit firm had to hire additional employees. Not surprising, the firm hired the exact same people that the previous audit firm had to let go due to the “loss of a client.” In fact, some of the employees were on their second or even third move. It was simply understood that the new auditor would hire the displaced audit staff from the prior auditor. It made things easier to keep staff who were familiar with the client. In fact, out of an audit team of 18, only 4 people were new: the partner, a manager, and two staff.

SLCapex is a stock exchange owned and operated by “residents” of the online virtual world Second Life. Despite its almost complete lack of regulation and legal protections against fraud or insider trading, issuers were able to raise approximately US$145,000 from investors, which grew to US$900,000 in market value before plummeting, resulting in overall investor returns of -71%. Investors in large issuances lost more than investors in small issuances, and small investors experienced more severe losses relative to large investors when more money was at stake, suggesting that the market did a poor job of protecting investors from issuers and of providing a level playing field for investors. Theories from financial economics can explain the markets’ poor performance in the absence of regulatory and legal institutions, but cannot easily explain why issuers were able to raise capital in such a setting.

Traditional economic theory tells us that firms that can’t provide credible financial reporting and other investor protections won’t be able to raise capital, because investors protect themselves from the obvious risks of fraud.  This reasoning is the bedrock of libertarian-style claims that market regulation is unnecessary.  But laboratory research shows repeatedly that people fail to protect themselves from risks of exploitation.  Sometimes people trade too much (violating the Milgrom-Stokey no-trade theorem by exposing themselves to others with better information).  My favorite example is a paper by Forsythe, Lundholm and Reitz (JF 1999) that was once called the “half-a-sucker” paper.  Why?  It showed that in the absence of credible standards against overreporting asset values, sellers would indeed overreport and buyers would believe them, to their detriment.  But since the buyers and the sellers were the same people–they alternated between acting as buyers and acting as sellers–the authors modified a famous quote, noting that half-a-sucker is born every minute.

The paper on SLCapex suggests that another famous quote could be modified.  Why would issuers try to raise capital in a market with no investor protections?  Because you can fool all of the people some of the time, and and some of the people all of the time–and that is more than enough to make it worth trying to do so.

And that, in turn, is enough to make it worth imposing regulations that wouldn’t be necessarily if the traditional assumptions of economic theory were valid.

SLCapex is a stock exchange owned and operated by “residents” of the online virtual world Second Life. Despite its almost complete lack of regulation and legal protections against fraud or insider trading, issuers were able to raise approximately US$145,000 from investors, which grew to US$900,000 in market value before plummeting, resulting in overall investor returns of -71%. Investors in large issuances lost more than investors in small issuances, and small investors experienced more severe losses relative to large investors when more money was at stake, suggesting that the market did a poor job of protecting investors from issuers and of providing a level playing field for investors. Theories from financial economics can explain the markets’ poor performance in the absence of regulatory and legal institutions, but cannot easily explain why issuers were able to raise capital in such a setting.

Traditional economic theory tells us that firms that can’t provide credible financial reporting and other investor protections won’t be able to raise capital, because investors protect themselves from the obvious risks of fraud.  This reasoning is the bedrock of libertarian-style claims that market regulation is unnecessary.  But laboratory research shows repeatedly that people fail to protect themselves from risks of exploitation.  Sometimes people trade too much (violating the Milgrom-Stokey no-trade theorem by exposing themselves to others with better information).  My favorite example is a paper by Forsythe, Lundholm and Reitz (JF 1999) that was once called the “half-a-sucker” paper.  Why?  It showed that in the absence of credible standards against overreporting asset values, sellers would indeed overreport and buyers would believe them, to their detriment.  But since the buyers and the sellers were the same people–they alternated between acting as buyers and acting as sellers–the authors modified a famous quote, noting that half-a-sucker is born every minute.

The paper on SLCapex suggests that another famous quote could be modified.  Why would issuers try to raise capital in a market with no investor protections?  Because you can fool all of the people some of the time, and and some of the people all of the time–and that is more than enough to make it worth trying to do so.

And that, in turn, is enough to make it worth imposing regulations that wouldn’t be necessarily if the traditional assumptions of economic theory were valid.

Join us Tuesday, March 9 at 4pm when Scott Dyreng of Duke University discusses his recent research on the cost of violating covenants on private debt.  The key message of the paper is that firms are willing to pay extra taxes in order to avoid debt covenant violations.  The study uses a somewhat unfamiliar data set (Loan Pricing Corporation’s DealScan database), and has an interesting policy twist — it applies to private firms as well as public firms.  This is timely given the recent announcement of a Blue Ribbon Panel to address accounting standards for private companies. ( Congratulations to Teri Yohn, who is a member of the panel!)

FASRI Roundtables tend to be rather informal and broad affairs, so you can expect us to talk about some of Scott’s other research.  I’m hoping we will also find time to talk about a more unusual paper of Scott’s, written with Bill Mayew and Christopher Williams on religious norms and financial reporting. From the abstract:

Social norms have been shown to influence economic decisions in a variety of contexts. We investigate how social norms stemming from religious adherence surrounding a firm’s headquarters affect financial reporting choices. We hypothesize and find that religious social norms are negatively associated with financial reporting aggressiveness. Relative to counties exhibiting low levels of religious adherence, firms operating in counties with high levels of religious adherence (1) are less likely to meet or beat analyst forecasted quarterly earnings, (2) have higher accrual quality, (3) have lower risk of fraudulent accounting, and (4) are less likely to restate their financial statements. Corroborating these results, we find that capital market participants respond to reported good news earnings in manor consistent with investor acknowledgement of the role of religious social norms curbing aggressive financial reporting. Finally, we extend our inferences to tax planning and find that religious social norms are also inversely associated with tax avoidance, where cash effective tax rates and tax haven usage act as proxies.

Please join us for what promises to be a very interesting conversation.  Details on participating are here.

If HRC’s actual results fell short of expectations, Scrushy would tell HRC’s management to “fix it” by recording false earnings on HRC’s accounting records to make up the shortfall.
– SEC vs. HealthSouth Corporation[HRC]

You look back and think, ‘What was I thinking? Why didn’t I just do the right thing?’ But when you’re caught up in the heat of the battle, it didn’t seem so simple.
– Aaron Beam, Former CFO of HealthSouth

Our next Roundtable (Wednesday, February 17^th, at 11am ET) will feature Aaron Beam, who served four years in Federal prison for his role in HealthSouth’s massive accounting fraud, and is now sharing his thoughts and experience in his book Wagon to Disaster and in speaking engagements around the South.

The 2003 SEC complaint alleges a fairly straightforward fictitious entry:  HealthSouth would reduce a contra-revenue account called Contractual Adjustments, which would allow them to show higher net revenue in a way that would be less visible and harder to track than changing revenue directly.   HealthSouth balanced this entry with increases to a fixed asset account called AP Summary.  The relevant portions of the SEC complaint are provided below, and you can also see a summary here.

Accounting educators and researchers should find this a fascinating conversation for many reasons, and you might want to encourage your students to listen in.  But, you may be asking, how is this conversation relevant to research on financial reporting standards?  No doubt Mr. Beam has a great deal to say about auditing, but it is hard to see how blame for HealthSouth’s reporting problems can be laid at the feet of reporting standards.  Actually, I am hoping to get some insight into a couple of standard-setting issues.

First, what roles can financial reporting standards play in limiting the damage done by outright fraud?  Weld, Bergavin and Magrath have an interesting article in CPA Journal arguing that HealthSouth’s financial statements provided a number of clues that earnings were being managed.  Top-quality financial statements (including additional disclosure) can’t directly prevent firms from committing fraud and fooling their auditors, but they can provide investors with a last line of defense:  the ability to raise specific questions about management’s claims.  I would be very interested to hear Mr. Beam’s perspective on what features of the financial reporting environment allowed HealthSouth to avoid questions for so many years.

Second, much standard-setting research is influenced by the enormous literature on earnings management.  But I don’t think researchers yet have a very good handle on how earnings management actually occurs — whether fraudulent or not.  Large sample evidence makes me pretty confident that many firms manage their earnings through operational and accounting decisions in order to satisfy Wall Street and hit specific targets (like the average analyst estimate or a management forecast).  But we know very little about how top management’s intent to achieve earnings goals actually percolates through a large and complex organization.  For example, you might suspect that firms adjust research and development expenses in order to meet or beat analysts’ estimates.  But if this is to be accomplished through an actual reduction in spending (rather than an adjustment in accounting estimates), how does management accomplish this in short window between knowing the size of the reduction needed and the end of the quarter?  Does the CFO need to plan a series of spending cuts throughout the period, to be enacted depending on the resolution of uncertainty?  Given the great stress Mr. Beam’s boss (HealthSouth CEO Richard Scrushy) placed on satisfying Wall Street, I imagine we will get some interesting insights.

As a related point, more than a few academics have suggested that allowing more flexibility in reporting standards can improve communication, and also serve as a substitute for more costly operational forms of earnings management.  I wonder if Mr. Beam agrees, or whether he sees loose standards as easing the wagon’s way from earnings management to outright fraud.

Click here for details on how to attend the discussion.

The Accounting Scandal (from the SEC Complaint — see top of post for link)

25.  HRC’s accounting personnel designed the false journal entries to the income statement and balance sheet accounts in a manner calculated to avoid detection by the outside auditors. For example, instead of increasing the revenue account directly, HRC inflated earnings by decreasing the “contractual adjustment” account. Because the amounts booked to this account are estimated, there is a limited paper trail and the individual entries to this account are more difficult to verify than other revenue entries.

26.  Additionally, each inflation of earnings and corresponding increase in fixed assets were recorded through several intermediary journal entries in order to make the false inflation more difficult to trace.

27.  Furthermore, HRC increased the “AP Summary” line item at various facilities by different amounts because it knew that across the board increases of equal dollar amounts would raise suspicion.

28.  HRC also knew that its outside auditors only questioned additions to fixed assets at any particular facility if the additions exceeded a certain dollar threshold. Thus, when artificially increasing the “AP Summary” at a particular facility, HRC was careful not to exceed the threshold.

29.  HRC also created false documents to support its fictitious accounting entries. For example, during the audit of HRC’s 2000 financial statements, the auditors questioned an addition to fixed assets at one particular HRC facility. HRC accounting personnel, knowing that this addition was fictitious, altered an existing invoice (that reflected an actual purchase of an asset at another facility that approximated the dollar amount of the fictitious addition) to fraudulently indicate that the facility in question had actually purchased that asset. This altered invoice was then given to the auditors to support the recording of the fictitious asset in question. Also, when the auditors asked HRC for a fixed assets ledger for various facilities, HRC accounting personnel would re-generate the fixed asset ledger, replacing the “AP Summary” line item with the name of a specific fixed asset that did not exist at the facility, while leaving the dollar amount of the line item unchanged.

* Update: A video of this Roundtable, along with some follow-up comments can be seen here.

If HRC’s actual results fell short of expectations, Scrushy would tell HRC’s management to “fix it” by recording false earnings on HRC’s accounting records to make up the shortfall.
– SEC vs. HealthSouth Corporation[HRC]

You look back and think, ‘What was I thinking? Why didn’t I just do the right thing?’ But when you’re caught up in the heat of the battle, it didn’t seem so simple.
– Aaron Beam, Former CFO of HealthSouth

Our next Roundtable (Wednesday, February 17^th, at 11am ET) will feature Aaron Beam, who served four years in Federal prison for his role in HealthSouth’s massive accounting fraud, and is now sharing his thoughts and experience in his book Wagon to Disaster and in speaking engagements around the South.

The 2003 SEC complaint alleges a fairly straightforward fictitious entry:  HealthSouth would reduce a contra-revenue account called Contractual Adjustments, which would allow them to show higher net revenue in a way that would be less visible and harder to track than changing revenue directly.   HealthSouth balanced this entry with increases to a fixed asset account called AP Summary.  The relevant portions of the SEC complaint are provided below, and you can also see a summary here.

Accounting educators and researchers should find this a fascinating conversation for many reasons, and you might want to encourage your students to listen in.  But, you may be asking, how is this conversation relevant to research on financial reporting standards?  No doubt Mr. Beam has a great deal to say about auditing, but it is hard to see how blame for HealthSouth’s reporting problems can be laid at the feet of reporting standards.  Actually, I am hoping to get some insight into a couple of standard-setting issues.

First, what roles can financial reporting standards play in limiting the damage done by outright fraud?  Weld, Bergavin and Magrath have an interesting article in CPA Journal arguing that HealthSouth’s financial statements provided a number of clues that earnings were being managed.  Top-quality financial statements (including additional disclosure) can’t directly prevent firms from committing fraud and fooling their auditors, but they can provide investors with a last line of defense:  the ability to raise specific questions about management’s claims.  I would be very interested to hear Mr. Beam’s perspective on what features of the financial reporting environment allowed HealthSouth to avoid questions for so many years.

Second, much standard-setting research is influenced by the enormous literature on earnings management.  But I don’t think researchers yet have a very good handle on how earnings management actually occurs — whether fraudulent or not.  Large sample evidence makes me pretty confident that many firms manage their earnings through operational and accounting decisions in order to satisfy Wall Street and hit specific targets (like the average analyst estimate or a management forecast).  But we know very little about how top management’s intent to achieve earnings goals actually percolates through a large and complex organization.  For example, you might suspect that firms adjust research and development expenses in order to meet or beat analysts’ estimates.  But if this is to be accomplished through an actual reduction in spending (rather than an adjustment in accounting estimates), how does management accomplish this in short window between knowing the size of the reduction needed and the end of the quarter?  Does the CFO need to plan a series of spending cuts throughout the period, to be enacted depending on the resolution of uncertainty?  Given the great stress Mr. Beam’s boss (HealthSouth CEO Richard Scrushy) placed on satisfying Wall Street, I imagine we will get some interesting insights.

As a related point, more than a few academics have suggested that allowing more flexibility in reporting standards can improve communication, and also serve as a substitute for more costly operational forms of earnings management.  I wonder if Mr. Beam agrees, or whether he sees loose standards as easing the wagon’s way from earnings management to outright fraud.

Click here for details on how to attend the discussion.

The Accounting Scandal (from the SEC Complaint — see top of post for link)

25.  HRC’s accounting personnel designed the false journal entries to the income statement and balance sheet accounts in a manner calculated to avoid detection by the outside auditors. For example, instead of increasing the revenue account directly, HRC inflated earnings by decreasing the “contractual adjustment” account. Because the amounts booked to this account are estimated, there is a limited paper trail and the individual entries to this account are more difficult to verify than other revenue entries.

26.  Additionally, each inflation of earnings and corresponding increase in fixed assets were recorded through several intermediary journal entries in order to make the false inflation more difficult to trace.

27.  Furthermore, HRC increased the “AP Summary” line item at various facilities by different amounts because it knew that across the board increases of equal dollar amounts would raise suspicion.

28.  HRC also knew that its outside auditors only questioned additions to fixed assets at any particular facility if the additions exceeded a certain dollar threshold. Thus, when artificially increasing the “AP Summary” at a particular facility, HRC was careful not to exceed the threshold.

29.  HRC also created false documents to support its fictitious accounting entries. For example, during the audit of HRC’s 2000 financial statements, the auditors questioned an addition to fixed assets at one particular HRC facility. HRC accounting personnel, knowing that this addition was fictitious, altered an existing invoice (that reflected an actual purchase of an asset at another facility that approximated the dollar amount of the fictitious addition) to fraudulently indicate that the facility in question had actually purchased that asset. This altered invoice was then given to the auditors to support the recording of the fictitious asset in question. Also, when the auditors asked HRC for a fixed assets ledger for various facilities, HRC accounting personnel would re-generate the fixed asset ledger, replacing the “AP Summary” line item with the name of a specific fixed asset that did not exist at the facility, while leaving the dollar amount of the line item unchanged.

* Update: A video of this Roundtable, along with some follow-up comments can be seen here.