Knowledge that Transforms

In this study, we predict and provide evidence that distressed firms that rely more heavily on major customers for sales have a comparatively higher incidence of receiving going‐concern opinions (GCOs). Moreover, we find that the effect of increased reliance on major customers is driven by firms that are more distressed. We also theorize that variations in key characteristics of the relationship between a distressed firm and its largest major customer are incrementally linked to GCOs, and present evidence consistent with this. Specifically, we find that the effect of greater reliance on major customers is driven by firms that are relatively smaller than their largest major customer. Additionally, we find that greater reliance on major customers is positively (negatively) associated with GCOs when firms are in a shorter (longer) relationship with their major customer and when firms have a different auditor to (same auditor as) the largest major customer. Overall, our study indicates that supply chain relationships are relevant business risks associated with auditors' going‐concern assessments.

We hypothesize that the arrival of star analysts improves the performance of incumbent financial analysts, while the departure of star analysts has the opposite effect. Our results consistent with this hypothesis are concentrated primarily in the tests related to star arrivals. Our findings are robust to an instrumental variable approach and a falsification test. In addition, we hypothesize that the impact of the arrival/departure of star analysts is more pronounced when the star analyst covers the same industry as the incumbents (especially for industries with high uncertainty), when the star analyst is more established, when the incumbent analysts are less experienced, and when the brokerage house has fewer existing star analysts. Overall, our paper offers evidence of peer effects among financial analysts, mainly through the arrival of star analysts.

Both soft, noncontractible, and hard, contractible, information are informative about managerial ability and future firm performance. If a manager's future compensation depends on expectations of ability or future performance, then the manager has implicit incentives to affect the information. We examine the real incentive effects of soft information in a dynamic agency with limited commitment. When long‐term contracts are renegotiated, the rewards for future performance inherent in long‐term contracts allow the principal partial control over the implicit incentives. This is because the soft information affects the basis for contract renegotiation. With short‐term contracts, the principal has no control over the basis for contract negotiation, and thus long‐term contracts generally dominate short‐term contracts. With long‐term contracts, the principal's control over implicit incentives is characterized in terms of effective contracting on an implicit aggregation of the soft information that arises from predicting (forming expectations of) future performance. We provide sufficient conditions for soft information to have no real incentive effects. In general, implicit incentives not controllable by the principal include fixed effects, such as career concerns driven by labor markets external to the agency. When controllable incentives span the fixed effects of career concerns, the latter have no real effects with regard to total managerial incentives—they would optimally be the same with or without career concerns. Our analysis suggests empirical tests for estimating career concerns that should explicitly incorporate noncontractible information.

We examine how often audit firms are sued in a large sample of accounting lawsuits that allege financial reporting failures. We find an insignificant relation between the likelihood of auditor litigation and restatements, but the likelihood of auditor litigation is strongly related to the types of alleged accounting deficiencies. We also find that the auditor's type influences the probability of the auditor being sued and the size of the payouts from auditor and nonauditor defendants. In particular, the Big N firms are approximately 7 percent less likely than non–Big N firms to be named as co‐defendants, and the auditor's contribution to the plaintiff's payout is significantly larger when a Big N firm is sued. Overall, our findings suggest that auditors are rarely blamed when there are allegations of financial reporting failures, but the types of accounting deficiencies and the auditor's type significantly influence the probability of the audit firm being sued and the outcomes of the lawsuits.

This paper seeks to understand how insolvency practitioners attempt to build trust with a heterogeneous creditor body during the crisis of formal insolvency and the role accounting information and processes play. Accounting information is mobilized in different ways according to how insolvency practitioners believe the information will be interpreted and valued. This paper suggests specific qualitative characteristics, accounting principles, and processes which appear to enhance trust building in a crisis context. These include perceived objectivity, comparability, cash flow accounting, “matching” of secured liabilities with secured assets, and “crisis” audit. The value ascribed by insolvency practitioners to maintaining specific creditor relationships also appears relevant to trust‐building activities. A “tit‐for‐tat” strategy emerges with secured creditors, whereby insolvency practitioners engage in demonstrable fee write‐offs, but on the implicit understanding that future, lucrative work will come their way. This study points to the importance for researchers and policymakers of understanding the “desirable” properties of accounting through informed understandings of how and why that information is mobilized and received in specific relationships between people.

We examine how short sellers affect long‐run management forecasts using a natural experiment (Regulation SHO) that relaxes short‐selling constraints on a group of randomly selected firms (referred to as pilot firms). We find that compared to other firms, the pilot firms issue more long‐run good news forecasts but do not change the frequency of long‐run bad news forecasts. The increase in good news forecasts is greater when the pilot firms have higher‐quality forecasts, greater uncertainty about firm value, or higher manager equity incentives. Overall, these results and the results of additional analyses indicate that the reduction in short‐selling constraints and the increase in short‐selling threat induce managers to enhance disclosures through more long‐run good news forecasts to discourage short sellers.

We examine the impact of China's anti‐corruption campaign on firm‐level financial reporting quality (FRQ). As an important component of the anti‐corruption campaign, in October 2013, “Rule 18” was issued to prohibit party and government officials from serving as directors for publicly listed firms. The regulation led to a large number of official directors resigning from their roles as directors involuntarily. As such, Rule 18 has effectively weakened, if not fully discontinued, the political connections of the firms that previously hired officials as directors. Our empirical analyses employ a difference‐in‐differences research design with firm fixed effects and propensity‐score matching to examine the pre‐ and post‐period FRQ around the enactment of Rule 18. We find that, compared to propensity‐score‐matched control firms, FRQ of firms with resigned official directors increases after Rule 18. Further evidence suggests that the impact is stronger when firms are located in regions with more developed financial markets and in regions with higher judiciary efficiency. We also find that the effect is more pronounced when firms are non‐state‐owned, received preferential credits, and face refinancing pressure.

This study provides the first large‐sample evidence on the economic tax effects of special purpose entities (SPEs). These increasingly common organizational structures facilitate corporate tax savings by enabling sponsor firms to increase tax‐advantaged activities and/or enhance their tax efficiency (i.e., relative tax savings of a given activity). Using path analysis, we find that SPEs facilitate greater tax avoidance such that an economically large amount of cash tax savings from research and development (R&D), depreciable assets, net operating loss carryforwards, intangible assets, foreign operations, and tax havens occur in conjunction with SPE use. We estimate that SPEs help generate over $330 billion of incremental cash tax savings, or roughly 6 percent of total U.S. federal corporate income tax collections during the sample period. Interaction analyses reveal that SPEs enhance the tax efficiency of intangibles and R&D by 61.5 percent to 87.5 percent. Overall, these findings provide economic insight into complex organizational structures supporting corporate tax avoidance.

We examine how compensation policies of audit firms are associated with audit quality. Specifically, we investigate the effects of the ratio of variable to fixed compensation and the size of the basis for profit sharing (i.e., whether partners share profits in a small or in a large profit pool). For our analyses, we use detailed mandatory disclosure of the compensation policies in German audit firms. We document that compensation policies vary considerably across audit firms. We find that profit sharing in a small profit pool and high variable compensation are two characteristics of auditor compensation associated with lower audit quality. We also find some evidence suggesting that audit quality may be most at risk in cases in which partners rely more heavily on variable compensation to divide a relatively small profit pool. In additional analyses, we find that these associations are more pronounced in medium‐sized audit firms. We argue that this finding may result from these firms being too large for audit partners to directly monitor each other effectively, yet simultaneously too small to have sophisticated centralized monitoring systems in place. Finally, we find that integrating partner‐specific, nonprofit‐related performance metrics into the compensation structure mitigates the adverse effects of small profit pools and high variable compensation.

Prior research indicates that most audit legal disputes settle. There is, however, little evidence of the factors that drive the settlement norm and its exceptions in audit legal disputes. To better understand these factors, we rely on theory related to how professionals manage risks and, as a result, how professions defend jurisdictional claims. We use this theoretical lens to help motivate four research questions that we probe by interviewing 27 prominent attorneys experienced in audit litigation. Consistent with our lens, our interview data indicate that attorneys manage their risks, including the risk of reputational loss, by settling based on their expectations of trial verdicts. Unlike trials, settlements simultaneously enable attorneys on both sides to limit costs and avoid catastrophic jury verdicts and, by doing so, claim “wins” for their clients. Attorneys also stress that they settle many audit disputes without any legal filings. Thus, a large subset of disputes is invisible to the public and researchers. Attorneys characterize trials as exceptions to the settlement norm that emerge due to abnormal conditions sometimes present in disputes. However, trial verdicts in these abnormal conditions help attorneys justify the use of settlements to clients, as attorneys stress that by settling they can avoid the dreaded possibility of extreme unfavorable verdicts. We conclude that as individual attorneys manage their risks, especially the risk of reputational loss, their profession maintains its public image and thereby defends its jurisdictional claims. Among the many questions we pose for future research is whether the settlement norm reduces society's ability to monitor the audit profession and, more generally, whether this norm's benefits outweigh its drawbacks.