Knowledge that Transforms

This paper studies how the accuracy of a short‐term performance measure affects its value when a principal decides whether to retain or fire an agent, who can manipulate that measure. Compared with ignoring performance and never firing the agent, the performance measure is valuable when the savings in the expected cost of the retention error is more than the expected cost of the firing error. A more accurate performance measure can have a non‐monotonic effect on its value: Greater accuracy improves the principal's ability to correctly identify the agent, which increases efficient firing, but it causes the incompetent agent to increase manipulation to avoid being fired, which increases inefficient retention. With a less accurate performance measure, the incompetent agent has weaker incentives for manipulation, and an increase in accuracy increases its value due to the identification effect. With a more accurate performance measure, the manipulation effect dominates, and an increase in accuracy decreases its value. The results imply that the principal prefers an imperfect performance measure when the agent can choose the level of manipulation.

Using online job postings data, we explore whether auditors adjust their human capital in response to clients' cyber breach incidents. We find that audit offices increase their demand for cybersecurity specialists after their clients' cyber breaches, implying that cyber breaches change not only client risk but also their auditor's production function. Consistent with expectations, we document that this impact is larger when breaches involve their own clients (rather than those of peer offices within the same audit firm) and when breaches directly involve financial information. Our evidence holds for both cyber‐focused and non‐cyber‐focused offices, highlighting the broad impact of cybersecurity risks on audit practices. Additionally, we find that audit offices with relatively high investment in cybersecurity human capital are better able to preserve their market share among clients in high‐cyber‐risk industries after a client's cyber breach.

Litigation risk is an important source of motivation for auditors to conduct high‐quality audits, but theory suggests that certain lawsuits will have a more salient disciplining effect on auditor behavior. To this end, we identify lawsuits naming an individual partner as a co‐defendant along with the audit firm. We then examine how these lawsuits affect subsequent behavior of other auditors in the office of the sued partner. Relative to lawsuits naming only the firm, our results indicate that lawsuits naming individual partners as co‐defendants are significant office‐level events that motivate a meaningful response from non‐sued audit partners in the form of higher quality and fees on existing clients and more careful client portfolio management. These results have practical implications about how auditor litigation incentivizes individual auditors to fulfill their professional duties. For regulators and audit firms seeking to promote audit quality, these findings highlight the disciplining effect of auditors' concern for their personal reputation and litigation exposure. Furthermore, audit committees, clients, and investors may observe elevated audit quality, effort, and fees following partner‐level litigation in the local office.

Prior research criticizes PCAOB inspection reports for focusing solely on audit deficiencies, arguing that this encourages auditors to pursue traditional procedures to demonstrate compliance with standards rather than procedures that maximize audit quality. We contribute to this debate by examining whether the PCAOB's approach discourages auditors from considering innovative audit procedures (that are potentially more effective), since they are, by definition, less standard. We compare the PCAOB's current inspection approach (which focuses on reporting audit deficiencies) to a balanced inspection approach that discloses examples of audit strengths as well as deficiencies discovered during inspections. We predict and find that when the risk of material misstatement (RMM) is moderate, a balanced inspection approach leads auditors to consider the potential effectiveness of innovative audit procedures to a greater extent, ultimately prioritizing more of them in audit plans. Our findings contribute to both research and practice by enhancing our understanding of ways to encourage audit innovation and ultimately improve overall audit quality.

When managers revise earnings guidance between earnings announcements, they choose not only what to disclose but also where to disclose—in a standalone release, a guidance call, an investor conference, or an analyst/investor (A/I) day. These venues differ in audience, format, and visibility, raising the question of whether venue choice is a strategic communication decision. In a large sample of unbundled revisions, we find that managers use calls for relatively large negative revisions and when litigation risk is higher and that they use conferences and A/I days for smaller revisions and when analyst disagreement is greater. Textual analysis reveals that calls feature cautious, litigious language for both upward and downward revisions, whereas conference and A/I day communications remain optimistic. In line with these framing differences, calls are associated with amplified reaction to negative news and are followed by more favorable earnings surprises, suggestive of effective expectation management, whereas conferences and A/I days are associated with muted reactions and reduced analyst dispersion and are followed by less favorable surprises. Our findings suggest that venue choice is a dimension of disclosure strategy for managers and an informative signal for investors.

Audits of complex fair value estimates involve evaluating and challenging key client assumptions. Auditors generally lack the necessary expertise to perform this work, and thus, they often engage valuation specialists to perform this audit work. However, valuation specialists primarily perform advisory work and may not put enough care into their audit work. We examine whether valuation specialists' psychological ownership of audit work and auditors' infringement on that work affect specialists' judgment quality. Using a survey and an experiment with practicing valuation specialists, we find that higher psychological ownership improves specialists' evidence evaluation and judgments, but only when auditors do not behave intrusively by infringing on their work. When auditors behave intrusively, the benefits of specialists' higher psychological ownership disappear. Our findings show that audit quality depends not only on specialist behavior but also on auditor interactions with specialists. Our study offers practical guidance to audit firms on how to organize audit work and manage internal working relationships between auditors and valuation specialists.

As firms increasingly rely on collaborative innovation to develop new technologies, they face a growing tension between signaling their technological capabilities and protecting sensitive information. This tension is especially important in co‐patenting settings, where firms jointly develop innovations and operate in a more interconnected information environment. We examine how firms' narrative R&D disclosures are associated with collaborative innovation, measured by firm‐level co‐patents (i.e., patents jointly owned by multiple entities). Using data for US public firms from 1996 to 2017, we find that firms with more co‐patents tend to disclose less R&D information in 10‐K filings, consistent with heightened proprietary cost and negative externality concerns. This negative relationship is stronger with greater competition, weaker intellectual property protection, a greater number of partners, or repeated collaborations with the same partners. However, the relation between co‐patenting and R&D disclosures becomes positive when firms collaborate with universities, consistent with signaling incentives. We also find that firms are more likely to highlight collaborations in their 10‐Ks when forming new partnerships, working with universities or public firms, or leveraging partners' complementary assets. Overall, our results suggest that firms' R&D disclosure choices are influenced not only by their own proprietary concerns but also by partner‐related disclosure externalities and signaling incentives. Our findings highlight the importance of considering collaborative innovation arrangements when interpreting firms' R&D disclosures. They also suggest that managers should tailor R&D disclosure strategies to the characteristics of their collaborations.

We investigate the development of professional skepticism prior to entering the accounting profession and consider opportunities for enhancing it through university instruction. In two longitudinal studies of 857 participants, we track performance over several years. Students with higher levels of trait skepticism perform better in accounting and auditing courses and score higher on their first attempt at the Certified Public Accountant (CPA) exam. However, students with lower trait skepticism demonstrate strong perseverance and ultimately pass the exam at similar rates. Audit instruction affects students differently: Those with the lowest initial skepticism show significant increases, while those with the highest initial levels show significant decreases. Trait skepticism is positively associated with initial risk judgments, but audit instruction reduces these differences by increasing risk perceptions across all students. Trait skepticism does not influence self‐selection into the accounting major. However, women with higher trait skepticism are more likely than men to choose auditing careers. In sum, these findings suggest that audit firms and educators should use trait skepticism assessments as an important developmental tool to identify promising candidates, diagnose training needs, and tailor support for those with lower initial levels of the trait.

We develop a method for estimating the private value of knowing the future realization of some financial statistics, and then we apply the measure to the familiar ratios from the DuPont decomposition of return on equity. The estimation is grounded in the standard rational expectations model, adapted to accommodate relative risk aversion, and determines an investor's willingness to pay for information denominated in units of a riskless asset (e.g., money). The method can accommodate different levels of investable wealth, multiple assets, and any information system regarding those assets. We use this method to document several interesting contrasts. An investor with $1 million in wealth who already knows all the current DuPont ratios, as well as the most recent analyst forecast, would be willing to pay $2861 to know all of next year's ratios. This amount increases to $3158 for firms below the median size. We find that the value of financial information is higher in periods of high sentiment and for firms that are hard to value or hard to arbitrage (i.e., firms with high sentiment exposure). In practical terms, this suggests investors prioritize their information search to small, young, loss‐making, high‐growth, low book‐to‐market, non‐dividend‐paying, and illiquid firms. In terms of the DuPont components, we find that knowing next year's operating profit margin alone is worth $1226, whereas knowing next year's leverage is worth only $170 and knowing next year's sales growth is worth only $184. In practical terms, this suggests that investors allocate more attention to forecasting profitability and less attention to forecasting sales growth. Finally, we demonstrate that the estimated value of financial statistics increases substantially when we assume the investor can trade in the firm asset and can also hedge using an industry exchange‐traded fund (ETF). This result suggests that professional investors integrate their information search with their hedging behavior.

Financial accounting standard setters recently changed the accounting for estimates involving credit risk. The change shifted the accounting from an incurred‐loss model (ILM), which is based on credit‐risk conditions that exist at the time of the estimate, to a model based on expected credit losses over the life of the asset in question (ELM), which considers expectations of future conditions. Our paper is based on the theoretical premise that ELM will reduce surprise via its Day 1 forewarning, which, in turn, should lessen the potential for hindsight bias (i.e., Monday‐morning quarterbacking) and judging management as having made a poor quality lending decision if an actual credit loss later occurs. Three experiments support this premise, revealing when ELM accounting should have a differential impact relative to the prior accounting.