This paper investigates how book rate of return under GAAP relates to risk and the required return for investing. A standard view sees the book rate of return as a measure of profitability to be compared to the required return to evaluate the success of an investment. A contrasting view sees the book rate of return as indicative of the required return, consistent with the standard risk-return tradeoff. There clearly is some sorting out to do.
The pivotal role of accounting in society
Accounting is essential to the functioning of the economy and, indeed, society in general. Accounting is the means by which we monitor our governments, our corporations, and our non-profit organizations. For business firms, so much the focus in business schools, accounting not only monitors the managers, but also informs the investors in these firms of the potential payoffs, the risk to those payoffs, and the consequent valuations. This “financial accounting,” determines the allocation of investment to its most efficient use in the economy and promotes well-functioning capital markets with transparent pricing. “Managerial accounting,” the accounting to managers rather than about managers, promotes decision making and efficiency within the firm.
The accounting area and its emphasis on theory meets practice
The Accounting Area at Columbia Business School epitomizes the school’s long-standing emphasis on bridging theory with practice and policy. Our Center for Excellence in Accounting and Security Analysis (CEASA) also takes that research to practice in White Papers and Occasional Papers that offer policy prescriptions.
Columbia Business School has a reputation as the leading school in value investing, going back as far as the days of Benjamin Graham, the so-called father of fundamental analysis. Fundamental investing involves the analysis of accounting numbers, so the Accounting Division is very much aligned with this activity, in research, teaching, and bringing research to practice. “Price is what you pay, Value is what you get” is very much part of our mantra. We thus engage with the Heilbrunn Center for Graham & Dodd Investing in the School. Our teaching electives in the MBA program have this focus, in courses titled Fundamental Analysis and Earnings Quality, Fundamental Analysis for Investors, Managers, and Entrepreneurs, Financial Statement Analysis and Valuation, and Accounting for Value, for example, along with courses on financial modeling. Our Masters of Science in Accounting and Fundamental Analysis is a unique specialty masters’ program bringing accounting analysis to fundamental analysis.
Regular faculty research seminars, an active PhD program, and outreach activities to practitioners and regulators stimulate our inquiry into the absorbing questions of accounting. I am so happy to be associated with a distinguished senior faculty, an energetic junior faculty, and dedicated PhD students in the pursuit of the answers.
Since 1981, the Accounting Division at Columbia Business School has hosted the annual Burton Conference in honor of Professor Sandy Burton who served as the Chief Accountant at the SEC, the Deputy Mayor of Finance in New York and as the dean of Columbia Business School. Prof. Burton earned considerable respect for attempting to bridge the gap between accounting practice and academia. In keeping with that spirit, the conference aims to assemble an accomplished group of scholars and practitioners to discuss new research findings, ideas, methodologies and trends.
Faculty in the CBS Accounting Division are experts on both the design of financial analysis--how investors, analysts, managers and regulators should extract insights from accounting information--and prescriptions for better accounting that enhances such analysis.
The accounting group thrives under the tone set by Stephen Penman’s path breaking work on finding fundamental accounting motivated links to explain asset prices and Trevor Harris’ pioneering work at Morgan Stanley that brings a back-to-basics fundamentals-based inquiry into the financial sustainability of businesses.
Tim Baldenius specializes in modeling the complex interaction between incentives, taxes and capital budgeting in the world of transfer prices. Most of Tim’s new work emphasizes the subtle implicit and explicit incentives underlying how corporate boards work. Jon Glover’s work seeks to understand incentive mechanisms work or sometimes don’t work as intended and how relational contracts interact with formal incentive programs.
Doron Nissim specializes in how financial data is reported and presented with a view to making quant-based models of capturing accounting performance more intelligent by incorporating detailed ground-level knowledge of how financial statements work. Shiva Rajgopal’s work has highlighted the prevalence of corporate myopia and the importance of corporate culture and governance mechanisms to address shareholder and stakeholder concerns about the role that companies play in society. Amir Ziv’s research deals with the effects of accounting regimes and alternatives on economic environments.
Our vibrant group of emerging scholars is world-class. Wei Cai specializes in field work that document the incentive effects of effective corporate culture. Thomas Bourveau’s studies how corporate disclosure by oligopolists aids collusion. Matthias Breuer works on rigorous application of sound econometric techniques to identify the intended and unintended consequences of mandatory disclosure on resource allocation and investment decisions of firms.
Anne Heinrichs works on investor access to corporate management via one-on-one meetings and in conference calls. Sehwa Kim studies reporting issues of banks and insurance companies. Lisa Liu’s work emphasizes the economic consequences of financial regulations. Sang Wu, who has just joined the group from Carnegie Mellon University, focuses on empirical anomalies in accounting practices and institutions that contradict conventional wisdom.
We examine contagion in earnings management using 2,376 restatements announced during the years 1997-2008. Controlling for industry and firm characteristics, firms are more likely to begin managing earnings after the public announcement of a restatement by another firm in their industry or neighborhood. Such contagion is absent when the restating firm is disciplined by the SEC or class action lawsuits, suggesting deterrent effects of enforcement activity.
In this paper we address two questions that emerged in the aftermath of the 2008 financial/banking crisis. First, did the financial statements of bank holding companies provide an early warning of their impending distress? Second, were the actions of four key financial intermediaries (short sellers, equity analysts, Standard and Poor's credit ratings and auditors) sensitive to the information in the banks' financial statements about their increased risk and potential distress?
This paper lays out alternative valuation models and evaluates their features. Three themes underlie the discussion. First, we require that the models be consistent with the theory of finance. Second, valuation involves accounting, so accounting theory as well as finance theory comes into play. Third, valuation models are a tool for practical valuation, so the respective models are judged on how they perform or do not perform (as a practical matter), with the emphasis is on caveat emptor.