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We identify covenants in commercial loan contracts that require public borrowers to periodically disclose two types of accounting-related private information to lenders: projected financial statements for future periods and monthly historical financial statements. We hypothesize and provide evidence that: (1) loan contracts include these covenants in settings where they enhance lenders’ loan contract monitoring; (2) the covenants are positively associated with the frequency of loan contract amendments; and (3) lenders trade on the borrower private information they receive in secondary loan markets. We further show that the two types of covenants have predictably different determinants and effects.

We investigate how overlapping activities of bank regulators and supervisors and bank auditors influence banks’ internal control quality, auditor-client contracting (audit fees and audit effort), and financial statement reliability. Using material weaknesses in internal controls as a proxy for internal control quality, we find that banks exhibit fewer internal control problems than do nonbanks. Using audit fees, earnings announcement lags and audit report lags as alternative proxies for audit effort, we find that auditors expend less effort in audits of banks than in audits of nonbanks. Despite the lower audit effort, we find that banks report fewer and less severe restatements of prior period financial statements than do nonbanks, suggesting that the aggregate efforts of bank regulators/supervisors and bank auditors generate more reliable financial reporting by banks. A notable implication of our study is that bank regulation and supervision alter the auditor-client contracting equilibrium, with a notable benefit being an increase in banks’ financial reporting quality.

Accounting principles state that the net presentation of offsetting assets and liabilities on the balance sheet is improper unless the right of setoff exists. Derivatives dealers and their frequent counterparties engage in master netting agreements (MNAs) that provide a limited right of setoff that is insufficient (sufficient) for net presentation under IFRS (US GAAP). To remedy this presentation difference, as of 2013, IFRS and US GAAP require dealers to disclose the gross, reported, and net amounts of derivatives assets and liabilities that they present net or present gross but cover under enforceable MNAs. We first study real effects of these mandatory disclosures on dealers’ financial leverage. We posit that dealers prefer market participants to view their leverage as lower. Because the 2013 requirements provide new information for IFRS dealers but not for US GAAP dealers, we hypothesize and provide evidence that the requirements induce IFRS dealers to reduce their derivatives leverage by eliminating unnecessary offsetting derivatives and using MNAs more effectively. We then study the usefulness of the disclosures to market participants. Because the right of setoff provided by MNAs does not eliminate all significant risks of the covered derivatives, we hypothesize and provide evidence that dealers’ net derivatives leverage and disclosure quality under the 2013 requirements inform market participants about dealers’ credit risk uncertainty.

This is an Online Appendix to "Economic Consequences of the AOCI Filter Removal for Advanced Approaches Banks", available at: https://ssrn.com/abstract=3071942.

We obtain industry output volume changes from the Census Bureau for 338 six-digit NAICS code manufacturing industries and from the Centers for Medicare & Medicaid Services for skilled nursing facilities as an example of a service industry. Industry output volume changes have distinct and largely desirable features as a news proxy to measure the asymmetric timeliness of (the accrual components of) earnings to good and bad news documented by Basu (1997) and the ensuing literature. Industry output volume changes (1) are exogenous to individual firms’ economic and accounting choices, as well as minimally correlated with firm characteristics that prior research shows are associated with statistical biases in measures of asymmetric timeliness; (2) reflect both the public and the private firms in the industry; and (3) have relatively short-run implications for firm performance, so that accounting rules typically require firms to recognize these implications in operating accruals. We exploit these features to reassess the previously identified drivers of asymmetric timeliness. We find that the use of industry output volume changes as the news proxy (1) enables researchers to demonstrate conditional conservatism through the asymmetric timeliness of operating accruals but not of write-downs of long-lived assets; (2) helps distinguish the effects of curtailment and cost stickiness on asymmetric timeliness; and (3) largely eliminates statistical biases in estimates of asymmetric timeliness.

We examine whether and how measures of market and credit risk modeling identified from banks’ financial reports enhance the returns-relevance of their estimated annual unrealized fair value gains and losses for financial instruments. To capture differences in market liquidity and fair valuation difficulties across types of financial instruments, we distinguish unrealized gains and losses that are recorded in net income versus recorded in other comprehensive income versus calculable using financial statement note disclosures. We predict and generally find that banks’ market (credit) risk modeling enhances the returns-relevance of their unrealized fair value gains and losses, more so for less liquid instruments subject to greater market-risk-related (credit-risk-related) valuation difficulties and during periods for which market (credit) risk is higher. We obtain these findings both for banks’ unadjusted risk modeling measures and for the portions of these measures that we model as attributable to banks’ risk modeling activities, but not for the portions we model as attributable to banks’ disclosure of these activities.

We examine trade-offs that Prosper, a large online peer-to-peer lending platform, has made over time in its lending processes. Since its 2006 inception, Prosper has (1) changed the way it sets the interest rates on loans from auctions among peer lenders to pre-set pricing based on a proprietary credit-rating model in December 2010; (2) enabled institutional investors to fund whole rather than just fractional loans in April 2013; and (3) reduced the extent of soft information available to peer lenders in September 2013. In each of these changes, Prosper has traded off the aggregation of soft information by peer lenders for transaction processing efficiency, a trade-off similar to that made by large traditional banks. We provide the following evidence regarding the costs and benefits of this trade-off. On the cost side, after the December 2010 change the distribution of loan interest rates shrinks and the ability of interest rates to predict loan default deteriorates, particularly for loans to low credit quality borrowers for whom soft information is more important for credit screening. After the April 2013 change interest rates for low credit quality loans in the fractional loan market are more predictive of default than are interest rates in the whole loan market. On the benefit side, loan volume and funding speed rise sharply after each of these changes. Moreover, the costs appear manageable, as peer lenders’ ability to diversify increases and the weighted-average interest rate of a modest-size portfolio of Prosper loans remain just as predictive of default. Placebo and difference-in-differences tests using a peer-to-peer lender that did not change its lending processes during our sample period (Lending Club) indicates that these effects are attributable to the changes in Prosper’s processes.

Beck and Narayanamoorthy (this issue) argue and provide evidence that SEC pressure culminating in the issuance of SAB 102 in July 2001: (1) caused banks to record allowances for loan losses that were more associated with historical loan charge-offs and less associated with current non-accrual loans; (2) primarily affected large and strong banks; and (3) caused allowances for loan losses to be more (less) informative of future loan charge-offs for strong (weak) banks. We argue and provide evidence that the results the authors ascribe to SAB 102 are primarily explained by consumer loan charge-offs dominating banks’ loan charge-offs and, thus, allowances for loan losses in the post-SAB 102/pre-financial crisis period. This period coincided with a real estate and general macroeconomic boom in which other loan types experienced very low charge-offs.

We document a significant increase in firms’ revenue growth rate as they approach $100 million annual revenue. We identify substantial capital markets and other visibility benefits to firms achieving this goal, including discontinuous increases in analyst and media coverage and in transient and growth-focused institutional investment. We find no evidence of decreased investment efficiency or overall profitability. We find that firm CEOs benefit through higher bonuses, pay-for-performance sensitivity, and stock and stock option awards in the year after reaching the goal. We find that firms make acquisitions, expand their labor forces, and increase leasing of assets to reach $100 million revenue. Collectively, our results suggest that achieving $100 million revenue is a critical event in the trajectory of firm growth that enhances firms’ capital market receptions and information environments and sharpens CEOs’ incentives. These results constitute rare systematic firm-level evidence of upward-striving, and they suggest conditions under which setting challenging goals enables firms to achieve positive performance effects.

We investigate the impact of recurring fair value versus amortized cost measurement for accounting recognition purposes on the timeliness of insurers' other-than-temporary (OTT) impairments of non-agency residential mortgage-backed securities (NAMBS) around the 2007–2009 financial crisis. Unlike largely predetermined amortized cost measurement, recurring fair value measurement requires firms to invest in information and control systems to assess relevant economic conditions and estimate fair values quarterly. We expect these systems discipline insurers' OTT impairments. Exploiting statutory requirements that PC (life) insurers measure securities with NAIC designations from 3 to 5 at fair value (amortized cost) and disclose security-level accounting information, we predict and find that PC insurers record timelier OTT impairments of the same NAMBS with NAIC designations of 3 to 5 than life insurers. We predict and find weaker evidence of spillover effects to the timeliness of OTT impairments of the same NAMBS with NAIC designations of 1 or 2. JEL Classifications: G22; M41. Data Availability: Data are available from public sources cited in the text.

We examine economic consequences of U.S. bank regulators' phased removal of the prudential filter for accumulated other comprehensive income for advanced approaches banks beginning on January 1, 2014. The primary effect of the AOCI filter is to exclude unrealized gains and losses on available-for-sale securities from banks' regulatory capital. We predict and find that, to mitigate regulatory capital volatility resulting from the filter removal, advanced approaches banks increased the proportion of investment securities classified as held-to-maturity, thereby limiting their financing and interest rate risk management options, and they decreased securities risk, thereby reducing their interest rate spread. We further predict and find that these banks borrow more under securities repurchase agreements potentially collateralized by held-to-maturity securities and reduce loan supply owing to their reduced financing options, and that they increase loan risk to mitigate the decrease in their interest rate spread. JEL Classifications: G21; G28; M41; M48. Data Availability: Data are available from the public sources cited in the text.

The use of accounting measures and disclosures in banks’ contracts and regulation suggests that the quality of banks’ financial reporting is central to the efficacy of market discipline and non-market mechanisms in limiting banks’ development of debt and risk overhangs in economic good times and in mitigating the adverse consequences of those overhangs for the stability of the financial system in downturns. This essay examines how research on banks’ financial reporting, informed by the financial economics literature on banking, can generate insights about how to enhance the stability of the financial system. We begin with foundational discussion of how aspects of banks’ accounting and disclosures may affect stability. We then evaluate representative papers in the empirical literature on banks’ financial reporting and stability, pointing out the research design issues that empirical accounting researchers need to confront to develop well-specified tests able to generate reliably interpretable findings. To this end, we provide examples of settings amenable to addressing these issues. We conclude with considerations for accounting standard setters and financial system policymakers.

We examine the real effects of FAS 166 and FAS 167 on banks’ lending and loan sale decisions. Effective as of 2010, the two accounting standards tightened the accounting for securitizations and the consolidation of securitization entities, respectively, causing banks to consolidate $765 billion of assets and thereby increasing capital requirements for consolidating banks. We find that banks consolidating more assets more strongly reduce loan supply, as proxied by loan-level mortgage approval decisions, and more strongly increase loan sales, as proxied by loan-level mortgage sale decisions. These effects of consolidated securitization entities are significantly larger than those of the assets held by banks’ unconsolidated securitization entities, consistent with it being the consolidation of securitization entities rather than securitization per se that reduces banks’ loan supply and increases their loan sales. The evidence suggests that FAS 166/167 leads regulated banks to reduce their loan risk, in part by transferring that risk to the less regulated shadow banking system.

In the present study we investigated the use of a green macroalga Ulvella lens on a commercial scale to improve the settlement and early growth of Haliotis rubra larvae. Two conditioning methods were evaluated comparing plates covered with U. lens grown over 4 and 18 days. An average settlement rate of 62% was estimated 3 days after larval release. This rate is amongst the highest recorded in commercial nurseries, suggesting that this technique of conditioning the settlement plates was efficient and reliable. Larvae showed a clear preference for older plates with a lower cover of U. lens . Larvae were released at two densities (50,000 and 100,000 larvae per 1000 l tank representing approximately 0.25 and 0.5 larvae cm −2 of substrate, respectively) to investigate if larval density influences overall settlement rate and later performance. Larval release density did not have a significant effect on settlement rate. After settlement, plates were randomised and the food density was enhanced. Half of the tanks were inoculated with the cultured diatom Navicula sp. and the other half received a mix of naturally developing diatom species, to determine the effect on growth and survival over a period of 4 months. We demonstrated that the type of substrate on which the larvae settled, light (which affects the food density but may also affect the oxygen level in the boundary layer of the biofilm) and the density of post-larvae have very marked effects on growth. Survival was strongly density-dependent after 64 days and the instant mortality rate (M) decreased from 43.7 in the first 10 days to 5.4 between 22 and 64 days after settlement. These results provide crucial technical and ecological information on the early development of H. rubra in the nursery and suggest that the use of U. lens will provide substantial improvements in nursery performance.

Prior research finds that commercial borrowers provide lenders with private information, but generally does not identify the attributes of the information provided or the mechanisms by which it is provided, which has limited the insights generated as to how lenders obtain and use the information. To help fill this gap, in this paper we construct a novel database of covenants in 3,309 commercial loan contracts that require public borrowers to periodically provide lenders with three types of private information: (1) projected financial statements for future periods; (2) monthly financial statements; and (3) written communications received from auditors. We hypothesize and provide evidence that: (1) loan contracts are more likely to include these covenants when they enhance loan contract monitoring by lenders; (2) the covenants are positively associated with the frequency of loan contract amendments, a proxy for lenders' monitoring intensity; and (3) lenders trade on borrower private information, which may yield proprietary costs for borrowers.

We provide evidence that firms holding higher proportions of financial instruments measured at Level 2 and 3 fair values report more conditionally conservative comprehensive income attributable to fair value measurements, contrary to the widespread belief that fair value measurements are unbiased. Firms measure fair values using Level 2 or 3 inputs when instruments do not trade in liquid markets, limiting market discipline over the measurements. Our findings are consistent with the prediction that firms measure Level 2 and 3 fair values conditionally conservatively to mitigate investors’ discounting of the measurements. We further predict and find that this conditional conservatism (1) increases with governance mechanisms that increase the strength and persistence of firms’ incentives to report conservatively and (2) decreases with earnings management incentives. We conduct similar analysis on oil and gas firms’ measurements akin to the fair value of their reserves and obtain consistent results.

We provide evidence that the determinants of the primary loan loss indicators reported in financial reports — non-performing loans, the allowance and provision for loan losses, and net loan charge-offs — vary dramatically across real estate, commercial, and consumer loans, because these loan types differ in their homogeneity and collateralization and thus in the measurement of incurred losses under GAAP. Extending Wahlen (1994), we develop and estimate models of the non-discretionary and discretionary determinants of these loan loss indicators by loan type. The estimations indicate that banks’ exercise of discretion over provisions for loan losses is largely limited to heterogeneous commercial loans, a small slice of banks’ loan portfolios, and they provide many insights into the bank-specific and macroeconomic drivers of banks’ loan loss accruals. To demonstrate the increased statistical power and construct validity that results from conducting research on banks’ loan loss accruals by loan type, we show that this approach significantly improves the accuracy of out-of-sample predictions of future net loan charge-offs, more so for samples of banks whose loan portfolio composition varies more from that of the average bank. Our results illustrate the usefulness of disaggregated disclosures of loan loss indicators by loan type for future accounting research.

Securitizations are complex and opaque transactions. We hypothesize that bank insiders trade on private information about banks': (1) securitization-related recourse risks, (2) not-yet-reported current-quarter securitization income, and (3) securitization-based business model sustainability. We provide evidence that proxies for each of these types of insider information are positively associated with insider trading. Specifically, we find that net insider sales in the 2001Q2–2007Q2 pre-financial crisis quarters predict not-yet-reported non-performing securitized loans and securitization income for those quarters, and that net insider sales during 2006Q4 predict write-downs of securitization-related assets during the 2007Q3–2008Q4 crisis period. We find that net insider sales are more negatively associated with banks' subsequent stock returns in their securitization quarters than in other quarters. In supplemental analysis, we show that the above findings are driven by trades by banks' CEOs and CFOs, and that insiders avoid larger stock price losses through 10b5-1 plan sales than through non-plan sales. Data Availability: All data are available from public sources.

We hypothesize and provide evidence that accounting conservatism and accounting-based debt covenants increase implied recovery rates by preserving the firm’s fungible economic assets at levels sucient to support recovery by debtholders. We employ Das & Hanouna’s (2009) approach to jointly estimate implied default and recovery rates from CDS spreads, implied stock return volatilities, and stock prices. Controlling for known determinants of recovery rates documented in the prior literature, we predict and find that implied recovery rates increase with the combination of conservatism and covenants, and that these results are stronger for riskier firms, when conservatism is conditional rather than unconditional, for capital rather than performance covenants, when accounting information is less contractible, and for bonds rather than loans.

We identify two credit risk modeling (CRM) activities from disclosures in banks’ 1995-2009 financial reports: (1) statistical analysis of historical data on underwriting criteria, loan performance statuses, and relevant economic variables (MODEL); and (2) stress testing of credit losses to possible adverse future events (STRESS). We expect MODEL to discipline banks’ loan origination and loan loss provisions (LLPs) for homogeneous loans during stable economic times, but to be limited for heterogeneous loans and for all loans during sharp economic downturns, when STRESS is essential. We predict and find that banks engaging in MODEL exhibit timelier LLPs during stable economic times, particularly for homogeneous loans, and also late in the financial crisis after data on elevated credit losses had accumulated, but not early in the financial crisis. We further predict and find that these banks exhibit less procyclical loan originations, particularly for homogeneous loans. We predict and find that banks engaging in STRESS exhibit timelier LLPs for both homogeneous and heterogeneous loans during recessions, including early in the financial crisis. We further predict and find that these banks exhibit less procyclical loan originations for both loan types during recessions.

Using interstate branching deregulation across contiguous counties of adjacent states, we investigate the effect of entry threat on incumbent banks’ loan loss provisions. Incumbents exposed to threat have offsetting incentives to report provisions; lower provisions make incumbents’ loan underwriting quality appear better, deterring entry, but local economic conditions appear better, encouraging entry. We find that the incentive to increase apparent loan underwriting quality dominates on average. We further find that this incentive is stronger in counties with a higher proportion of heterogeneous loans, and the other incentive dominates in counties with both few heterogeneous loans and highly volatile economic conditions.

Prior research shows that firms' financial statement comparability improves the accuracy of market participants' valuation judgments and thus may reduce firms' costs of capital. Distinct from prior research focusing on the equity market, we develop measures of comparability relevant to debt market participants based on the within-industry variability of Moody's adjustments to reported accounting numbers for the purposes of credit rating. We examine two sets of adjustments: (1) to the interest coverage ratio and (2) for non-recurring income items. We validate these comparability measures by providing evidence that greater comparability is associated with lower frequency and magnitude of split ratings by credit rating agencies. We predict and find that greater comparability is associated with: (1) lower estimated bid-ask spreads for traded bonds, (2) lower credit spreads for both bonds and five-year credit default swaps, and (3) a steeper one- to five-year credit default swap term structure. Our results are consistent with financial statement comparability reducing debt market participants' uncertainty about and pricing of firms' credit risk.

Complementing prior literature that examines determinants of the sensitivity of returns to losses, we provide evidence that the sensitivity of returns to gains increases with firms’ real continuation call options, i.e., their discretionary ability to continue operations, to make new investments, and to raise capital when financing deficits arise. To ensure that our findings are incremental to those reported in prior literature, we estimate the sensitivity of returns to losses and gains using spline regressions for sequential partitions of the sample based on proxies for general optionality, liquidation likelihood, investment in real continuation call options, and financing of those investments. We find that the investment and financing of real continuation call options partitions primarily explain the sensitivity of returns to gains and that, despite their subordinated position in this sequence, these partitions have more explanatory power over the returns-earnings relation than do the general optionality and liquidation likelihood partitions. We conduct analyses that validate our measures of the sensitivity of returns to gains as capturing firms’ real continuation call options. Collectively, our results enhance our understanding of how optionality influences the returns-earnings relation.

We examine the determinants of the timing of and financial instruments involved in banks’ initial fair value option (“FVO”) elections upon their adoption of SFAS No. 159. We focus on regular (in 2008:Q1) adopters of the standard, and distinguish their FVO elections from those of early (in 2007:Q1) adopters. Song (2008), Henry (2009), and Guthrie, Irving, and Sokolowsky (2009) find that early adopters’ elections exploited SFAS No. 159’s transition guidance to manage their accounting numbers. These studies provide essentially no evidence that either early or regular adopters complied with the standard’s intent that FVO elections remedy accounting mismatches for economically offsetting positions. In contrast, we hypothesize and provide evidence that regular adopters complied with that intent, having learned from guidance the SEC and others provided about that intent and from the scrutiny early adopters’ FVO elections received. Specifically, we predict and find that variables related to accounting mismatches explain regular adopters’ FVO elections but not early adopters’ elections. We predict and find that variables related to the management of accounting and regulatory capital numbers explain early adopters’ FVO elections but not regular adopters’ elections. We also examine banks’ initial FVO elections for the three most frequently elected types of financial instruments: AFS securities and debt for early adopters and loans held for sale for regular adopters. We provide four distinct economic and accounting reasons why banks’ FVO initial elections for AFS securities and debt were both amenable to exploitation of SFAS No. 159’s transition guidance and likely to create accounting mismatches, whereas banks’ initial FVO elections for loans held for sale were both not amenable to exploitation of the standard’s transition guidance and likely to remedy accounting mismatches. Based on these reasons, we predict and find that regular adopters’ FVO elections for loans held for sale remedied accounting mismatches and did not exploit SFAS No. 159’s transition guidance. We predict and find the opposite for early adopters’ FVO elections for AFS securities and debt. Our findings are consistent with regular adopters’ FVO elections, particularly for loans held for sale, complying with SFAS No. 159’s intent. Our findings are broadly consistent with Henry’s (2009) evidence that some early adopters rescinded or revised their FVO elections because of informal mechanisms that arose to help firms interpret and implement SFAS No. 159.

We hypothesize and provide evidence that convexity in the returns-earnings relation results in significant part from firms' real continuation options, i.e., their discretionary ability to continue operations, to make new investments, and to raise capital when financing deficits arise. We estimate convexity using spline regressions for sequential partitions of the sample based on proxies for general optionality, liquidation likelihood, and continuation optionality. We develop four measures of convexity that capture the positive implications of earnings uncertainty from the perspective of equityholders. We predict and find that all four measures are significantly positively (negatively) associated with firms' future equity (debt) financings. These results suggest that our convexity measures have general usefulness for research in accounting and finance, which typically focuses on the negative implications of earnings uncertainty.

We examine the implications of the presence of risky debt-which embeds an economic written put option on the firm (Merton 1974)-and mixed-attribute accounting for assets versus debt-an accounting option exercisable by accounting standard setters and/or firms preparing financial statements-for the empirical identification of conditional conservatism as asymmetry. We first conduct analytical and simulation analyses to develop a rich set of testable hypotheses about the effects of these two options on asymmetry. We then conduct archival empirical analysis to show that researchers can control for the riskiness of debt using measures of economic leverage, equity return volatility, and debt credit ratings. In this analysis we control for a measure of the percentage of economic assets that are recognized for accounting purposes and so are potentially subject to conditional conservatism. We find that, after controlling for declines in economic leverage and the asset recognition percentage over time, the upward trend in asymmetry is stronger and more monotonic than is the upward trend in the asymmetry for the overall sample that Basu (1997) documents.

This essay describes implications of the subprime crisis for accounting. First, I overview the institutional and market aspects of subprime mortgages and other positions, focusing on those with the greatest relevance for accounting. I explain how the investment performance of subprime-mortgage-related positions has a binary quality that depends on subprime mortgagors' ability to obtain cash-out refinancing. I describe how the subprime crisis evolved in four waves that roped in more positions and affected those positions more severely over time. Second, I discuss the critical aspects of FAS 157's definition of fair value and guidance for fair value measurements. I explain the practical difficulties that have arisen in applying that definition and guidance to subprime positions in the current illiquid markets. I also raise a potential issue regarding the application of FAS 159's fair value option. Third, I discuss issues that have arisen regarding sale accounting for subprime mortgage securitizations under FAS 140 and consolidation of securitization entities under FIN 46(R) associated with foreclosures and modifications of mortgages. Fourth, I indicate ways that accounting academics can address the implications of the subprime crisis in their research and teaching.

We hypothesize and provide evidence that certain general characteristics of banks' loan securitizations accounted for as sales determine the extent to which banks retain the risks of the securitized loans. We show that banks retain more risk when: (1) the types of loans have higher and/or less externally verifiable credit risk (specifically, commercial loans more than consumer loans more than mortgages), so banks must retain larger contractual or noncontractual first-loss interests in the loans; (2) the loans are closed-ended and banks retain larger contractual interests in the loans; and (3) the loans are closed-ended and banks retain types of contractual interests that more strongly concentrate the risk of the securitized loans (specifically, credit-enhancing interest-only strips more than other subordinated asset-backed securities). We also show that the magnitude and type of retained contractual interests are not risk-relevant in revolving loan securitizations, because banks have more incentive and ability to provide implicit recourse, a noncontractual interest. We infer that banks retain more of the risk of their securitized loans when their total equity risk as measured by future stock return volatility is more positively associated with the off-balance sheet securitized loans and the on-balance sheet contractual retained interests in those loans, all else being equal.

We investigate whether the market prices the change in net trading assets as an operating or non-operating activity or some mixture of the two, and whether this market pricing is consistent with the (fundamental) association of the change in net trading assets with future cash flows from operations (CFO). Our investigation is motivated by the observation that - despite the classification of the cash flows on trading positions as operating under FAS 102 - trading is economically a hybrid operating/non-operating activity. Reflecting this hybrid nature, we hypothesize and find that the change in net trading assets has a less positive association with returns and future CFO than do the pure operating components of cash flows and accruals, and that it has a more positive association with returns and future CFO than do the pure non-operating components of cash flows. To the best of our knowledge, our paper is the first to propose and test hypotheses about the valuation implications of such hybrid cash flows and accruals.

The study derives a relationship between prices changes and earnings changes by expanding the information upon which earnings expectations are conditioned to include data other than prior earnings history. In particular, price is used as a surrogate for additional information available to market participants. This relationship provides an interpretation of the contemporaneous association between price changes and earnings changes previously observed by Ball and Brown (1968) and Beaver, Clarke and Wright (1979), among others. It also provides a basis for inferring from prices the earnings process and the expected future earnings as perceived by market participants. In doing so, it inverts the familiar price-earnings relationship and uses price as a predictor of earnings. The study differs from previous research which has examined the time series behavior of earnings based solely on previous earnings realizations. This approach can potentially lead to earnings forecasting models that are more accurate than the random walk with a drift that has been robust against challengers. In particular, the evidence indicates that security prices behave as if earnings are perceived to be dramatically different from a simple random walk process. Preliminary evidence also indicates that price-based forecasting models are more accurate than the random walk with a drift model.