Knowledge that Transforms

Most firms covary more positively with downmarkets than upmarkets—a phenomenon I refer to as “risk asymmetry.” I predict and find that risk asymmetry is caused, at least in part, by a firm's ability to selectively obfuscate poor performance. Risk asymmetry decreases significantly when firms are required to adhere to the more stringent auditing standards mandated under Section 404 of the Sarbanes‐Oxley Act, however this decrease is more muted for firms with weak internal controls. Consistent with my predictions, these patterns are stronger for more market‐sensitive firms and weaker for firms that include relative performance evaluation in their CEOs' pay packages. Taken together with prior literature (which documents that risk asymmetry is priced), my results suggest that a firm can lower its cost of capital by credibly reducing its ability to obfuscate value‐relevant information.

We document that stocks that have optimistic (pessimistic) consensus recommendations and are currently held by many short‐term institutions exhibit large stock‐return reversals: Their large past outperformance (underperformance) is followed by large negative (positive) future alphas. The predictable return reversals originate from overreaction to past recommendation releases and the correction of these overreactions around future releases. Results are stronger when earnings news is released and at firms with higher fundamental uncertainty. Further, firms with more short‐term institutions show stronger announcement returns and price drift after recommendation changes. Our results are consistent with models of higher order beliefs where short‐term institutions coordinate trading around public signals.

We examine the relation between disclosure quality and information asymmetry among market participants following an exogenous shock to macroeconomic risk. In 2015, the Swiss National Bank abruptly announced that it would abandon the longstanding minimum euro‐Swiss franc exchange rate. We find evidence suggesting that firms with more transparent disclosures regarding their foreign exchange risk exposure ex ante exhibit significantly lower information asymmetry ex post . The information gap in bid‐ask spreads appears within 30 minutes of the announcement and persists for two weeks, during which new information gradually substitutes for past disclosures. We validate the information dynamics of past risk disclosures with three field surveys: (1) Sell‐side analysts emphasize the importance of existing (risk) disclosures in evaluating the translational and transactional effects of the currency shock. (2) Lending banks’ credit officers rely on past disclosures as the primary information source available for smaller (unlisted) firms in the immediate aftermath of the shock. (3) Investor‐relations managers use existing financial filings as a key resource when communicating with external stakeholders. The results suggest that historical disclosures help investors attenuate information asymmetry in light of unexpected news.

Competition in audit markets is an important topic but direct tests of market competition have been limited. In this paper, we examine how audit firms behave when they are confronted with competition from another firm in a wide range of industry segments in a local market. Sharing a large number of market segments can lead to mutual forbearance among audit rivals. Such mutual forbearance is likely to manifest as higher audit fees in a market because rivals are hesitant to aggressively compete in the face of potential competitive retaliation. Using a sample of 25,662 observations from 2004 to 2015, we find evidence that supports this argument as proxied by the extent that audit firms compete in the same industries in the same locations. This result persists after controlling for several tight fixed‐effects specifications based on time, location, industry, and market segments. In supplementary tests, we also find that the likelihood of client switching is negatively associated with the multi‐industry contact of the incumbent, but clients that do switch are more likely to choose an alternative audit firm that confronts the predecessor auditor in fewer market segments. Our evidence is consistent with mutual forbearance among rival audit firms when confronted with the same competitor in different market segments.

This study provides descriptive evidence on how firms respond to activist short seller reports and how these responses are associated with outcomes for the targeted firms. We show that the frequency of these reports has grown substantially in recent years. Although we find that firms respond only 31% of the time, this rate increases substantially when the report is accompanied by significantly negative abnormal returns and when the report contains new evidence. Not responding is associated with a less negative stock price response at report release and fewer adverse outcomes. Firms that launch internal investigations following the report release have significantly higher subsequent rates of stock exchange delisting and SEC enforcement actions, and lower rates of being acquired. Overall, our results highlight the impact of activist short sellers on target firms and that firm responses are associated with material outcomes.

This paper evaluates the role of accrual accounting in improving firms' production decisions and resource allocation across firms. I introduce two imperfect firm‐performance measures, cash flows and accounting earnings, into a general equilibrium model with heterogeneous firms under imperfect information. The model demonstrates that improvements in measurement systems lead to more informed decisions on the part of firms and ultimately to allocation of greater resources to high‐productivity firms via the product and input markets. Estimated parameter values are consistent with accrual accounting improving managers' information about current productivity by providing a better measure of historical firm performance. Quantitative analysis suggests that introducing accrual‐accounting information on top of cash‐accounting information leads to a 0.5% increase in aggregate U.S. productivity and a 0.7% increase in aggregate U.S. output via improved resource allocation. The corresponding estimates for China and India, as benchmarks for developing countries, are larger: a 1.5% to 2.3% increase in aggregate productivity and a 2.3% to 3.4% increase in aggregate output. I conclude that accrual accounting plays a significant role in determining aggregate productivity via improved resource allocation.

This paper examines the impact of mandatory reporting and auditing of firms’ financial statements on industry‐wide resource allocation. Using threshold‐induced variation in the share of mandated firms in a given industry, I document that reporting mandates facilitate ownership dispersion in capital markets and spur competition in product markets. I, however, do not find that reporting mandates unambiguously improve the efficiency of industry‐wide resource allocation. With respect to auditing mandates, I find only that they impose a fixed cost on firms, deterring smaller entrants.

We use complaints filed with the Consumer Financial Protection Bureau (CFPB) to study the interplay between social norms and the effectiveness of consumer protection laws. We find that a higher level of trust in a given location is associated with a lower number of complaints filed against financial institutions in that location. Employing a difference‐in‐differences approach, we further find that, after the establishment of the CFPB, banks in low‐trust areas reduce fees charged to consumers more compared to banks in high‐trust areas. Our results suggest that the threat of consumer complaints to a government agency affects how banks treat their customers, and they shed light on the interaction between informal culture and formal institutions, as well as on stakeholders’ influence in corporate policies.

We examine whether firms that imitate peer companies’ strategies (copycats) profit from such behavior and how their success may cause competitive harm to disclosing companies. We identify copycat companies by tracking the digital footprints of investment companies that view disclosures on the SEC EDGAR Web site. We find that copycat companies are able to identify profitable trades that outperform other trades disclosed by the copycatted companies by 5.5% annually. Such stock‐screening skills are related to investment sophistication and research intensity. Furthermore, copycats inflict greater damage on the performance of disclosing companies when they possess superior copycat skills, when disclosed trading strategies take longer to complete, and when disclosed stock holdings are characterized by high information asymmetry.

Accounting for credit losses under U.S. GAAP is transitioning from an incurred to an expected loss model. The model change was motivated by concerns that reporting only incurred losses does not provide investors with sufficient and timely information about banks’ credit risk. In this paper, I develop a measure of lifetime expected credit losses using vintage analysis to examine whether stock prices reflect information about unrecognized expected credit losses in an incurred loss regime. Consistent with investors being able to obtain information about expected losses that are not recognized in the financial statements, I find that unrecognized expected credit losses are negatively associated with bank stock prices. The pricing of these losses is stronger for larger banks, consistent with lower costs of obtaining this information for banks with better information environments. I also find that recorded allowances were less than estimated expected losses, on average, consistent with concerns that implementing the expected loss model will adversely impact regulatory capital adequacy.