Knowledge that Transforms

ABSTRACT This study investigates whether PCAOB inspections of foreign auditors affect global financial reporting comparability. Foreign auditors may adjust audit methodologies to address PCAOB inspection findings, which could affect financial reporting of local clients. Exploiting both within‐ and cross‐country variation in PCAOB inspections, we predict and find that non‐US‐listed foreign companies' financial reporting becomes more comparable to their US and non‐US industry peers after their auditors undergo an initial inspection. However, there is a decrease in comparability compared to local peers whose auditors have not been inspected. Subsample tests suggest that the improvement in comparability is driven by (i) auditors that satisfactorily address deficiencies and (ii) auditors that do not publicly push back against deficiencies. The effects are dampened after local audit regulators begin inspection programs. Overall, our evidence suggests that the PCAOB international inspection program affects audit methodologies of inspected auditors in a consistent way, improving comparability across jurisdictions. The improved comparability implies that the PCAOB international inspection program may unintentionally help meet accounting regulators' goals of cross‐country financial reporting convergence, which potentially promotes efficient cross‐country capital allocation.

ABSTRACT This study examines the relation between earnings management and block ownership of same‐industry peer firms by a common set of institutional investors (common institutional ownership). This relation is important given the tremendous growth of common institutional ownership and the significant influence of blockholders on financial reporting. We hypothesize that common institutional ownership mitigates earnings management by enhancing institutions' monitoring efficiency and by encouraging institutions to internalize the negative externality of a firm's earnings management on peer firms' investments. Consistent with our hypothesis, we find that higher common institutional ownership is related to less earnings management. Analyses of a quasi‐natural experiment based on financial institution mergers show that this negative relation is unlikely to be driven by the endogeneity of common institutional ownership. Cross‐sectional tests provide evidence that the negative relation is stronger among firms for which common institutional ownership is likely to generate a greater reduction in institutions' information acquisition and processing costs, and among firms whose severe financial misstatements are more likely to distort co‐owned peer firms' investments, supporting both mechanisms underlying our hypothesis. Our findings inform the ongoing debate on the costs and benefits of common institutional ownership by highlighting an important benefit: the enhanced monitoring of financial reporting.

ABSTRACT Prior research finds that women receive lower salaries than men. Similarly, we show that female audit partners in Belgium receive significantly lower compensation than male partners. However, there are alternative explanations for the pay gap other than gender discrimination. For example, the gap in compensation could reflect that men are paid more because they have higher levels of productivity. We provide new predictions and tests of gender discrimination by comparing the fees generated by audit partners (a measure of partner productivity) and the types of clients assigned to partners. Consistent with our prediction of female partners having to meet higher performance thresholds than male partners, we show that female partners generate larger fee premiums, but they are less likely to be assigned to prestigious clients. To test whether these patterns are attributable to gender discrimination, we examine whether the results are stronger in male‐dominated offices, because this is where we would expect to find the most discrimination against women. We find the fee premiums generated by female partners are larger in male‐dominated offices, while the negative association between prestigious clients and female partners is stronger in male‐dominated offices. Collectively, our combined predictions and tests are consistent with female partners facing gender discrimination in audit offices that are dominated by male partners.

ABSTRACT We use a novel data set to examine the across‐time consistency and across‐firm comparability of firms' non‐GAAP earnings disclosures. Given widespread concern about non‐GAAP reporting among regulators, standard setters, the investor community, and academics, our investigation provides timely evidence on how managers' deviations from their own non‐GAAP disclosure history, or the reporting of industry peers, affects how well earnings inform on firm performance. We begin by identifying firms that change their non‐GAAP earnings definition from one year to the next. These deviations are uncommon, but when managers change the items they exclude in calculating non‐GAAP earnings, the changes generally enhance the information in earnings about firms' core performance. We also examine whether non‐GAAP earnings are more comparable than GAAP earnings and find that firms' non‐GAAP adjustments result in greater earnings comparability. Finally, we examine instances in which firms deviate from common sector‐wide definitions of non‐GAAP earnings. We find that these deviations also result in earnings metrics that better represent firms' core operations. Overall, our results suggest that when managers vary their non‐GAAP calculations, either across time or across firms, the resulting non‐GAAP metrics generally enhance the information in earnings about firms' ongoing performance. Thus, our analysis helps mitigate concerns about why managers might vary their non‐GAAP reporting calculations.

ABSTRACT The Clean Development Mechanism (CDM) is a flexible carbon market mechanism managed by the United Nations. The program grants tradable carbon emissions credits (Certified Emission Reductions) for carbon‐reducing projects in developing countries. A project can only be admitted to the program if it is not financially profitable, and thus would not take place without the emission credits granted through the CDM. In this paper, we examine how monitoring reduces incentives of companies to bias the reported expected financial viability of potential CDM projects to gain admission to the program. We find that reported rates of return, which are a key factor for admission to the program, tend to be downwardly biased and are negatively associated with the expected benefits stemming from forecasted greenhouse gas reductions. However, monitoring from various sources mitigates some of the distorted incentives and related reporting bias. Furthermore, the monitoring effect becomes much stronger after 2008, when the CDM Executive Board implemented a series of measures to strengthen the additionality testing that provides guidance for program applications.

ABSTRACT The objective evaluation of evidence is imperative for audit effectiveness and the proper exercise of professional skepticism. However, numerous studies suggest that auditors fail to evaluate evidence objectively when assessing or addressing the risk of material misstatement due to fraud. We develop theory to predict that auditors do evaluate evidence objectively but only when they have stronger wise‐thinking dispositions (WTDs), a construct that is new to the audit literature. We define WTDs as the tendency of individuals to naturally engage in the balanced revision of beliefs and doubts about target phenomena by thinking openly and reflectively about evidence. We report prediction‐consistent results from two experiments that measure the strength of participants' WTDs and manipulate whether the underlying evidence is less or more indicative of fraud. The experimental results also document that auditors vary considerably in WTD strength and collectively demonstrate the reproducibility of audit judgment‐quality benefits of stronger WTDs. We further validate the WTD construct in auditing using confirmatory bi‐factor analyses to show that it has one higher‐order general factor along with several subfactors. Overall, our theory and results advance the literature by identifying WTDs as a determinant of auditors' ability to objectively evaluate evidence. In addition, our findings have implications for standard setters and audit firms as quality control standards and audit working paper review processes might benefit from revisions that take into account that auditors do not objectively evaluate evidence unless they have stronger WTDs.

ABSTRACT This paper reports the results of multiple studies that together provide converging evidence in support of the theory that gender stereotypes bias employee selection during group recruiting events. Specifically, we predict and find that female (male) job candidates who exhibit stereotypically male behaviors receive lower (higher) evaluations during group recruiting events, particularly among male recruiters. Prior research suggests gender stereotypes do not bias employee selection during one‐on‐one interviews. However, our results suggest that evaluating job candidates in the more social context of group events can have important unintended consequences on employee selection, a key component of the accounting control environment. Given the importance of group recruiting events to inform hiring decisions across organizations such as investment banks and public accounting firms, our results contribute to a better understanding of survey and field evidence suggesting that entry‐level male and female employees have different personalities at these organizations, which appear to influence their career trajectories.

ABSTRACT We study manufacturing firms' asymmetric inventory investment in response to sales changes. Focusing on the costs of resource adjustment and stockout that likely differ in sales‐increasing and sales‐decreasing periods, we predict and find that inventory investment declines less during periods with sales decreases than it rises during periods with sales increases. We validate this claim by showing that managers' expectations of future demand and desire to avoid inventory stockouts are important determinants of this asymmetry. In addition, we find that asymmetric inventory investment provides useful information for predicting future sales growth, and that both managers' and analysts' sales forecasts are positively associated with the asymmetry. Lastly, we document that forecasts of future sales growth that incorporate asymmetric inventory investment are associated with lower absolute forecast errors than benchmark forecasts. Overall, we highlight the importance of inventory information in understanding managers' resource adjustment and utilization decisions that have implications for forecasting future demand. Our findings on asymmetric inventory management provide new insights to fundamental analysis based on inventory signals.

ABSTRACT Regulators and researchers tend to focus primarily on the risk‐shifting benefits of audit liability insurance. We obtain field data from the US audit insurance industry (16 interviews and 83 survey responses) to examine whether insurers also possess characteristics favorable to transferring their private risk management knowledge to the audit firms they insure. Possessing such characteristics would enable insurers to use their relative knowledge advantage to provide a benefit to audit firms beyond risk shifting. Thus, examining this issue helps broaden our understanding of insurers' role in auditing. We examine our data through the lens of the knowledge transfer theory and find evidence that audit liability insurers have the motivation and capacity to accumulate and transfer risk management knowledge to the audit firms they insure. We find that audit firms, particularly the small resource‐constrained firms (i.e., non–Big 4 and non‐second‐tier), rely on and benefit from their insurers' risk management knowledge. We also find that insurers transfer such knowledge through multiple mechanisms, including free consultative services, policy premium incentives, and continuing professional education classes. Our results highlight the important role of audit insurers as transferors of risk management knowledge to audit firms. Broadly, our results extend knowledge transfer theory and suggest areas for future research in US and international contexts.

ABSTRACT We test the association between CFO effort and the quality of public firms' financial information environments. We evaluate this relation using a measure of CFO leisure consumption—specifically, the amount of golf played—as an inverse proxy for effort. We find a negative relation between CFOs' compensation incentives and golf play, suggesting they exert more effort when they have greater incentives to increase firm value. High CFO leisure consumption is associated with lower earnings quality, less accurate earnings guidance, and reduced CFO conference call participation. Additionally, CFO leisure appears to affect external monitors, as it is associated with greater analyst forecast dispersion and increased audit fees. We do not find similar relations when evaluating the amount of golf played by CEOs, suggesting the unique importance of CFO effort in the financial reporting process.