Knowledge that Transforms

Abstract Over the past decade, the audit profession has significantly increased its use of non‐equity partners for private (non‐listed) company audits. Such partners lead audit engagements and sign audit reports but do not share in the partnership's profits. Non‐equity partner positions were introduced in response to increasing workloads and to retain talented individuals unsuited to or uninterested in equity partnership, either temporarily or permanently. Using data from Big 4 private company audits during the period 2008–2017, our analyses show that equity incentives affect auditors' reporting behavior and their clients' financial reporting quality. Non‐equity partners are less likely to issue going‐concern opinions to their financially distressed clients, their reporting is less accurate (i.e., more Type II errors), their reporting is less conservative, and their clients' financial reporting is of lower quality (i.e., more frequent reporting of small earnings increases and more tax restatements). We also find that equity incentives mitigate some of the negative effects of fee‐based compensation on auditors' reporting behavior. Moreover, our findings suggest that incentives arising from ownership, rather than partners' innate differences or client differences, drive these associations.

Abstract Accounting Standards Update (ASU) 2016‐01 requires that unrealized gains and losses on equity investments (equity‐URGL) previously recognized in other comprehensive income now be included in net income. Using a sample of public insurers, we examine how this accounting standard change influences managerial investment decisions, with a particular focus on the moderating effects of compensation contracting and financial reporting practices. We find that prior to ASU 2016‐01, equity‐URGL was positively associated with CEO compensation, but this association dissipates in the post‐adoption period, when equity‐URGL is more frequently excluded from CEO performance metrics. Despite purported concerns about increased earnings volatility due to the new reporting requirements, highly affected insurers do not significantly reduce the size or risk of their equity investment portfolios following ASU 2016‐01, particularly when compensation metrics exclude equity‐URGL. We also find that equity‐URGL is more frequently excluded from non‐GAAP earnings post‐adoption, suggesting that managers adjust financial reporting practices as a response to the change. Moreover, highly affected insurers maintain the size and risk of their equity portfolios when equity‐URGL is excluded from non‐GAAP earnings. These findings suggest that managerial responses to ASU 2016‐01 are influenced by a balance between incentive structures and the costs associated with adjusting investment strategies.

Abstract In this study, we leverage judgment decomposition and information acquisition theories to develop and test an intervention to improve group auditors' identification of and response to component‐level qualitative risk. Improving group auditors' response to qualitative risk is important because (1) group audits are prevalent today and require multiple qualitative risk assessments, (2) auditors have historically overlooked qualitative risks, and (3) prior interventions have failed to improve auditors' response to qualitative risk. In an experiment with 88 audit partners and managers, we find that a hybrid risk assessment approach that combines elements of judgment decomposition and notetaking improves auditors' group audit planning decisions. Specifically, auditors utilizing our hybrid approach are better able to identify and respond to component‐level qualitative risks than auditors who use a holistic approach. Importantly, the improvement in qualitative risk response does not come at the expense of auditors' response to quantitative risk.

Abstract Product market advertising, while containing little new information, triggers spikes in investor attention. Using weekly advertising data, we find that sell‐side analysts issue optimistic earnings forecasts in response to heavier advertising in the prior week. This effect is not driven by confounding earnings or product news. It is more pronounced for experienced analysts and analysts affiliated with brokerages that rely solely on trading revenues. The optimistic forecast bias intensifies the impact of advertising on investor trades of the underlying stock during the following week, especially on retail buying. Overall, analysts appear to issue optimistic forecasts to exploit retail investor attention spikes induced by advertising.

Beginning May 1, 2020, with the strong support of our team of Editors, CAR implemented a reviewer recognition program.The purpose of the program is to annually recognize reviewers, nominated by the Editors, who regularly perform exceptionally high-quality and timely reviews.CAR has a long-standing tradition of providing thoughtful and constructive reviews

Abstract Prior research has established that tax liability increases lead to decreased compliance. However, tax liability changes do not happen in a vacuum. Notably, prior research has also identified a withholding phenomenon: individuals in a tax due position are less compliant than those in a refund position. Additionally, tax law changes are often enacted in politically polarized environments. We examine how three factors—tax liability changes, withholding position, and group affiliation—combine to influence individuals' tax compliance decisions. Our experimental results show that a tax increase is universally experienced as a loss, even when coupled with a tax refund and enacted by an ingroup, leading to decreased compliance. However, a tax decrease coupled with a tax due position is viewed neutrally and leads to less compliance than a tax decrease coupled with a tax refund. Further, group affiliation influences compliance in some situations. Individuals in a tax due position are less compliant when an outgroup, versus an ingroup, is responsible for the tax change. This study contributes to the mental accounting literature by examining how individuals react to mixed gain/loss situations when the gains and losses are of different types. We also integrate the previous separate research streams on the withholding phenomenon and tax liability changes. Practically, our results contribute to tax policy by showing how individuals react when tax law changes are enacted. Importantly, even when a tax change results in a decrease in tax liability, tax compliance may be affected by individuals' withholding position and group affiliation.

Abstract We provide evidence that some managers use a multi‐period, coordinated strategy involving inflated current‐period discretionary accruals and optimistic forecasts of future earnings to delay the revelation of bad news. Inflating discretionary accruals increases investor expectations of future performance, and issuing optimistic earnings forecasts of future earnings supports the inflated accruals and extends the horizon for managers to benefit. This strategy is more pronounced for firms that engage in earnings management outside of GAAP, suggesting intentional behavior. Our evidence indicates that managers use this coordinated strategy when firms experience significant bad news and cannot delay revealing all of the bad news through accrual management. We also find that managers use this coordinated strategy when focusing on short‐term performance due to career concerns (i.e., dismissal) or retirement or when they have shorter stock option vesting schedules, which motivates them to inflate investor expectations for shorter‐term personal benefits. Furthermore, managers using this strategy do not hold deep in the money exercisable stock options, which is consistent with managers' private assessment of a higher (lower) likelihood of releasing bad (good) news in the future.

Abstract Security prices are affected by information strategically disclosed by managers as well as by informed trading of outsiders and vice versa. However, market frictions, such as short‐selling costs and constraints, significantly affect trading in financial markets. In this article, we examine the joint determination of voluntary disclosure, security prices, and short‐selling, and address the following issues: How do major market frictions affect managerial disclosures? How do disclosures influence strategic informed trading in the presence of frictions? What does the interaction of strategic disclosure and informed trading imply for price efficiency? We find that short‐selling (trading) costs have a substantial impact on the equilibrium disclosure policy and its interaction with informed trading and price efficiency. Because of endogenously binding short‐sale constraints, better‐informed traders can either deter or encourage disclosure, thus reconciling mixed available evidence on the relation between short‐sale constraints and managerial disclosure. Furthermore, price efficiency need not improve with managers' information endowment because greater disclosure can endogenously inhibit informed short‐selling in equilibrium. Our analysis also generates novel empirical predictions relevant to the literature on managerial disclosure, shorting, and price efficiency.

Abstract In this paper, I conduct three experiments to investigate whether and how relative performance information (RPI) influences employee advice‐seeking and how advice‐seeking, in turn, affects employees' trust in their manager. The first experiment shows that, in a setting where the manager can provide useful advice, RPI increases advice‐seeking frequency, which is marginally positively associated with trust in the manager. The second experiment indicates that RPI increases advice‐seeking frequency when the manager's advice is highly useful, with a marginally significant effect when the advice is of low usefulness. Mediation analyses reveal that RPI alleviates employees' concerns about self‐presentation toward their manager, thereby increasing advice‐seeking frequency, but only when the manager's advice is of high usefulness. The third experiment shows that advice usefulness impacts employees' trust in their manager by influencing their perceptions of managerial competence and benevolence. This paper discusses theoretical and practical implications of these findings.

Abstract Professional skepticism is an essential element of a healthy audit. In this study, we present a framework in which the two elements of professional skepticism—skeptical judgment and skeptical action—differ in that skeptical judgment involves paying attention to audit risks, whereas skeptical action often involves overcoming personal risks. This distinction suggests that the optimal conditions for skeptical judgment may differ from the optimal conditions for converting that judgment to skeptical action. Specifically, interventions that promote vigilance will facilitate judgment because they make potential accounting issues salient, but such a focus will also draw attention to potential adverse consequences of taking action. To test this proposition, we conduct two studies in which we align skeptical judgment and skeptical action with two pairs of distinct and contrasting mindsets to operationalize differential vigilance. Our results suggest a duality in skepticism which has important implications for researchers and practitioners designing interventions to improve audit quality.