University of Arkansas

Walton College

The Sam M. Walton College of Business

Episode 56: Kris Allee Discusses How New Innovations Impact Generally Accepted Accounting Principles

January 29, 2020  |  By Matt Waller

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Kris Allee is an Associate Professor & Doyle Z. Williams Chair in Professional Accounting at the Sam M. Walton College of Business. After receiving his Master of Accountancy from BYU, Kris received his Ph.D. in Accounting from Indiana University. Kris specializes in Firm Disclosure Policies, Financial Statement Analysis and Valuation, Banking, and Taxation. His research has been published in many accounting journals.

Episode Transcript

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00:08 Matt Waller: Hi, I'm Matt Waller, Dean of the Sam M. Walton College of Business. Welcome to Be EPIC, the podcast where we explore excellence, professionalism, innovation, and collegiality and what those values mean in business, education, and your life today.

00:27 Matt Waller: I have with me today Kristian Allee, he is an Associate Professor in the department of accounting, and he holds the Doyle Z. Williams Chair in Professional Accounting. The Walton College has four primary values: One is excellence, the other is professionalism, innovation, and collegiality. And today, I've asked Kris to talk to me a bit about the I of innovation. And, yes, there's lots of innovation in accounting, and he has lots of expertise in accounting disclosures and financial statement analysis and valuations. So Kris, thank you so much for taking time to visit with me about your research, I appreciate it.

01:20 Kristian Allee: Thanks for having me on, Matt.

01:21 Matt Waller: Kris you have been a very prolific author and researcher and you have an article coming out in Management Science, which is a very hard journal to hit. Congratulations.

01:34 Kristian Allee: Thank you. It was tough to get it in there.

01:36 Matt Waller: When did you, when were you notified of that.

01:39 Kristian Allee: Pretty recently. I guess about a couple of months ago. We just did the final proofs of the paper, which feels pretty good.

01:45 Matt Waller: But you have a lot of other articles that have been published in top accounting journals, and I noticed you also have a lot of working papers, you're working on a lot of things simultaneously. But what are some of your favorite research papers or maybe some research you've done that has been really interesting and you think might be good to share?

02:09 Kristian Allee: I think talking about the voluntary disclosure space that we were referencing before, I really like doing research in conference calls, particularly right now, because for years as accountants, we focused on the numbers. We focused on, "Okay, what were earnings. What's the asset balance?" Those sorts of things. But today, we're much more focused on the context of the earnings and how managers describe it. And so I do some research in textual analysis where we look at a conference call and we say, "Okay, managers can describe their performance in certain ways. How are they describing it in terms of the tone of their performance? How are they describing it in terms of the uncertainty associated with their future performance? How are they looking at this space, which is the voluntary disclosure of earnings conference calls? And how are they managing the calls to structure their narrative such that the market might have one perception of their performance or another perception of their performance?" And I really, really enjoy doing research in that area. Another one of my papers, recently published in the Journal of Accounting Research that you referenced, was a paper called Disclosure Scriptability where we know that about two-thirds of all trades today on the stock market happen because of algorithms.

03:36 Kristian Allee: It's basically computers making trades not some trader, an individual making a trade on the market. And so, our research looked into how robots or how computers might analyze accounting financial reports, specifically how readable they are. And so if you look at an accounting report as a human, it's pretty easy for us to deal with some of the intricacies of a annual report: The different sections, the different headings, the different places for footnotes, and those sorts of things. But it's not as easy for a computer to process all of those bits and those elements, and to specifically find the element that they are interested in or looking for. And so if I, as a manager, for example, decide to make my disclosure more scriptable, I make it more programmable such that a computer can find my pro form or earnings number, which is the one number I want to emphasize as opposed to a gap number, for example. Is that a way that I can influence the market and the pricing of my stock? And so we look at the disclosure scriptability of annual reports, which, again, is mandated. There's much less voluntary disclosure that goes into an annual report, but also at things like their 8-ks, their announcements and see, "Okay, well, let's look at how easily a computer can access this report and maybe pull pieces of information in that report to trade on without the interference of a human having to mess with the process."

05:11 Matt Waller: I know you've done some research on financial reporting practices of small privately held businesses. And what were some of your findings there?

05:21 Kristian Allee: Our main finding was that small businesses don't do accounting as much as we would really like them to. When we teach accounting here at the Walton College, we talk about how important it is that all of our students, every student has to take it, because Accounting is a very important discipline. We call it the "language of business". It's a way to communicate performance, position, and risk of a business. And so you'd think that every business out there in the world would want to understand its performance, its position, and its risk. But what we ended up finding is that a lot of managers use their tax reports, for example, as their primary means of understanding their performance. Which anybody who's ever filled out a tax return knows that that's not a great way to view your company holistically in terms of performance. And so we found that few companies, private companies where the SEC or somebody didn't mandate them to do it, very few companies did it voluntarily. But for those that did, we found something quite important. That if you chose to have financial statements, if you had financial statements, that you had greater access to capital and you had a lower cost of that capital, especially based on how, I guess, I'd say detailed your financial statements were. The higher your financial reporting quality, I guess, the better job you did with your financial statements, the greater access you had to capital and the lower cost of that capital.

06:49 Matt Waller: Now that is an interesting finding, and it seems like a finding that would be good for companies to know about.

07:00 Kristian Allee: I would think so. I certainly wish all companies understood that when you go to a bank and you have a nice set of financial statements, in other words, you have a fair representation of your performance, your position and the risks of your business. The bank is far more likely to look at you and say, "Yeah, here's some capital." Certainly, if you go to any equity market any, even the Shark Tanks of the world, if you go and you try to get access to capital that way and you say, "Okay, here's how we've been doing. Here's our forecasts of the future, how we expect to do." That business plan would be far more successfully... That business plan would be far more successful if it's more detailed, if it has more information in it especially information that is value relevant.

07:50 Matt Waller: So tell me a little bit about what are accounting disclosures?

07:55 Kristian Allee: Yeah. So generally speaking, when we think about accounting disclosures we think about disclosures that are either mandated by some regulatory body or voluntary disclosures undertaken by management voluntarily. And so the best examples of accounting disclosures would be an annual report that a company would produce. So for years we as accountants focused on those disclosures and we did a lot of research. Recently we've also began to focus on companies voluntary disclosures, where companies can issue, for example, guidance for the next quarter or the next year. Companies will often issue something we call pro-forma earnings, which are earnings that management creates for themselves, as opposed to following the generally accepted accounting principles that are given to us by the Financial Accounting Standards Board, the FASB. And so recently we've begun to look at those in addition to the mandated disclosures required if you're a public company, for example, by the SEC.

09:03 Matt Waller: Suppose your company, a given company, like let's say JB Hunt for example, JB Hunt Transport Inc. How would they go about deciding what to voluntarily disclose and how would they do that?

09:19 Kristian Allee: So JB Hunt, obviously would, because they are a publicly traded company would have to issue the mandated disclosures. And so they'd have to give an annual report, they'd have to have quarterly financial statements, the SEC would make them issue 8-Ks which is kind of an announcement that they have news and they'd have to do those things. That's what they'd have to do now. JB Hunt would also sit there and say, "Okay, we could issue a text report, submit it to the EDGAR website." Which is the site where the SEC houses all these type of mandated disclosures. And investors and regulators could read those things absent our ability to kind of manage the message. Or alternatively, we could hold a conference call. And so we could then get up and we could explain to the world the market, the investors, the regulators, the competitors, everybody. How we at JB Hunt see the landscape of our business, our performance, our prior performances, as well as our future performance.

10:23 Kristian Allee: And with that JB Hunt could decide, do we feel that generally accepted accounting principles correctly describes our performance or do we need to do a pro-forma earning statement where, "Hey, we're going to come up with our own earnings number, eliminate some items that we don't think gap fairly presents and report that number." Those are all decisions that JB Hunt has to sit there with respect to their disclosures and say, "Okay, how are we gonna manage this game? That is the way that we describe our company to the world."

10:57 Matt Waller: That sounds so interesting because I would think there would be a lot of competing priorities there.

11:03 Kristian Allee: Absolutely. As you might imagine, the market wants future guidance, the market wants us to tell us what they expect to perform. We know that JB Hunt is going to issue their quarterly and annual earnings. So the only difference here is timing. When does the market understand what JB Hunt has earned or at least what it expects to earn. And so I do some research where we look for example at the effects of competition on voluntary disclosures. And you could imagine giving your competitors information about your future profits or your current profit margins in certain segments. And those things you could voluntary disclose could affect a lot of things. The financial markets would love it, you probably would get a lower cost of capital because of all that disclosure. But alternatively, you could cost yourself in terms of future business, future profitability and...

11:58 Matt Waller: Because if I've got five segments, five different segments of my business and one of them starts having really high margins and I disclose that, then my competitors are gonna think, even non-competitors, everyone's gonna think, "How do we get into that?" So as a company you would feel like, "Well, I don't know if I want to disclose that." And then as an investor, I might look and think that company isn't very smart about how they disclose things because now I know competitor X, Y, Z is gonna want to get right into that. Does that go on at all?

12:39 Kristian Allee: Absolutely, yeah. So I have a paper that's forthcoming now where we show that one of the consequences of being a public company is it appears that you have lower profitability. You might be familiar with Elon Musk and all his comments relating to, "Okay, I'm gonna take Tesla private. And managing Tesla as a public company is a nightmare because I have these quarterly benchmarks that I have to make and the pressure from the market is too intense." And so we have a paper that shows that public companies on average, holistically are less profitable than their private counterparts. And some of that evidence suggests that it's because of this competition problem. If you go and ask a bunch of private companies, big private companies that are some of America's most profitable and amazing companies, "Why aren't you a private... " Excuse me why, if you go and ask some of America's largest private companies, why are you not a public firm?" They'll respond and say, "Partly because of this quarterly, pernicious earnings pressure and partly because of the disclosures that are mandated by the SEC, which we don't want any part of. We don't want to have to disclose the profitability of our different segments to the public. We want to be able to manage as a private company because it allows us to have competitive advantages relative to our public counterparts.

14:07 Matt Waller: So there's, I don't remember the statistics exactly, but the number of firms that are publicly traded versus year 2000, so about 20 years ago, has gone down dramatically. Do you think this is partly the reason?

14:26 Kristian Allee: I think it's part of it, certainly. 2000, we had a bit of a bubble because of the tech stocks and what have you, but it does appear that today, to thrive in business you don't necessarily need to be a publicly traded company. Part of that is because of this wonderful way that we can raise capital now, the Shark Tanks of the world, where people will give you and me $20,000 for start-up funds, right? But I do believe that because the world has become increasingly innovative because the value of most companies today is intellectual property not necessarily physical property. And so it is certainly when you have intellectual property rights or something that somebody could take from you, it certainly is in your best interest to be careful at what you disclose and how much you disclose.

15:15 Matt Waller: Kris, you've done some research on how monitoring and verification of accounting-based performance benchmarks influenced design and efficiency of mergers and acquisitions.

15:28 Kristian Allee: Yes, yeah, so this is a paper that was pretty recently published in the review of accounting studies. And in this study what we do is we look at a fun thing called an earn-out. So let's say I have a business and you want to buy it. You probably have a price in mind for my business which is probably lower than my price, [chuckle] that I have in my mind for my business. And ultimately, the difference between the prices is likely due to expectations for the future. And so what will often happen about 10-15% of the time, is you offer me a price that is your price and then offer me an opportunity to earn out the rest of the value that I think is in my business. And what's been interesting is relatively recently, the Financial Accounting Standards Board, the FASB, changed the rules in how to account for these earn-outs. And so what we found in this paper is that mechanisms, such as auditing, is likely to increase the efficiency of the use of these contracts such that they'll be used more, more frequently, and that the outcomes will actually be somewhat better if they're monitored.

16:37 Matt Waller: That reminds me of some of the older research in principal-agent theory. In principal-agent theory, the principal can't monitor perfectly the agent's performance and effort. And so they're really looking at an outcome from a probability distribution because the agent can if they put in lots of effort, they can increase the probability of favorable outcomes but it's still probabilistic.

17:14 Kristian Allee: That's a perfect description. Yeah, absolutely. The problem with these earn-outs is after you buy my company, I don't get to run it anymore. And so you have every incentive to run the company such that, of course, it's profitable for you, of course, that's what you want, but that you don't make the benchmarks where you have to pay me millions of dollars. And so the idea here, the whole crux of the paper says that if you, the purchaser have a highly reputable accounting company as an auditor because of these accounting changes that have been made that auditor is gonna be looking into that contract and making sure that if you owe that payment, if you have that liability, that you're gonna make that payment. And so the idea behind it is that auditor is gonna help me as a target. The purchaser's auditor is gonna help me as a target because I can trust that when you have the performance that we've agreed upon that will result in me getting cash flows, I'll actually get it.

18:14 Matt Waller: So Kris, we've been talking about the research you've done on voluntary disclosures, but you've also done research on mandatory disclosures. What are some innovative things there that you'd like to share with us?

18:28 Kristian Allee: Probably the most innovative project that I have right now is a project where we look at electricity usage of companies to try to examine whether or not those companies are being fraudulent in their financial reporting. So you know that companies have incentives to try and make themselves look better than they actually are. And in the past research has tried to examine under what circumstances can you identify companies that are fraudulently reporting because it's very costly to invest your money in a company that is a fraud and for that fraud to be revealed and for you to lose your capital. And so one of my current projects, we have data from KEPCO, which is the Korean electricity producer. And they were kind enough to give us all of their data for the entire country. So unlike the United States, Korea being a relatively small geographical area, has only one electricity provider for the entire country. And so they gave us basically all of their data. We matched that data to the public and private companies that we have data on in the databases of financial information.

19:38 Kristian Allee: So what we do in Korea, which is largely a manufacturing country, their primary industry is manufacturing, we look at a company's growth in sales, and we compare that to their growth in electricity usage. And when a company has an extraordinarily large growth in sales without an accompanying large growth in electricity usage, that's suspect. And so, we do seem to find some evidence that these other metrics, metrics that were not currently required as mandated disclosures, but potentially we could. The SEC could say, "Hey, in addition to reporting your sales and your growth and all those sorts of things, report this." This is kind of invoked today also because electricity usage is largely related to corporate social responsibility and how green the company is. And so you not only get the benefit of looking at how good is this company doing with respect to its responsibility to the Earth, but also could have positive externalities in terms of, "Can we identify whether or not the company is fairly presenting its performance relative to its growth?

20:47 Matt Waller: That is a clever way to do this study. Has that been published yet?

20:52 Kristian Allee: It is currently a revise and resubmit at one of our top journals. The impetus from the project comes from an article that was published about China's GDP growth. So China famously several years ago was touting huge growth and some really smart economist said, "It's interesting. China is mainly, largely a manufacturing economy and it's saying it has all this growth, but its electricity growth hasn't increased that much." And so, they did some investigating and sure enough China had to walk back their estimates of growth because they were falsely presenting their GDP growth, and electricity usage was the mechanism that this economist found. And so clearly we found that study, we found it interesting, and we thought, "Wow, this could really be used in an accounting context."

21:45 Matt Waller: Thanks for listening to today's episode of the Be EPIC podcast from the Walton College. You can find us on Google, SoundCloud, iTunes, or look for us wherever you find your podcast. Be sure to subscribe and rate us. You can find current and past episodes by searching BeEPIC podcast, one word, that's B-E-E-P-I-C podcast. And now, be epic.

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Matt WallerMatthew A. Waller is the dean of the Sam M. Walton College of Business, Sam M. Walton Leadership Chair and professor of supply chain management. He is also the host for the Be EPIC Podcast for Walton College.

 

Walton College's EPIC values -- Excellence, Professionalism, Innovation and Collegiality -- are the heart of Dean Waller’s podcast. Since the beginning of the series, Waller has interviewed business professionals, industry experts, CEOs and Walton College students to bring listeners first-hand accounts directly from the entrepreneurial world.

 

Waller is an SEC Academic Leadership Fellow and coauthor of “The Definitive Guide to Inventory Management: Principles and Strategies for the Efficient Flow of Inventory across the Supply Chain,” published by Pearson Education. He is the former co-editor-in-chief of Journal of Business Logistics. His opinion pieces have appeared in Wall Street Journal Asia and Financial Times.

 

Waller received an M.S. and Ph.D. from Pennsylvania State University and a B.S.B.A., summa cum laude, from the University of Missouri.





Walton College

Walton College of Business

Since its founding at the University of Arkansas in 1926, the Sam M. Walton College of Business has grown to become the state's premier college of business – as well as a nationally competitive business school. Learn more...

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