Do Sophisticated Investors Understand Accounting Quality?

Do Sophisticated Investors Understand Accounting Quality?

Evidence from Bank Loans

Since banks significantly rely upon financial statements to assess and monitor borrowers’ accounting quality, we measure accounting quality as the magnitude of abnormal operating accruals, after controlling for industry and the firm’s normal level of activity. Operating accruals represent the difference between the reported earnings and the operating cash flows of a firm. Large deviations between earnings and operating cash flows make it harder for the bank to assess the ability of borrowers to generate cash flows in the future. Differentiating between earnings and cash flows is crucial for the bank because the payments by borrowers in the form of interest or principal will be serviced out of cash flows.


IV. Conclusion

We examine if banks have the ability to understand the relationship between operating accruals, future earnings and cash flows. Differentiating between earnings and cash flows is crucial for the bank because, the payments to the loan contracts in the form of interest or principal will be serviced out of cash flows and not earnings of the borrower.

This issue is important since various papers have documented that stock market investors (Sloan (1996); Xie (2001)) as well as sophisticated bond market investors (Bhojraj and Swaminathan (2004)) do not seem to price poor accounting quality as reflected in accruals.

In sharp contrast to these studies we find evidence in support of (Working Capital/ Total Assets) + 0.076 (Current Liabilities/ Current Assets) – 1.72 (1 if Total Liabilities >Total Assets, 0 otherwise) – 0.521 ((Net Incomet - Net Incomet-1)/( Net Incomet + Net Incomet-1)) the banks being able to discern the true accounting quality of borrowers and incorporate loan terms, price and non-price terms, appropriately.

Our paper makes four contributions to the literature.

• First, by showing that banks consider the deviations between cash flows and earnings in pricing and structuring their contracts, we provide direct evidence supporting the specialness of financial intermediation. The financial intermediation literature has hitherto relied on indirect evidence supporting the specialness of banks.
• Second, we add to the growing body of evidence that investors misprice information in financial statements, by showing that some sophisticated investors (banks, in our case) properly use this information while structuring financial contracts.
• Third, we advance the explanation that our results support, and are consistent with, the notion of limited information as a source of risk – a view increasingly gaining currency in the asset pricing literature.
• Finally, we show how accounting quality has a direct and measurable impact on a firm’s cost of capital.

http://www.bis.org/bcbs/events/rtf04sunder.pdf