Knowledge that Transforms

We examine how regulatory restrictions on capital market activity affect the compensation contracting environment within firms. This study aims to expand our understanding of how financial market development affects firm risk‐taking via management compensation designs. Specifically, taking advantage of the staggered implementation of the Interstate Banking and Branching Efficiency Act (IBBEA), which increases bank competition and loan geographical diversification, this study examines how borrowing firms' compensation structures change when banks increase risk tolerance in their loan portfolios. Using hand‐collected compensation data of firms with market capitalization less than $75 million, we hypothesize and find that borrowing firms are likely to increase risk incentives after IBBEA and that this increase is more pronounced for firms located in states with less banking competition in the pre‐IBBEA period. We also show the findings to be more significant for borrowers whose lenders acquire more diversification benefits after IBBEA. These findings suggest that following deregulation, when banks face increased competition as well as an enhanced ability to diversify their credit risk geographically, these same banks tend to increase their tolerance for borrowers' risk‐taking. That is, their clients—nonfinancial firms borrowing from them—adjust their compensation contracts that are previously constrained by bank distaste for risk. We also document that firms that increase their risk incentives the most invest more in R&D, suggesting that management compensation is a complementary channel through which IBBEA affects firm innovation.

This study examines the impact of cross‐firm financial statement comparability on regulatory oversight of accounting quality. Required to review each firm's periodic filings at least once every three years, the SEC learns about the degree to which a firm's accounting system is comparable to those of its peers. We posit that the SEC's ex ante knowledge about financial statement comparability, gleaned from prior‐year filing reviews, facilitates its evaluation of firms' accounting quality during the current‐year filing review. Consistent with the notion that comparable accounting systems enhance regulators' ability to identify discretionary accounting deviations, we find that the likelihood of the SEC issuing a comment letter for higher abnormal accruals increases with financial statement comparability. Further analysis reveals that the regulatory benefits from higher financial statement comparability are more salient when the SEC faces higher monitoring constraints in filing reviews. Moreover, our finding shows that comparable accounting numbers across firms help the SEC detect severe accounting violations that necessitate restatements. Overall, we provide novel evidence suggesting that higher financial statement comparability improves the efficacy of the SEC's oversight of accounting quality by reducing the information costs associated with cross‐firm comparisons.

This study examines whether auditors' evaluation and reporting of firms' internal control over financial reporting (ICFR) affects firm operational efficiency. Prior research indicates that the strength of internal controls is positively associated with economic benefits. However, notwithstanding the underlying strength of controls, whether the mere presence of an ICFR audit provides similar economic benefits is unclear. We predict and find that small firms with ICFR audits have significantly higher overall operational efficiency than small firms with only management ICFR reports, even after controlling for underlying internal control strength. We find this effect manifests through improvements in inventory turnover and innovation, and through increased relative product market share. Separately, we find ICFR audits are associated with lower efficiency in SG&A expenses. Cross‐sectional analyses indicate that the mechanism by which ICFR audits affect overall operational efficiency is through auditor detection of internal control problems and through knowledge spillover from auditing other highly efficient firms in the audit office's metropolitan statistical area. These results provide additional evidence on the ongoing cost and benefit debate of ICFR audits for small firms.

We present evidence on the effects of target firms' accounting conservatism in a merger and acquisition transaction. Conservatism is distinct from other accounting or accrual quality constructs examined in prior work. Its unique features can lead to potential benefits for both the targets and the acquirers. The use of conservatism by targets reduces acquirers' risks of acquiring underperforming assets or overpaying for well‐performing assets. In addition, targets' conservatism results in greater production of verifiable information that can help the acquirers better estimate and realize synergies of the combined firm. Consistent with these arguments, we find that firms with greater accounting conservatism are more likely to receive a bid. We also find that targets' conservatism increases the deal premium and the announcement returns of both the targets and the acquirers, respectively. Overall, these results indicate that conservatism provides benefits to both sellers and buyers of equity in an acquisition transaction.

This study examines the role of information transparency in facilitating peer firms' investment in follow‐on innovation. We capture information transparency with both textual and numerical information disclosed in 10‐Ks. Using patent citations to proxy for investment in follow‐on innovation, we predict and find a positive association between transparency at the knowledge source and follow‐on innovation. We further show that the effect of information transparency varies with the degree of uncertainty around technological innovation. Thus, the evidence suggests that information transparency facilitates investment in follow‐on innovation by resolving uncertainty associated with investment in technological innovation. An analysis using the cited firms' going‐private decision as a negative shock to information transparency confirms the significant effect of a cited firm's disclosure on its decision to invest in follow‐on innovation. Our study contributes to the literature on the positive externalities of peer‐firm disclosures and highlights the important role of information transparency in shaping innovation investment decisions.

Stock exchanges are important intermediaries in how firm information enters price. Trading halts are a key tool, often exercised at the exchanges' discretion, to prevent extraordinary price volatility when new information arrives. We investigate how exchanges use discretion and whether the discretion alters the effectiveness of the halts. We provide evidence consistent with halts reflecting the preferences of listed firms rather than the stated exchange objectives (i.e., minimizing excess volatility and off‐equilibrium trades). Furthermore, when exchanges exercise more discretion (unexplained by firm and information characteristics), the halts are less effective. Specifically, halts with more discretion are less likely to resume trading with efficient prices and are more likely to have been called unnecessarily (i.e., little to no price movement during the halt). These findings are consistent with exchanges using halts to cater to listed firms rather than to meet exchange objectives such as minimizing excess volatility or avoiding trades at off‐equilibrium prices.

This study examines whether analysts have an industry‐level information advantage over managers when forecasting earnings. While analysts are often viewed as industry experts, prior research fails to document such an advantage. We predict that analysts' industry‐level information advantage is more likely to exist in industries where firm performance is more sensitive to industry‐level external economic forces. We find that for such firms, analysts provide relatively more accurate earnings forecasts compared to managers. Consistent with our predictions, we further find that managers of such firms provide fewer and less precise forecasts and that this association is more pronounced in firms with higher analyst following. Collectively, these findings suggest that analysts have an industry‐level information advantage over managers when forecasting earnings for firms in industries with high sensitivity to external forces, and that industry sensitivity risk is a distinct industry characteristic that affects firm‐level disclosure.

A recent trend in organizations is to motivate employees with goal‐based prosocial rewards, whereby employees must donate their rewards to charities upon goal attainment. We examine the motivational effects of goal‐based prosocial rewards versus cash rewards under different levels of goal difficulty. We develop our hypotheses based on affective valuation theory, which posits that when valuing uncertain outcomes by affect rather than calculation, individuals are largely insensitive to changes in probability of the outcomes, including probability of goal attainment. Experiment results support our hypotheses. Specifically, we find that employees who are rewarded with prosocial (vs. cash) goal‐based rewards are more likely to adopt an affective valuation approach. Consequently, when employees are assigned either an easy goal or a stretch goal, their effort is higher when incentivized with a goal‐based prosocial reward than a cash reward. Furthermore, there is a less curve‐linear relationship between goal difficulty and effort with prosocial (vs. cash) goal‐based rewards. These findings highlight for incentive system designers the motivational advantage of goal‐based prosocial rewards relative to traditional cash rewards. Furthermore, we extend the academic literature by showing how affect‐rich rewards such as prosocial rewards can influence employees' assessment of the probability of goal attainment.

This study investigates when and why intrayear bonus target revisions occur. This is important as intrayear target revisions occur regularly in practice but are not well understood. Specifically, we analyze two potential drivers of intrayear bonus target revisions: reduced managerial incentives owing to managers dropping out of the incentive zone of their piecewise defined bonus function and potential spillovers from planning target revisions that reflect changes in performance expectations during the year. We also investigate the effects of organizational characteristics on intrayear bonus target revisions. Using data collected from sales executives via multiple waves of surveys, we find evidence for both predicted drivers. In addition, consistent with our predictions, we find that the levels of delegated decision authority, intrafirm interdependencies, and information asymmetry negatively moderate the positive association between reduced managerial incentives and revision likelihood. Our paper contributes to the target setting literature by being the first study to investigate intrayear bonus target revisions and shed light on when firms commit to not revising such targets intrayear.

We investigate whether the PCAOB's decision to expand the number and location of its inspection offices in 2009 improved the reliability of US audits. We use a difference‐in‐differences empirical design to consider the impacts of the expansion on audit quality and find that audit quality significantly improved following the PCAOB's expansion in markets where new offices opened relative to markets without an office opening. We find that the improvement in audit quality appears to be driven by auditors' reaction to real changes in PCAOB oversight and that triennially inspected auditors appear to be impacted the most by this office expansion. Our findings provide new insights into the PCAOB's operational decision‐making and suggest that the regulator's additional investment in audit oversight was effective in improving audit quality.