Knowledge that Transforms

Abstract In this study, we examine how norms about the use of negotiation strategies by different parties in an auditor–client negotiation influence the relative efficacies of these negotiation strategies. We conduct an experiment with experienced auditors/financial managers as participants, who enter into a negotiation on an income‐decreasing audit adjustment with a hypothetical client/auditor who uses a strategy where the same concessions are given either at the start, gradually, or the end of the negotiation. We find that the concession‐end strategy is more effective than the concession‐start strategy when used by auditors; however, the reverse is true when these same strategies are used by financial managers. The concession‐gradual strategy leads to superior outcomes when used by either auditors or clients. We also provide evidence that auditors’ and financial managers’ perceptions of the norms relating to the use of these strategies correspond to what we propose in our theory.

Abstract Recent accounting research provides evidence that similar profit‐based compensation incentives are used in for‐profit and nonprofit hospitals. Because charity care reduces profits, such incentives should lead for‐profit hospital managers to reduce charity care levels. Nonprofit hospital managers, however, may respond differently to the same incentives because they face a different set of institutional pressures and constraints. We compare the association between pay‐for‐performance incentives and charity care in for‐profit and nonprofit hospitals. We find a negative and significant association between charity care and our proxy for profit‐based incentives in for‐profit hospitals, and no significant association in nonprofit hospitals. These results suggest that linking manager pay to profitability does not appear to discourage charity care in nonprofit hospitals. Apparently, the nonprofit mission, institutional pressures, and ownership constraints moderate the potentially negative effects of profit‐based incentives. Because this evidence partially alleviates concerns over nonprofit compensation arrangements that mirror those used in for‐profit hospitals, it should be of interest to regulators and policymakers. In addition, this study provides insights into accounting researchers about institutional and organizational influences that affect managerial responses to financial incentives in compensation contracts.

Abstract We introduce a measure of customer franchise value for subscription‐based companies—a fast growing and vital sector of the economy. This measure is based on information voluntarily disclosed by some, but not all, firms. Controlling for self‐selection, we examine the measure's information content and find that customer value is significantly positively associated with stock price and this association is incremental to both GAAP and a set of non‐ GAAP variables typically considered in valuation tests. Furthermore, we show that the customer value measure is positively associated with future earnings and analysts' forecast errors. Importantly, we find that the documented results are robust to controlling for the individual inputs used to derive the measure, highlighting the need to consider the interaction between stand‐alone value drivers in assessing a firm's performance. These findings indicate that the proposed measure of customer value is an important valuation tool that quantifies and summarizes the main trends and factors underlying the performance of subscription‐based enterprises. This study informs researchers and investors, as well as accounting policymakers, about a major value‐generating asset currently missing from corporate financial reports.

Abstract Corporate governance mechanisms designed to alleviate manager‐shareholder agency conflicts can worsen shareholder‐bondholder conflicts. This study examines how one such corporate governance mechanism, monitoring by large outside shareholders, influences the choice between public and private debt. I conjecture and find that firms with higher outside blockholdings are inclined to choose bank loans over public debt when they borrow, consistent with the notion that banks are better monitors than public debt markets. I also find that bank loans carry less price protection than corporate bonds against increased agency risk associated with outside blocks. Corroborating the monitoring story, I document that bank loans contain more accounting‐based covenants and dividend restriction provisions for firms with higher outside blockholdings than for those with lower blockholdings. I find no such relation for public debt covenants. This supports that banks' monitoring of their loans counters the agency risk caused by blockholders. This study extends prior research that associates governance mechanisms with agency costs of debt, by incorporating lenders' differential monitoring mechanisms in the overall corporate governance system.

Abstract Using samples of restating and nonrestating U.S. firms, the study empirically investigates the relationship between the incidence of fraudulent financial reporting and accounting‐based performance outcomes. The outcomes are framed as gains and losses relative to a reference point, defined as the mean performance of industry peers. Consistent with cumulative prospect theory (CPT), the findings show that fraud incidence is positively (negatively) related to the probability of a loss (gain); more (less) sensitive to the probability of a loss (gain) (i.e., loss‐aversion); and more (less) sensitive to an extra unit of the probability at a high‐ or low‐ (medium‐) probability level (i.e., nonlinear probability weighting function). The study extends the fraudulent financial reporting literature by formulating fraud incidence as a function of performance outcomes using peer performance as a reference point. By testing CPT's individual‐level behavioral implications on firm‐level archival data, the study reconceptualizes the investigation of fraudulent financial reporting in terms of risk attitude and extends prior investigations of CPT from laboratory experiments to a real‐world setting of fraudulent financial reporting.

Abstract Prior research indicates that a firm's use of derivatives to manage business risks is viewed favorably by investors. However, these studies do not consider a potentially key factor in this setting—namely, the typical behavior (or norms) regarding derivatives by other firms in the industry or the firm itself. In this paper, we report the results of multiple experiments that test whether norms are influential in affecting investors’ evaluations of firms’ derivatives choices. Our results show that the generally favorable reactions to derivative use actually reverse and become unfavorable when firms’ derivative decisions are inconsistent with industry or firm norms. Somewhat surprisingly, though, we find that industry and firm norms are not viewed similarly by investors. These results expand our understanding of how investors respond to firm's derivative use decisions and demonstrate the role of norms as factors that influence investors’ judgments in financial reporting settings. Our results have implications for firm managers making decisions about derivative use.

Abstract Even though there is a worldwide consensus as to the necessity of an audit of annual financial statements for public companies, there is divergence of views as to the review of interim financial statements. While some jurisdictions make it mandatory (e.g., Australia, France, United States ), others allow the review without requiring it (e.g., Canada, United Kingdom ). Using a sample of companies listed in Canada, we examine the costs associated with these reviews and the benefits they generate in terms of improvement in the quality of interim financial statements for the years 2004 and 2005. Controlling for the decision to purchase the reviews, we find that audit fees are 18 percent higher for firms with interim reviews and, contrary to many regulators' assumption, we find no evidence that this cost increase is proportionally higher for smaller firms. Regarding the benefits of interim reviews, we find no significant association between either accruals‐ or nonaccruals‐based measures of earnings management and the fact that the interim statements are reviewed by the auditor, neither in the interim reports nor in those of the fourth quarter. The results suggest that auditors' involvement with interim reports may not be as effective as previously thought at controlling the quality of interim financial statements.

Abstract This study investigates how external corporate governance provisions, specifically statutory and corporate charter provisions that limit direct shareholder participation in the governance process, affect the likelihood of an accounting restatement. The analysis indicates that strong external governance (fewer restrictions on shareholder participation) is associated with a relatively low incidence of accounting restatements. The effect of external governance is incremental to that of internal governance, which is considered as provisions that foster effective board oversight of management. Such evidence supports the premise that shareholder participation improves financial reporting quality.

Abstract This study examines a setting in which a tax‐reporting decision is delegated to a firm's tax manager. Using financial accounting measures of tax expense to evaluate the tax manager allows the firm to efficiently attain the level of tax avoidance it prefers, despite the fact that the consequences of the tax‐reporting decision will occur in the future. The study also examines how well two accounting measures of tax aggressiveness — cash taxes paid and the unrecognized tax benefit — distinguish between conservative and aggressive firms.