Why do some countries adopt the European Union (EU)-based International Financial Reporting Standards (IFRS) when others do not? To expand our understanding of the determinants and consequences of IFRS adoption on a global sample, HBS professor Karthik Ramanna and MIT Sloan School of Management coauthor Ewa Sletten studied variations over time in the decision to adopt these standards in more than a hundred non-EU countries. Understanding countries' adoption decisions can provide insights into the benefits and costs of IFRS adoption.
How does the political process affect accounting? During the 2004 U.S. congressional elections, outsourcing of American jobs was a major campaign issue. Because outsourcing is assumed to be net profitable, the use of income-decreasing accruals would enable donor firms to deflect public scrutiny of both the firm and the political candidate over outsourcing. HBS professor Karthik Ramanna and MIT Sloan School professor Sugata Roychowdhury examine the accrual choices made by outsourcing firms with links to U.S. congressional candidates during the 2004 elections, and specifically test for income-decreasing discretionary accruals. Evidence is consistent with firms using earnings management to reduce both direct political costs and the costs associated with causing embarrassment to affiliated political candidates.
SFAS 142 is an accounting rule that requires managers to use estimates of their firms' discounted future values to determine goodwill write-offs. Such estimates are different from the discretion historically afforded in financial reporting in that they are ex post unverifiable. For example, under the standard, a manager of a single-reporting-unit firm can avoid a goodwill write-off despite market indications to the contrary by generating a hypothetical firm value that exceeds the firm's liquid market value. Ex post, if the firm value used to justify non-impairment is not realized, the manager can claim it was due to factors outside his control (e.g., macroeconomic conditions), which is difficult to verify or falsify in a court of law. By promulgating SFAS 142, standard setters must implicitly assume that managers will, on average, use unverifiable discretion to convey private information on future cash flows. In contrast, agency theory predicts managers will, on average, use unverifiable discretion opportunistically. HBS professor Karthik Ramanna and MIT Sloan School professor Ross L. Watts investigate managers' implementation of the goodwill impairment test in SFAS 142 in a sample of firms with market indications of goodwill impairment.
The changeover from defined benefit to defined contributions retirement plans in the United States has created a vast group of individuals that faces (or will face) the difficult problem of using a lump sum of assets to provide consumption for a relatively long but uncertain number of years. Up to this point, however, consumers appear not to have embraced annuitization. HBS professor Julio J. Rotemberg suggests an alternative instrument that, like immediate annuities, provides longevity insurance and postpones income until old age. In the proposed Mutual Inheritance Fund (MIF), a pool is formed by having individuals of a particular age buy shares in a mutual fund. The income from the underlying assets in the mutual fund is reinvested in the fund so that the value of the shares in an individual's name (and possibly also the number of these shares) grows over time. The basic idea behind the MIF is that the shares of pool members who die are liquidated, and the proceeds are then distributed in cash to the remaining members in proportion to the number of mutual fund shares that are currently in their name.
Insurance markets are growing rapidly in developing countries. Despite the promise of these markets, however, adoption to date has been relatively slow. Yet households often remain exposed to movements in local weather; regional house prices; prices of commodities like rice, heating oil, and gasoline; and local, regional, and national income fluctuations. In many cases, financial contracts simply do not exist to hedge these exposures, and when contracts do exist their use is not widespread. Why don't financial markets develop to help households hedge these risks? Why don't more households participate when formal markets are available? HBS professor Shawn Cole and coauthors attempt to shed light on these questions by studying participation in rural India in a rainfall risk-management product that provides a payoff based on monsoon rainfall. The results suggest that it may take a significant amount of time—and substantial marketing efforts—to increase adoption of risk-management tools at the household level.
Why is there apparently limited demand for financial services in emerging markets? On the one hand, low-income individuals may not want formal services when informal savings, credit, and insurance markets function reasonably well, and the benefits of formal financial market participation may not exceed the costs. On the other hand, limited financial literacy could be the barrier: If people are not familiar or comfortable with products, they will not demand them. These two views carry significantly different implications for the development of financial markets around the world, and would suggest quite different policy decisions by governments and international organizations seeking to promote "financial deepening." HBS professor Shawn Cole and coauthors found that financial literacy education has no effect on the probability of opening a bank savings account for the full population, although it does significantly increase the probability among those with low initial levels of financial literacy and low levels of education. In contrast, modest financial subsidies significantly increase the share of households that open a bank savings account within the subsequent two months.
The present financial crisis should remind us that private financial institutions and markets cannot always be counted upon to manage risk optimally on their own. Almost everyone now recognizes that the government has a critical role to play—as the lender, insurer, and spender of last resort—in times of crisis. But effective public risk management is also needed in normal times to protect consumers and investors and to help prevent financial crises from starting in the first place. According to HBS professor David Moss, the biggest threat to our financial system today is posed not by commercial banks (as in 1933), but rather by systemically significant institutions (outside of commercial banking) that have the potential to trigger financial avalanches. The threat posed by these financial institutions is only compounded by the unprecedented federal guarantees introduced in response to the current crisis and the pervasive moral hazard they spawn. Under the system that Moss proposes, no financial institution would be too big to fail.
Although 99 percent of the companies operating in the United States are private, according to the American Institute of Certified Public Accountants, their accounting practices remain largely unknown due mainly to the lack of publicly available financial statements. In this study, HBS professor Sharon P. Katz used a unique database of firms with privately held equity and publicly held debt to examine how two different ownership structures-private equity sponsorship and non-private equity sponsorship-affect firms' financial reporting practices, financial performance, and stock returns in the years preceding and following the initial public offering (IPO).
Does access to personal savings increase female decision-making power in the household? The answer could be important for policymakers looking to increase female empowerment. HBS professor Nava Ashraf and colleagues developed a commitment savings product called a SEED (Save, Earn, Enjoy Deposits) account with a small, rural bank in the Philippines. The SEED account requires that clients commit not to withdraw funds that are in the account until they reach a goal date or amount, but it does not explicitly commit the client to continue depositing funds after opening the account. This working paper examines the impact of the commitment savings product on both self-reported decision-making processes within the household and the subsequent household allocation of resources.
The quality of accounting information is influenced by an array of factors, most of which stem from the demand for such information for use in contractual arrangements and from the incentives and opportunities of management to manage the reported numbers. Both the demand for quality accounting information for contractual purposes and management incentives to adjust the reported earnings are likely to be influenced by whether the equity of the company is privately held or publicly traded. This study examines the differential earnings quality of private equity and public equity firms in order to shed light on how public ownership of equity affects the quality of firms' earnings. The research highlights how the presence of public equity investors affects management's reporting behavior.
This paper examines the politics of corporate governance at the world's largest appropriations committee, the World Bank's Board of Executive Directors, and exposes a weakness in the design of the World Bank's decision-making structure. Any large public organization faces a challenge of representation and management. Since all decisions cannot be made by all members, founders often grant a more nimble body with decision-making powers. But representatives on the decision-making body may face a temptation to govern in the interests of their own wallet or narrow constituency rather than in the interests of the larger body. In 2008, the Bank's two primary component institutions—the International Bank for Reconstruction and Development (IBRD) and the International Development Association (IDA)—committed nearly $25 billion in loans and grants through some 300 development projects around the globe. Where did it go? By exploring the political dynamics and corporate governance of an international appropriations committee, we not only learn about international organizations but also the nature of the international system itself.
The role of sovereign wealth funds (SWFs) in the global financial system has been increasingly recognized in recent years, and many reports suggest that SWFs are often employed to further the geopolitical and strategic economic interests of their governments. The resources controlled by these funds—estimated to be $3.5 trillion in 2008—have grown sharply over the past decade. Projections, while inherently tentative due to the uncertainties about the future path of economic growth and commodity prices, suggest that they will be increasingly important actors in the years to come. Despite this significant and growing role, financial economists have devoted remarkably little attention to these funds. The lack of scrutiny must be largely attributed to the deliberately low profile adopted by many SWFs, which makes systematic analysis challenging. Bernstein, Lerner, and Schoar analyze how SWFs vary in their investment styles and performance across various geographies and governance structures. Taken as a whole, results suggest that high levels of home investments by SWFs, particularly those with the active involvement of political leaders, are associated with trend chasing and worse performance.
Gray market goods are brand-name products that are initially sold into a designated market but then resold through unofficial channels into a different market. Gray markets can arise when transaction and search costs are low enough to allow products to "leak" from one market segment back into another. Examples of industries with active gray markets include pharmaceuticals, automobiles, and electronics. Understandably, reactions to gray market encroachment are mixed. On the one hand, consumer advocates and governments have applauded the increasing role that gray markets have played in improving competition for domestic goods. On the other hand, multinationals have decried the increasing role of gray markets in the economy, with an estimated $40 billion in cannibalized sales resulting from gray markets in the information technology sector alone. This study investigates the optimal price of a multinational's internal transfers and the consequences of regulations mandating arm's-length transfer pricing.
This paper investigates the spectacular rise and fall of structured finance. HBS professor Joshua Coval, Princeton professor Jakub Jurek, and HBS professor Erik Stafford begin by examining how the structured finance machinery works. They construct simple examples of collateralized debt obligations (CDOs) that show how pooling and tranching a collection of assets permits credit enhancement of the senior claims. They then explore the challenge faced by rating agencies, examining, in particular, the parameter and modeling assumptions that are required to arrive at accurate ratings of structured finance products. They conclude with an assessment of what went wrong and the relative importance of rating agency errors, investor credulity, and perverse incentives and suspect behavior on the part of issuers, rating agencies, and borrowers.
Popular imagination often links two significant economic developments: the rapid escalation of the foreign activities of American multinational firms over the last 15 years, and rising levels of economic insecurity, particularly among workers in certain sectors. The presumed linkages between these phenomena have led many to call for a reconsideration of the tax treatment of foreign investment. Increasing the tax burden on outbound investment by American multinational firms, it is claimed, offers the promise of alleviating domestic employment losses and insecurity while also raising considerable revenue. HBS professor Mihir A. Desai looks beneath the trends, examining the economic determinants of outbound investment decisions and synthesizing what is known about the relationship between domestic and foreign activities.
Can patterns of corporate net stock issuance help identify times when particular characteristics, such as industry, size, or book-to-market ratio, are mispriced? The authors of this study argue that differences between the characteristics of issuers and repurchasers can shed light on characteristic related stock returns. Consider the case in which analysts were interested in forecasting the returns of Google. The standard approach would be to collect Google's characteristics (e.g., large, technology, non-dividend paying, etc) and associate these characteristics with an average return in the cross-section. The authors argue that if other stocks with these characteristics are issuing stock, this bodes poorly for Google's future returns, even if Google is itself not issuing. This research by HBS professor Robin Greenwood and Harvard doctoral student Samuel Hanson has implications for studying the stock market performance of seasoned equity offerings (SEOs), initial public offerings (IPOs), and recent acquirers.
Are nominal government bonds risky investments that investors must be rewarded to hold? Or are they safe investments, whose price movements are either inconsequential or even beneficial to investors as hedges against other risks? U.S. Treasury bonds have performed well as hedges during the financial crisis of 2008, but the opposite was true in the late 1970's and early 1980's. John Y. Campbell, a Visiting Scholar at HBS, Harvard Ph.D. candidate Adi Sunderam, and HBS professor Luis M. Viceira explore such changes over time in the risks of nominal government bonds.
Professor David Moss says we need ongoing federal regulation of the few "systemically significant" institutions whose demise could threaten financial stability.
The sub-prime crisis has thrown a harsh spotlight on the practices of securities underwriters, which provided too many complex securities that proved to ultimately have little value. Certifiers such as rating agencies, journals, standard setting bodies, and providers of standardized tests play an increasingly important role in the market economies. Yet as scrutiny of rating agencies in the aftermath of the sub-prime crisis has shown, these organizations have complex incentive structures and may adopt problematic approaches. On an explicit level, all major rating agencies follow a well-defined process, whose end product is the publication of a rating based on an objective analysis. But firms have been historically able to get rating agencies not to disclose ratings that displease them. HBS professor Josh Lerner and colleagues examined when certifiers might adopt more complex rating schemes, rather than the simple pass-fail scheme, and highlight that such nuanced schemes are more likely when the costs of such ratings are lower. In addition, these schemes are more common when sellers are less averse to the revelation of information about their quality, and more impatient.
How did the process of securitization transform trillions of dollars of risky assets into securities that many considered to be a safe bet? HBS professors Joshua D. Coval and Erik Stafford, with Princeton colleague Jakub Jurek, authors of a new paper, have ideas.
