Eric Hirst, the John Arch White Professor of Business at The University of Texas at Austin’s McCombs School of Business, will be honored Aug. 9 with the Distinguished Contributions to Accounting Literature Award at the American Accounting Association’s (AAA) annual meeting in Denver.
Hirst, with co-author Patrick Hopkins of Indiana University, published a study in 1998 that demonstrated the format of financial statements issued by companies affects whether professional securities analysts detect companies’ earnings management activities. Earnings management is a common yet controversial accounting practice used by companies to produce a desired financial appearance by, for example, strategically timing gains or losses from sales of financial assets to produce rising earnings.
This study, which has been heavily cited in other research articles, helped inform an Accounting Standards Update [PDF] issued in June by the Financial Accounting Standards Board (FASB). According to a statement released by FASB in June, “The Update is intended to increase the prominence of other comprehensive income in financial statements.”
Since 1996 FASB, which sets financial reporting standards for U.S. companies, required that “other comprehensive income” be disclosed in company financial statements. But the rule-makers were less specific about where in the statements this information had to be reported.
The information reported as “other comprehensive income” is typically more volatile than the “net income” reported on a company’s financial statement. Pension assets and liabilities, derivatives, marketable securities and other assets and liabilities are among the items that may change in value day to day and can’t be pinned down until they are sold, at which point they are included on the income statement. The strategic timing of these sales, which may affect a company’s net income for the statement period, is known as managing earnings.
Hirst and Hopkins, a former University of Texas Ph.D. student, enlisted 96 securities analysts to evaluate six sets of fictional financial statements. In some the comprehensive income was prominently displayed in a performance statement; in others, it was buried in a less prominent statement. In yet others, it was not displayed at all. A second variable in their study had to do with managing earnings: one company was managing earnings, the other was not.
“The information that tells you, ‘this is smoke and mirrors,’ is not in an obvious place, and these securities analysts — who, this is what they do for a living — get fooled,” Hirst said. When that same information was more clearly displayed on the performance statement, the analysts quickly realized, “those earnings per share are going up because they’re timing the sale of those securities.”
“We heard from investors there was a need to present other comprehensive income information more prominently in financial statements,” said Leslie F. Seidman, chairwoman of the FASB, in a statement that accompanied the rule change in June. The Update eliminated the option for companies to report comprehensive income in the statement of changes in equity.
“It’s kind of fun to know that you did some work, it was interesting work, it was fun to do and then ultimately someone outside of academe read it, not just your peers,” Hirst said. “It’s an example of how the knowledge we create through our research slowly but surely impacts practice. Patrick and I can demonstrate a direct link between our work and the changes the FASB instituted — changes that affect every company that follows U.S. GAAP [generally accepted accounting principles].”
Instituted in 2010, the Distinguished Contributions to Accounting Literature Award recognizes research of exceptional merit published within the last five to 15 years. The AAA previously awarded Hirst with the Notable Contributions to Auditing Literature Award in 2001 and the Best Financial Reporting Paper Award in 1999.
Hirst has taught accounting at McCombs since 1991 and serves as associate dean for graduate programs. His research interests include financial accounting, decision theory and financial statement analysis.
