To bleg is to write a blog entry or comment for the sole purpose of asking for something.

Today, I am asking for input on what roundtable speakers you would like to see over the coming academic year.  As I indicated in Reimagining FASRI, we will be planning roundtables to serve three objectives:  bringing academic research to standard setters (input), informing academics about the state of deliberations and related research (updates), and growing our community by scheduling events of general interest to academics (outreach).

Please comment below (or just email me) with your suggestions.  At our meeting last week, FASB expressed particular interest in getting input on four issues:

• The Disclosure Framework
• The measurement chapter of the Conceptual Framework
• Other Comprehensive Income (and income recycling)
• Post-Employment Benefits (pensions)

Which researchers do you think the Staff and Board should hear from?

For outreach, I imagine many of you would like to hear about deliberations on the many standards likely to be issued soon (revenue recognition, leasing, financial instruments, etc.).  You might also want to hear the perspectives of preparers, auditors, and other participants in the financial reporting process.

For service, many young academics might like to hear advice on navigating the publication process from some journal editors, or advice on balancing teaching and research by some established scholars and top teachers.

When you make your suggestions, let me encourage you to be ambitious.  For example, I’d love to hear views on the proposed leasing standards from the CEO or CFO of Boeing or Walgreen’s–and the Chairmen of the Big 4 audit firms.  How about hearing from Paul Krugman or Larry Summers on the impact of academic research on policy?

Ask your colleagues, and pass along your suggestions!

As discussed on the conference website, the objective of this year’s conference is:

to provide the FASB and IASB with timely feedback on the Conceptual Framework issue of recognition criteria and their potential role, if any, in the revised conceptual framework. The FASB and IASB are engaged in projects aimed at improving and converging certain financial reporting standards, with the ultimate goal being the provision of comparable financial reporting information under U.S. GAAP and International Financial Reporting Standards. This year’s conference will focus on matters related to the relationship between Conceptual Framework recognition criteria and decisions the Boards have made in developing standard-setting solutions to the same issues in related projects (Leases, Insurance, Revenue Recognition, Financial Instruments and Emission Trading, among others). The conference will explore whether any inconsistencies in Board decisions can be attributed to weaknesses in the existing Conceptual Framework (relating to, for example, definitions of elements or other recognition criteria) or if key guidance is missing in the Framework (relating to, for example, presentation, measurement or the unit of account). These issues are of significant interest to participants in the financial reporting process, and relate to a number of the major joint projects currently on the FASB’s and IASB’s agendas. Academic participants also are urged to offer insights on these issues based on research with which they are familiar.

The conference materials are, as always, thought provoking. They consist of three sets of cases and several items of background reading. In the round table on Weds, we will review some of these case and discuss the role of recognition criteria, whether recognition criteria are necessary and, if so, what their purpose is intended to be.

One of the background readings that will be of particular interest to academics is a research paper on emission rights by Yonca Ertimur, Jennifer Francis, Amanda Gonzales, and Katherine Schipper. In that paper, the authors discuss at length several different methods of accounting for emission rights. They then simulate the likely effect that these treatments would have had on the financial statements of companies with significant annual emissions. As a final empirical test, they look at stock returns to see how the market values these various pieces of information.

Should be a fun discussion. Hope you can join us!

Details for participation are here.

The proposal generated a lot of discussion and quite a few comment letters (242 letters were summarized by the FASB staff in their comment letter summary).  201 (83%) of those letters did not support the FASB’s proposal.  Preparers and their auditors expressed concern that the new disclosure rules would compel firms to disclose information that would harm their cases by providing private information to plaintiffs suing them. 

After many months of additional research, contacts and pilot studies with cooperative firms, public roundtables held March 9, 2009, and redeliberations by the Board, this new exposure draft, while accomplishing many of the initial objectives of the project, appears to have addressed the concerns that were raised.

My colleagues (Rosemond Desir, Colorado State University; and Kirsten Fanning, soon to be at Villanova University) and I conducted an empirical study aimed at testing the assertions upon which the FASB’s project were based.  In particular, we tried to determine the rate at which firms in the population of public companies were seemingly withholding relevant information about lawsuits until after the suits were settled and losses were recognized.  In our view, such a phenomenon should essentially never occur if the spirit of SFAS No. 5 were followed, so we expected that rate to be very close to zero.  However, we found in our sample of 52 lawsuits that in 4 cases, it appears that an arguably material loss that was apparently probable at the financial statement date was not disclosed and no loss was accrued until the following financial report, when the lawsuit was settled or adjudicated.  This is a rate of 8%.

Overall, we believe our study supports the FASB’s assertion that there is insufficient disclosure under the current regime.  The paper is forthcoming in Accounting Horizons.  Contact Ray Pfeiffer if you would like a copy of the paper in the mean time.

It should be interesting to gauge the response of the legal/preparer and audit communities to this revised proposal.  Have the revisions to the proposal provided the necessary protections as seen by preparers?  It should be equally interesting to see the response of the investor community, whose claims of insufficient disclosure motivated this project.  Have the revisions to the initial proposal gone too far?

Comments are due very quickly (letters are due by August 20).  Stay tuned!

While the paper contains a number of issues that would lead to interesting debate within the FASRI community, this post focuses on how the authors manipulate the relevance of fair value information regarding a building.  This task is harder than it might sound.  I was not impressed by their first attempt – one group of subjects was told the building was to be sold in the short term, while the other group was told the building was a long term investment.  The problem is, as a passive investment, fair value is relevant in both cases for assessing current period stock price.

The authors’ second approach to manipulating relevance seems much more appropriate.  One group is told the building is being held as a passive investment, while the other is told the building will be used for production purposes.  During my year as FASB Research Fellow, I and others at the FASB observed that constituents tend to accept fair value accounting in the first case but tend to view it as not very relevant in the second.  Why?  My intuition is that as a passive investment, the cash flows generated for the company by the building will be determined by market forces, so a market price of the building is very relevant to assessing the value of the company.  But when used in production, the cash flows produced by an asset will depend on all of the potential firm-specific synergies that the asset brings to the company.  For example, while the market may value two buildings on different sides of a town (or a state) the same, the cash flows generated from using the building in production will be higher if the company acquires the building on its side of town (lower transportation costs).  My impression is that rather than trying to add up the fair value of each productive asset, most investors try to project the economic rents (income, cash flows, or other measures) generated by using the productive assets collectively, and apply some present value technique to the rents.

In this sense, the fair value of a single productive asset is not very relevant to assessing current stock price of the company because the market price for the single asset probably does not reflect all of the possible firm-specific synergies associated with that asset.  Kudos to Koonce and her co-authors for developing this second manipulation.  If any other experimental researchers are struggling to find a good manipulation for relevance, I urge you to contact Lisa.

Using an experimental methodology, the authors randomly assigned participants to one of two groups who had to negotiate salary payments for three workers. Half of the participants were assigned to be a boss, essentially having the last say on how much workers were paid (a form of the dictatorship game). The other half of the participants were assigned to be a worker. Bosses were seated individually in a large office with windows and a big desk. Workers were seated in a small cubicle with no windows. After looking over the details of the job descriptions, etc., the worker had to walk into the boss’s office and discuss salaries with the boss, who was sitting behind the desk. After the discussion, the boss decided how much would be paid to all workers, including the participant-worker.

All of this first scenario set the stage for what was to happen next. Participants were told they were needed to participate in a second study. In this study, participants were led into a room and sat in front of a computer screen. They were told that within a minute, the computer screen would tell them either to take $100 inside a book on the desk or not to take that $100. People told to take the $100 needed to hide it somewhere out of sight. Participants were told that after five minutes, a person would enter the room who had no idea whether they had actually taken the $100. If participants could convince the person that they had not taken the $100, they could keep the $100, regardless of what the computer had told them to do. This meant that if participants followed the instructions about taking the $100, half of the participants would be telling the truth and half of the participants would be telling a lie. The incentive for all participants was to persuade the person that they had not taken the $100. If they did persuade the person, participants could keep the $100 and were entered into a random drawing for an additional $500.

The authors wanted to know whether people assigned to the POWER group in the first study would be better than those assigned to the WEAK group at deceiving the questionner in the second study. The authors hypothesized that being in a powerful setting makes it less difficult to lie because of the emotional and chemical changes in the body that power seems to cause. The authors measured physiological changes and asked many debriefing questions to get at the mental state of participants. Based on the deception attempts, coded body language indicative of lying (also called deceptive tells), and a saliva analysis of a hormone that often elevates after lying situations, the authors provide convincing data suggesting that power is likely to make it easier for a person to lie.

Of course this is way too brief of a summary, but I hope you get the idea (and want to read the paper yourself). After reading the paper, I wondered whether there were any testable hypotheses that would relate earnings restatements to the number of “deceptive tells” a CEO or CFO might display in a video earnings announcement. Or, is their a relationship between the number of syllables per second spoken by a CFO in relation to a pointed conference caller’s question and the likelihood of an earnings restatement. Or perhaps even better, does the market somehow pick up on these deceptive tells in conference calls and react? I also wonder about audit implications, but those sound to invasive to even imagine for right now. So, I’ll stop here. Take a look at this study and tell me what you think.

Adam Grant, a management professor from Wharton, presented some of his work at OU on Monday. He began with a story of a university’s call center where student employees call alums for donations.  The employees hated their jobs.  Managers in the call center had tried all kinds of traditional motivation tools.  Adam learned that most of the money raised went to scholarships, so he arranged to have a scholarship recipient spend 5 minutes with half of the callers to explain what a difference the scholarship made in his life.  The other half did not meet the recipient.  Over a 6 week period, the performance of the treatment callers was 2-4 times that of the control group.

Upon seeing the results, the call center managers started explaining the importance of the scholarships to new employees.  No effect; the callers only responded to hearing directly from the beneficiaries.  Adam tested a lot of other aspects of how appealing to pro-social emotions can lead to better performance.  I think that folks who do principal agent modeling and empirical work on compensation plans may be very interested in his work.

In regards to financial reporting, I know that auditors attend a lot of education sessions related to fraud, and they probably hear how missing a fraud can have severe consequences to their careers and their firms.  I wonder if a visit by widows and orphans who had their savings wiped out by a fraud might prove a better motivator?

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.

Although a substantial body of academic research is devoted to developing and testing risk proxies that detect or predict accounting irregularities, the academic literature has paid little attention to commercially developed risk measures. This is surprising given the general consensus that accruals-based risk proxies in the academic literature are very noisy (McNichols [2000]). We compare the commercially developed AGR risk proxy with proxies from the academic literature to determine which measure best detects and predicts accounting irregularities. We find that AGR outperforms academic risk measures in all head-to-head tests for detecting and most head-to-head tests for predicting Securities and Exchange Commission enforcement actions (AAERs), egregious accounting restatements, and shareholder lawsuits related to alleged accounting improprieties. Incorporating commercially developed risk proxies into future research may yield interesting insights beyond what academic proxies have provided to date.

This looks like a good paper, not only because of the comparison it performs, but also because it gives a good overview of the state of the art in risk measures, both commercially and academically. I’m looking forward to reading the rest of the paper.