Knowledge that Transforms

This study reports on an experiment conducted to assess the influence of different affective mood states on auditors’ ability to resist obedience pressure to commit or overlook unethical acts in six audit contexts. Obedience pressure from superiors to comply with unethical directives is of particular concern in public accounting, given the hierarchical structure of audit teams and the power imbalance in superior–subordinate relationships. One hundred and seventy audit seniors from two large international public accounting firms participated in an experiment. Three different moods were induced in participants through work‐related trigger events: one positive active mood state (arousal) and two negative passive mood states (fear and insignificance). These mood states were anticipated to influence auditors’ expressed willingness to comply with their superiors’ unethical directives as set forth in our ethical scenarios. Our results indicate that low levels of arousal and high levels of fear and insignificance influenced compliance intentions. Our results also indicate overall high levels of expressed willingness to comply with superiors’ unethical directives. Implications of our findings for understanding the antecedents of unethical conduct within the accounting profession and for future research are discussed.

We find evidence indicating that donors use third‐party rating information when they donate to U.S. nonprofit organizations (nonprofits). Specifically, using a sample of over 3,800 unique nonprofits rated by the three largest charity rating organizations in 2007, and over 12,000 unrated control nonprofits, we find that rated nonprofits have significantly higher direct donations than unrated charities. We also hypothesize and find that nonprofits with ratings from multiple rating organizations receive incrementally higher levels of donations. In addition, although charities that receive a positive rating have higher levels of donor support than those receiving a negative rating, both positively and negatively rated nonprofits receive a higher level of direct donations than unrated nonprofits. Finally, we find that nonprofits with consistently good ratings receive higher donations than those with mixed or consistently negative ratings, indicating the donor community values consistency across the three rating agencies.

In this paper, we address two questions that emerged in the aftermath of the 2008 financial/banking crisis. First, did the financial statements of bank holding companies provide an early warning of their impending distress? Second, were the actions of four key financial intermediaries (short sellers, equity analysts, Standard and Poor's credit ratings, and auditors) sensitive to the information in the banks’ financial statements about their increased risk and potential distress? We find a significant cross‐sectional association between banks’ 2006 Q4 financial information and bank failures over 2008–2010, suggesting that the financial statements reflected at least some of the increased risk of bank distress in advance. The mean abnormal short interest in our sample of banks increased from 0.66 percent in March 2005 to 2.4 percent in March 2007 and the association between short interest and leading financial statement indicators also increased. In contrast, we observe neither a meaningful change in analysts’ recommendations, Standard and Poor's credit ratings, and audit fees nor an increased sensitivity of these actions to financial indicators of bank distress over this time period. Our results suggest that actions of short sellers likely provided an early warning of the banks’ upcoming distress prior to the 2008 financial crisis.

In this paper, I examine the relation between disclosure commitment and cost of equity capital using accelerated earnings announcement disclosures as a measure of commitment. In settings characterized by imperfect market competition, I find that firms which consistently disclose balance sheet detail in relatively timely earnings announcements have lower costs of capital compared to other firms. This result is statistically significant and economically meaningful, and is robust to various alternative measurements for cost of capital, and alternative designs addressing endogeneity and underlying information quality. Overall, this result is important because it highlights additional dimensions of disclosure commitment (consistency and timeliness), while incorporating important features from theoretical models (information quality and market competition). In particular, my results suggest that consistency and timeliness are salient features of firms' disclosure behavior that have predictable and robust relations with capital market outcomes. This result is robust to controlling for underlying information quality; however, consistent with theory, it is conditional on low levels of market competition.

The literature on shareholder voting has mostly focused on the influence of proxy advisors on shareholder votes. We exploit a unique empirical setting enabling us to provide a direct estimate of management's influence. Analyzing shareholder votes on the frequency of future say on pay (SOP) votes, we find that a management recommendation for a particular frequency is associated with a 26 percent increase in voting support for that frequency. Additional tests suggest that the documented association is likely to capture a causal effect. Management influence varies across firms and is smaller at firms where perceived management credibility is lower. Compared to firms adopting an annual frequency, firms following management's recommendation to adopt a triennial frequency are significantly less likely to change their compensation practices in response to an adverse SOP vote, consistent with the notion that a less frequent vote results in lower management accountability.

Organizations have often been criticized for reliance on a single item of accounting information (e.g., profit) in evaluating performance, because of its incompleteness. We provide theory‐based experimental evidence that under frequently occurring performance‐evaluation conditions (subjective performance evaluation, causal ambiguity, and individual differences in cognitive ability, knowledge, and/or motivation that lead to different interpretations of information), reliance on a single item of accounting information (profit), rather than profit plus additional (e.g., nonfinancial or external) information, can provide two potential benefits which offset the costs of information incompleteness. First, subordinates are more likely to make the management decisions that superiors will evaluate and reward highly—that is, there are fewer coordination failures in management decisions. Second, even after controlling for the presence or absence of coordination failures, subordinates experience less negative surprise about their performance evaluations.

Firms have increasingly adopted open work environments. Although openness is thought to have benefits, it could also expose firms to an unanticipated cost. An open (closed) internal reporting environment makes it more (less) likely that managers will observe a colleague's communications with senior executives. This increase in what one manager knows about another manager's communication to senior executives could facilitate employee collusion to extract resources from the firm. To test whether internal reporting openness results in more collusion, we conduct an experiment in which two managers each make separate reports to the firm about cost information they know in common but that remains unknown by the firm. Because both managers face the same truth‐inducing contract, conventional economic theory predicts that they will not collude to misreport costs regardless of reporting openness. However, using behavioral theory involving trust and reciprocity, we predict and find that managers honor their nonbinding collusive agreements and successfully collude more often in an open versus closed internal reporting environment, leading to lower firm welfare in the open environment. These results suggest that firms should consider how the cost of collusion compares to the benefits of openness.

During the past decade, new regulations have been adopted to improve audit committee effectiveness. Prior research has generally provided evidence in support of these regulations and suggests that a more independent and expert audit committee is more effective. We posit that CEO power reduces or even eliminates the improvements in audit committee effectiveness resulting from independent and financially expert committee members. Thus, CEO power may result in an audit committee that appears effective in form but is not in substance. We construct a composite index for CEO power by combining ten CEO characteristics and employ the incidence of internal control weaknesses as a proxy for audit committee monitoring quality. Since all the firms in our sample have completely independent audit committees, we use financial expertise to examine the impact of CEO power on audit committee effectiveness. We find that, when CEO power is low, audit committee financial expertise is negatively associated with the incidence of internal control weaknesses. However, as CEO power increases, this association monotonically weakens. When CEO power reaches a sufficiently high level, this association is no longer negative. The moderating effect of CEO power on audit committee effectiveness is more prominent when the CEO extracts more rents from the firm through insider trading. Our results are not driven by the CEO 's involvement in director selection. Our paper suggests that more expert audit committees in form do not automatically translate into more effective monitoring. Rather, the substantive monitoring effectiveness of audit committees is contingent on CEO power.

We examine whether firms decrease tax reserves to meet analysts’ quarterly earnings forecasts in the period prior to FIN 48, and whether that behavior changed following FIN 48. We use analysts’ forecasts of pretax and after‐tax income to impute premanaged earnings, or earnings before any tax manipulation. Pre‐ FIN 48, we observe that firms reduce their tax reserves (i.e., increase income) when premanaged earnings are below analysts’ forecasts. Specifically, 78 percent of firm‐quarters that would have missed the analyst forecast if not for the tax reserve decrease, meet that target when the decrease is included. Furthermore, we find a significant positive association between the decrease in tax reserves and the deviation of premanaged earnings from analysts’ forecasts. In contrast, post‐ FIN 48, we find no evidence that firms use changes in tax reserves to manage earnings to meet analysts’ forecasts. Thus, our results suggest that FIN 48 has, at least initially, curtailed firms’ use of tax reserves to manage earnings.

This study examines the implicit incentive effects of horizontal monitoring and team member dependence for individuals working in teams but facing explicit incentives based solely on measures of individual performance. We combine proprietary performance data with survey data for 133 internal auditors. We show that the social influences of relatively high levels of both horizontal monitoring and team member dependence provide implicit incentives that motivate individual performance, making the provision of team rewards unnecessary to ensure individual and team productivity. We conclude that horizontal monitoring and team member dependence are complementary control mechanisms whose effectiveness helps explain the observed practice of organizing work into teams without explicit team‐based rewards.