Knowledge that Transforms

ABSTRACT In‐house human capital tax investment is a significant input to a firm's tax decisions. Yet, due to the lack of data on corporate in‐house tax departments, there is little empirical evidence on how tax departments are associated with tax planning and compliance outcomes. We expect the size of tax departments to be positively associated with the effectiveness of tax planning and compliance. Using hand‐collected data on the number of corporate tax employees in S&P 1500 firms over the 2009–2014 period, we find that firms with larger tax departments are associated with lower and less volatile cash effective tax rates. Furthermore, using tax employees' specialization, we identify tax departments' relative focus on planning or compliance and document a trade‐off between tax avoidance and tax risk. Specifically, tax departments with more of a tax planning focus have incrementally greater tax avoidance but higher tax risk, whereas tax departments with more of a tax compliance focus have incrementally lower tax risk but higher tax rates. Overall, this paper contributes to the literature by looking inside the “black box” of corporate tax departments and shedding light on the importance of human capital tax investment for tax outcomes.

ABSTRACT This study uses experimental economic markets to investigate the impact of risk and the potential for loss on managers' demand for audit quality. We posit that these two important contextual factors influence managers' audit quality preferences. We study these factors because they are ubiquitous to companies, and we focus on their influence on managers because managers continue to play a significant role in the auditor hiring process and we know relatively little about their auditor preferences. We predict that risk, the potential for loss, and their interaction will each decrease manager demand for high audit quality due to a desire to achieve greater reporting flexibility. Experimental results are consistent with our predictions; specifically, increased risk, the potential for loss, and to a lesser extent their interaction, significantly reduce managers' likelihood of hiring the best available auditor in the market. Path analysis indicates that this reduction in audit quality demand leads to increases in misreporting. Finally, we observe investors overpaying for assets to a greater extent when managers hire lower‐quality auditors. Our results show that the contextual factors of risk and the potential for loss, which are ubiquitous to companies, can reduce demand for audit quality, which can increase misreporting behavior and ultimately harm investors.

ABSTRACT We examine the relation between low‐quality internal controls and audit fee premiums. Using a novel data set of audit hours and audit fees we find, consistent with the audit risk model, that auditors increase their effort (hours) owing to low internal control quality. We find that auditors also charge a significant fee premium to clients with internal control weaknesses. This premium is observed for severe internal control weaknesses and companies with low‐quality alternative governance mechanisms. The results are robust to multiple methods to address endogeneity, including company fixed effects, difference‐in‐differences design, and a propensity score‐matched sample. Taken as a whole, low internal control quality leads to fee premiums, which are a deadweight loss to client companies.

ABSTRACT This study investigates why auditors leave public accounting and the consequences of auditor departures, both of which have been of great concern for audit firms and regulators worldwide. Using data from China and controlling for demographics, we find that audit partners and managers, auditors who generate more revenue, and auditors who provide higher audit quality have a lower likelihood of departure, while non–Big 4 auditors have a higher likelihood of departing public accounting. We also find that an audit firm is likely to lose clients when an auditor departs. Clients who stay with the same firm pay lower audit fees but with no drop‐off in audit quality after a signing auditor departs. In supplementary analyses, we also demonstrate that the determinants and consequences of auditor departures are different for auditors who leave the firm but not the profession (i.e., auditor turnover). Specifically, high audit quality is associated with a lower likelihood of auditor departure, but it increases auditor turnover. We also observe that audit quality is reduced for the clients who stay with an audit firm after highly skilled auditors depart for high‐visibility corporate positions. Our study provides insights that should be of interest to the audit profession, audit firms, and regulators.

ABSTRACT Staggered boards (SBs) are one of the most potent common entrenchment devices, and their value effects are considerably debated. We study SBs' effects on firm value, managerial behavior, and investor composition using a quasi‐experimental setting: a 1990 law that imposed SBs on all Massachusetts‐incorporated firms. We find that relative to a matched control group of companies, for treated companies the law led to an increase in Tobin's Q, investment in capital expenditures and R&D, patents, and higher‐quality patented innovations, resulting in higher profitability. These effects are concentrated in innovating firms, especially those facing greater Wall Street scrutiny. An increase in institutional and dedicated investors also accompanied the imposition of SBs, facilitating a longer‐term orientation. The evidence suggests that SBs can benefit early‐life‐cycle firms facing high information asymmetries by allowing their managers to focus on long‐term investments and innovations.

ABSTRACT Understanding the role of bank lending in corporate innovation is important to policymakers, practitioners, and academics. We provide new evidence on such a role by exploiting the implementation of SFAS 166/167, which removed the off‐balance sheet status of certain securitized assets of banks. The regulation affects bank lending and thus represents a credit supply shock to borrowing firms. We find that affected banks raise spreads and cut loan amounts after the regulation. Firms that borrow from affected banks reduce R&D investment and the number and quality of the patents they generate. The reduction is concentrated among firms whose banks experience more downward pressure on capital ratios and greater market discipline, and firms that are more dependent on external financing. Additional analyses reveal that information asymmetry between incumbent banks and outsiders with respect to borrowing firms prevent them from switching. The overall findings suggest that bank lending promotes borrowing firms' innovation activities. Policies that restrict bank lending are likely to hurt innovation of borrowers.

ABSTRACT We examine the extent to which deferred vesting of stock and option grants (deferred pay) helps firms retain executives. To the extent an executive forfeits all deferred pay if they leave the firm, deferred vesting will increase the cost (to the executive) of an early exit. The impact of deferred pay on executive retention, a key ingredient for firms to create shareholder value is hence an important empirical issue. Using pay duration proposed in Gopalan et al. (2014) as a measure of the extent of deferred equity, we find that CEOs and non‐CEO executives with longer pay duration are less likely to leave the firm voluntarily. The talent retention role of deferred pay is mitigated by performance‐vesting provisions and signing bonuses offered by industry peers. Moreover, we also find that voluntary turnover is less sensitive to pay duration for executives who are perceived to be more talented and have more firm‐specific skills. Overall, our study highlights a strong link between compensation design and turnover of top executives. It suggests that firms take into account the need for retaining managerial talent in designing executive compensation.

ABSTRACT High investor sentiment has been linked with opportunistic managerial behavior in the face of more optimistic investors and analysts. We extend this line of work by documenting that the likelihood of misstatements is higher when sentiment is high. Although this would suggest elevated audit risk, we posit that a contemporaneous reduction in auditors' litigation cost could drive down audit fees and going concern opinion (GCO) reporting conservatism in order to please clientele. Consistent with this notion, we document that auditors charge lower fees and report GCOs less conservatively when sentiment is high. However, this reduction in reporting conservatism is unwarranted; results reveal that auditors are less likely to issue GCOs to clients which subsequently file for bankruptcy during high sentiment periods. We conduct additional tests to examine whether auditors' litigation costs indeed vary with sentiment and document that auditors are less likely to be sued and the market reacts less negatively to misstatement announcements when sentiment is high. Collectively, our findings suggest that, although misstatement risk is increasing with sentiment, auditors' litigation risk actually declines.

ABSTRACT Using proprietary data from a global accounting firm, we investigate the determinants of auditors' interim effort as well as the impact of interim effort on audit quality, client disclosure timeliness, audit hours, and audit fees. Public statements from accounting firms and regulators suggest various benefits from accelerating auditor effort, but these claims remain largely untested. We find that interim effort is higher for large, complex clients that require integrated audits of both financial statements and internal control over financial reporting. With respect to consequences, we find that allocating relatively more work to the interim period is associated with a reduced likelihood of late 10‐K filings, decreased total audit hours, and higher fees. Although increasing interim period effort is not, on average, associated with a reduced likelihood of misstatement, we do find that current period material weaknesses are less likely with greater interim work. Thus, greater interim effort appears to facilitate the remediation of internal control deficiencies before year‐end. We also show that the benefits of increased interim period effort allocation are much stronger—including improved audit quality—when manager and partner interim involvement is high. Overall, our study provides important new insights on audit production and highlights benefits of reduced hours for auditors, earlier identification of control deficiencies for clients, and more timely financial reports for investors.