Knowledge that Transforms

This paper reports the results of three studies (archival, experimental, and qualitative) designed to examine the effects of auditor narcissism on auditor‐client negotiations in China. We contend that narcissistic characteristics fuel auditors' competitiveness and embolden them to stand firm in negotiations, potentially lengthening the negotiation process but leading to more conservative negotiation outcomes. As predicted, our archival results suggest that auditor narcissism is positively associated with audit delay and negatively associated with clients' absolute and positive discretionary accruals. Our experimental results document that narcissistic auditors are more likely to be involved in negotiations that reach an impasse or take longer to resolve and that narcissistic auditors negotiate reported asset values that reflect less aggressive reporting choices. Our qualitative results from field interviews with practicing audit partners corroborate our archival and experimental findings. Overall, the data collected using three different research methods yield consistent results in support of our theory. Our findings shed light on factors that influence audit efficiency and quality in China. We discuss the key cultural and contextual differences between China and the West as well as the implications of these differences for future research.

In strategic outsourcing contracts, a substantial portion of implementation occurs at the client's premises and requires integration of effort between the vendor and the client. Compensation design in such contracts involves trade‐offs between the higher (lower) incentive properties of fixed‐price (cost‐plus) contracts and their higher (lower) ex ante contracting and ex post adaptation costs. Uncertainty influences these trade‐offs and affects compensation design. We explore the compensation implications of two types of uncertainty—volatility and ambiguity—which are reflected in the client's accounting measures. Volatility reflects the unpredictability of changes in the future environment, which makes it difficult to contractually specify future contingencies. Ambiguity reflects lack of consensus about the nature, drivers, and value effects of uncertainty, which makes it difficult to contractually specify responses to contingencies if and when they occur. Volatility increases the likelihood of ex post adaptation costs, while ambiguity increases ex ante contracting costs; therefore, volatility and ambiguity decrease the attractiveness of fixed‐price contracts. We use accounting and market measures to calibrate volatility and ambiguity and examine their implications for compensation design and ex post renegotiation. Analysis of archival data for 455 strategic outsourcing contracts valued over $15 million indicates that volatility and ambiguity influence contract compensation design and renegotiation likelihood. These results hold even after controlling for asset specificity, task complexity, and relational factors. We conclude that accounting measures can provide signals of volatility and ambiguity and thereby influence compensation design in strategic interfirm contracts.

Auditing standards task auditors with collecting sufficient appropriate evidence to form audit judgments. Yet, cognitive psychology documents a robust finding in which people evaluate a bundle of relevant, directionally consistent evidence as though averaging the strength of the components. In consequence, a bundle of evidence may be viewed as weaker evidence than the bundle's strongest evidence item alone. We experimentally examine whether this averaging effect occurs in an audit context, and we test a potential moderator. In three independent mini‐cases, we ask auditor participants to make judgments about going concern, internal controls, and fraud risk. We present auditors with unfavorable audit evidence relevant to each judgment, manipulating whether we present a single strong evidence item or bundle it with a weaker evidence item. We also manipulate the auditor's initial impression of the client's state. We find that experienced auditors succumb to the averaging effect, making more strongly unfavorable judgments in response to the single evidence item than the bundle, and that this bias is reduced when the observed evidence is inconsistent with the auditor's initial impression. We interpret our results as consistent with the dual‐processing theory of cognition.

Recent research finds that investors' assessments of a stock's fundamental value are influenced by corporate social responsibility (CSR) performance through the affect‐as‐information heuristic. We extend prior research by examining two boundary conditions for the use of this heuristic: (i) whether the CSR performance relates to activities that are integrated in a firm's core business practices (material CSR issues) or not (immaterial CSR issues), and (ii) whether the CSR performance is positive or negative. Employing an experimental method, we find that the affect‐as‐information heuristic applies only to immaterial CSR issues but not to material CSR issues, and only to positive but not negative CSR performance. Our findings suggest that investors likely use a heuristic approach to process immaterial and positive CSR issues, and a more deliberate and systematic approach to process material or negative CSR issues. Our study has both practical and theoretical implications.

In measuring tunneling with intercorporate loans disclosed by Chinese listed companies, we analyze the underlying channels through which aggressive tax planning facilitates the diversion of corporate resources by firm insiders. Using path analysis, we document that the path from tax aggressiveness to related loans is mediated by both the additional cash flows from tax savings and the increased financial opacity from tax planning, and that additional cash flows plays a much more important role than opacity in helping controlling shareholders to divert corporate resources under the guise of tax aggressiveness. Beyond the two mediated paths, we also detect a residual, direct path from tax aggressiveness to related loans. After an exogenous shock from the government crackdown on diversionary related loans, we find the direct path is fully mediated by the two indirect paths, suggesting that tunneling via related loans only occurs at firms where insiders can mask tunneling under the cover of opacity or can justify related loans on grounds of abnormal cash flows from tax savings. Our evidence supports the notion that greater outside scrutiny increases the hurdle for, but does not entirely eradicate, diversion facilitated by tax aggressiveness. Collectively, our research lends some support to recent theory on the importance of taxes to corporate governance by demonstrating how the agency costs of tax planning allow certain shareholders to benefit from firm activities at the expense of others.

Recent accounting research indicates that capital markets price firms' greenhouse gas (GHG) emissions and that disclosed emissions levels are negatively associated with firms' market values. The departure point for this study is to investigate whether investors value firms differently based on the strategies firms use to mitigate GHG emissions. These strategies include making operational changes, which reduces emissions attributable to the firm, and purchasing offsets, which reduces emissions unattributable to the firm. Using an experiment, we hold constant a firm's financial performance, investment in emissions mitigation, and net emissions, and find evidence that nonprofessional investors perceive the firm to be more valuable when it primarily uses an operational change strategy versus an offsets strategy. However, consistent with theory, this result only occurs when the firm's prior sustainability performance is below the industry average and not when it is above the industry average. This difference in firm value is consistent with the notion that nonprofessional investors believe information about a firm's emissions management strategy is material. Supplemental exploratory analyses reveal that our results are mediated by investors' perception that an operational change strategy is more socially and environmentally responsible than an offsets strategy for below industry average firms. Implications for our findings on theory and practice are discussed.

In an experiment including experienced managers, we investigate how supervisor and subordinate narcissism influence a supervisor's review of a subordinate's accounting estimate. While narcissistic supervisors express greater liking for narcissistic subordinates (narcissistic tolerance), they nonetheless reject and revise the accounting estimates of narcissistic subordinates to a greater extent than they reject estimates of non‐narcissistic subordinates (narcissistic hypocrisy), even when doing so inhibits the supervisor's ability to reach a profit target. Our findings contribute to extant research in accounting and psychology. We demonstrate that narcissistic hypocrisy extends beyond the evaluation of others and alters narcissists' willingness to rely on other narcissists in a meaningful financial reporting decision. We also find that narcissistic hypocrisy is robust across age, gender, and supervisory experience.

What incentives drive managers to disclose immediately when they have an option to delay disclosures? I examine this question in a two‐period setting in which public news that is positively correlated with firm value arrives periodically. I show that, when the manager's likelihood of receiving information is independent of the public news, an informed manager is more likely to disclose immediately when the public news is good. This happens even as the disclosure threshold itself increases in the public news. My model provides a potential explanation for why managers have a higher propensity to provide earnings forecasts when current earnings are high. I also show that, even when disclosures are credible, the average price reaction to a voluntary disclosure is (i) decreasing in the magnitude of the public news and (ii) lower when the manager is more myopic. These results have potential implications for studies that use stock returns to measure the news contained in management disclosures.

Auditors have difficulty evaluating the assumptions underlying management's estimates. One source of these problems is that auditors appear to dismiss evidence contradicting management's assumptions because their initial preference to support management's accounting biases their preliminary conclusions and, thus, their interpretation of evidence. We experimentally examine whether auditors with a balanced focus (i.e., a focus on documenting evidence that supports and contradicts their preliminary conclusion) are less likely to dismiss evidence that contradicts management's assumptions than auditors with a supporting focus (i.e., a focus on documenting evidence that supports their preliminary conclusion). We expect and find that, compared with auditors with a supporting focus, auditors with a balanced focus create documentation that is less dismissive of evidence contradicting management's estimate. Importantly, a balanced focus changes auditors' cognition and affects how auditors interpret contradicting evidence rather than merely increasing their documentation of this evidence. The effects of reduced dismissiveness persist to improve auditors' evaluations of a biased estimate and subsequent actions, improving audit quality in an important and difficult area.

This paper demonstrates that measures of stock price synchronicity based on market model R 2 s are predictably biased downward as a result of stock illiquidity, and that previously employed remedies to correct market model betas for measurement bias do not fix R 2 . Using a large international sample of firm‐years, we find strong negative and nonlinear relations between illiquidity and R 2 across countries, across firms, and over time. Because variables of interest frequently relate to illiquidity as well, we illustrate the consequences of not controlling for illiquidity in synchronicity research. More generally, we demonstrate the importance of using nonlinear control variable methods. Overall, we conclude that the illiquidity‐driven measurement bias in R 2 provides an explanation for why prior research finds low‐ R 2 firms to have weak information environments, and suggest future research carefully evaluate the sensitivity of its results to nonlinear controls for illiquidity.