THE CONTRIBUTIONS OF ACCOUNTING RESEARCH:

ACHIEVEMENTS AND THINGS TO DO

Baruch Lev

New York University

blev@stern.nyu.edu

www.baruch-lev.com

August 2012

At a Glance 2

Accounting Research had

considerable success in the regulatory, managerial and investment areas. Examples:

Fair value accounting

Sarbanes-Oxley consequences

Managerial compensation—“Say on Pay”

Corporate governance

Earnings guidance

Managerial quality

lack of progress, or even serious efforts, to change the accounting model, its framework or practices

Accounting heavy reliance on subjective managerial estimates and projections

Fair Value (FV) Accounting is Not a Myth

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Major questions: Is FV relevant for share valuations?

For risk assessment? Is it manipulated by management?

Did it enhance the 2007-2008 financial crisis?

Research findings:

Fair values of assets/liabilities, even Level 3, more

relevant to investors than amortized costs.

Fair values are highly informative regarding firm risk and

liquidity—a weak aspect of accounting.

Fair values are sometimes manipulated by managers.

There is no evidence that fair values were “procyclical”—

contributing to the financial crisis.

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Major questions: given that the Act is very costly, are there

noticeable benefits to it? Particularly to disclosure of

material internal control weaknesses which adversely affect

quality of financial reports

Research findings:

Passage of the Act triggered significantly positive market reaction

of investors.

Firms disclosing material internal control weaknesses experienced

a significant decrease in stock prices.

These decreases were smaller if auditors were of high quality.

Material control weaknesses led financial analysts to reduce

earnings forecasts.

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Major questions: “Say on Pay” regulation which

started in the U.K. (2002), and enacted recently in the

U.S. (2010) gives shareholders a vote on executive

compensation. Question: Is this a good thing?

Research findings:

The UK and US experience shows that negative SOP vote

targets companies with excessive compensation.

After negative vote, executive compensation is cut

significantly.

No evidence of serious political influence on SOP votes.

“Say on Pay” (SOP) Restricts

Unwarranted Compensation

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Major questions: The corporate scandals of the early 2000s (Enron, Parmalat, Siemens) focused attention on corporate governance. Questions: Do governance refroms improve corporate performance, reduce fraud, increase reports quality?

Research findings:

The correlation between directors’ independence and corporate performance is weak at best (US data)

Directors’ financial expertise is associated with less fraud and higher quality reports.

No evidence that separating CEO from board chair contributes to performance.

Mixed Evidence on Corporate Governance

Earnings Guidance Benefits Investors

and Firms 7

Major questions: About 1,500 US companies regularly

disclose earnings and sales guidance (forecasts) to

investors. Question: What are the benefits of guidance?

Research findings:

Guidance decreases investors’ disappointment, increases

managers’ credibility, and reduces litigation exposure.

Firms that stop guidance suffer share price decreases.

Firms that stop guidance increase investors uncertainty and

lose analyst following.

Firms often guide when they see an increase in stock

volatility (investor uncertainty).

Managerial Quality Can Be Measured 8

Major questions: The most important asset of most

companies is the quality of their managers. Questions: Can

managerial quality be measure? Does it affect business

performance and ethical conduct?

Research findings:

With several teams of researchers I developed two approaches

to measure quality of managers.

These quality measures are strongly associated with business

performance and stock prices.

Managerial quality measures predict future stock performance.

High quality managers produce more reliable, less manipulated

financial reports.

Summary: Research Contributions 9

Relevance: The above examples clearly show that certain

research findings are relevant to society (regulations),

investors (managerial quality), and managers (guidance).

Accounting reforms: Surprisingly, accounting research has

very little to say about improving the accounting model,

new modes of reporting, accounting for intangibles, etc.

Post Mortem: Researchers don’t even try to explain why

financial information failed to alert investors and the public

to accounting scandals, or the excessive risk taken by

financial institutions before the 2007-2008 crisis.

A lot of things remain to be done.

Accounting Reform: An Example 10

Most financial statement items (accounts receivable, inventory, fixed assets, sales of long term products, pension expense, etc.) are based on managers’ estimates and forecasts; often multiple estimates.

These estimates and the consequent reliability of financial information are increasingly challenged by:

Deregulation, globalization, and fast technological changes, all enhancing business uncertainty, and making accounting forecasts (asset write-offs, options expense) increasingly difficult.

Managers’ manipulation of financial information by misestimates and biased forecasts. They can do it with impunity.

Investors Unable to Assess Impact

and Reliability of Estimates

“GE brings good things to life” (but not to accounting):

“We estimate total long-term contract revenues… We

measure long-term contract revenues by applying our

contract-specific estimated margin rates to incurred

costs. We routinely update our estimates of future

costs for agreements in process…We provide for any

loss that we expect to incur on these agreements when

the loss is probable.” (GE 2010 financial report).

Shouldn’t investors know how much of GE’s total 2010 revenue of

$150 billion is based on estimates?

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Investors Unable…Continued

Investors are generally unable to determine the impact of estimates on key financial statement items (e.g., how much of earnings is fact, and how much estimate?)

Investors unable to assess reliability of estimates. For most accounting estimates, the ex post realizations are not reported (e.g., the multiple estimates underlying the stock option expense). An invitation to manipulation.

Managers are rarely tracking the quality of their estimates and projections—crucial for improving the estimation procedures. Auditors too are largely uninterested.

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Standard-Setters constantly increase the

prevalence and impact of estimates in

financial reports:

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assets and goodwill write-offs

fair value

accounting

stock option

expense

environmental

risks (?)

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The Result: Constant Increase in

Earnings Uncertainty

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0.03

0.04

0.05

0.06

0.07

0.08

0.09

1960s 1970s 1980s 1990s 2000s

Decade

Average Standard Deviation of Net Income (ROA) for S&P 500 Firms

from 1960s to 2000

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Relevance-Challenged Earnings Have

Low Predictive-Ability

I compared the predictive-ability of net earnings with

that of gross profit, cash from operations, and free cash

flows (latter three are less affected by estimates than

net earnings) regarding future values of these series

(out of sample).

Results indicate that net earnings generally perform the

worst of the four measure. It is best only in predicting

next-year’s earnings. It is worst in beyond-one-year

predictions. Cash flows outperforms earnings in

predicting cash flows. Source: Lev, Li and Sougiannis, "The Usefulness of accounting estimates for predicting cash flows

and earnings," Review of Accounting Studies, 2010 15

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So, What’s To Be Done?

Various suggestions have been made to mitigate

the adverse effects of unreliable estimates on the

usefulness of financial information.

None received serious consideration by accounting

policymakers.

None received serious attention by accounting

researchers.

A sad commentary

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Yuji Ijiri’s Separation of Facts from

Forecasts*

Income Statement

Facts Forecasts Total

Revenue

Expenses

Net Income

*Yuji Ijiri, "Cash is a fact, but income is a forecast," working paper, 2002. 17

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Jim Ohlson’s Gradation of Reliability

The income statement should reflect gradations of reliability.

• Revenues and expenses not subject to estimates (recall GE)

• Items subject to high quality estimates (bad debt expense, warranties expense)

• Items subject to low-reliability estimates (stock options expense, gains/losses from Level 3 fair values)

• Net income

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Lundholm’s Suggestion for Comparison

of Estimates with Ex-Post Realizations

A routine comparison in financial reports of key estimates with realizations, and managers comments on the deviations.

This will do wonders to improve managers’ ex-ante incentives to provide reliable estimates.

Lundholm, R., "Reporting on the

past: A new approach to

improving accounting today,"

Accounting Horizons, 1999.

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Lundholm, R., "Reporting on the past: A new approach to improving accounting today,"

Accounting Horizons, 1999.

Lev-Ryan-Wu’s Proposal for a Required

Revision of Earnings for Major Misestimates*

Research has documented that the history (pattern) of earnings matters to investors (Barth, Elliott, Finn, 1999), and that revisions of this history affects investors’ decisions (Lev, Ryan, Wu, 2008).

Significant deviations between estimates and realizations change the pattern of earnings, and therefore call for disclosure of revised earnings.

The result: an improved “history of the firm.”

This is done routinely in the national income numbers (GDP, unemployment).

20 *Lev, Ryan and Wu, "Rewriting earnings history, "Review of Accounting Studies, 2008. 20

Lastly, 21

The world benefitted from so many

Japanese innovations and contributions,

perhaps it is time that the accounting world

will benefit from a Japanese accounting

makeover.

Suggested Readings

• Ryan, 2012, Financial Reporting for Financial Instruments, Foundations and Trends in Accounting, forthcoming.

On fair value

• Beneish, Billings and Hodder, 2008, Internal Control Weaknesses and Information Uncertainty, The Accounting Review, May, 665-703

On Sarbanes-Oxley

• Ferry and Maber, 2011, Say on Pay Votes and CEO Compensation, working paper, Harvard Business School

On “Say on Pay”

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• Bhagat and Black, 2002, The Non-Non-Correlation Between Board Independence and Long-Term Firm Performance, Journal of Corporation Law, 231-273

On independent

directors

• Houston, Lev, Tucker, 2010, To Guide or Not to Guide? Causes and Consequences of Stopping Quarterly Earnings Guidance, Contemporary Accounting Research, 143-185

On earnings guidance

• Demerjian, Lewis, Lev, McVay, 2012, Managerial Ability and Earnings Quality, The Accounting Review, forthcoming

• Lev, Radhakrishnan, Zhang, 2009, Organization Captial, Abacus, 275-298

On managerial

quality

Suggested Readings

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