Knowledge that Transforms

ABSTRACT Although prior studies provide evidence on the financial reporting incentives to inflate core earnings through classification shifting (e.g., shifting core expenses to income‐decreasing noncore items), few examine the tax‐related incentive to report lower core earnings through classification shifting. We examine the effect of controlling shareholders' tax incentives on firms' classification shifting using the introduction of a tax law in Korea that imposes a gift tax on controlling shareholders based on firms' reported core earnings. This tax law creates incentives for managers to report lower core earnings through classification shifting, even though doing so would incur significant financial reporting costs. Using a difference‐in‐differences research design, we find that firms with controlling shareholders subject to the gift tax exhibit a significant decline in classification shifting in the post‐tax period, while those not subject to the tax do not. We also predict and find that the extent to which managers reduce classification shifting decreases with financial reporting costs and increases with the tax benefits. Overall, our results indicate that firms forgo financial reporting benefits associated with reporting higher core earnings for the tax savings of their controlling shareholders.

ABSTRACT Prior research documents that information transmitted via director networks affects firms' policies and real economic activities. Given a manager's potential monopoly over firm information, it is important to analyze whether information transmission through director social networks undermines the manager's control. Specifically, we explore whether information flow through director networks influences managers' ability to hoard bad news. We predict and find that the extent of external connections of the board of directors is negatively associated with future stock price crash risk. Additional analysis implies that this evidence is driven by firms with more powerful executives, with weaker auditor monitoring, or subject to strong investor protection, and by directors with greater monitoring incentives or responsibilities and directors with less firm‐specific knowledge. Collectively, our research lends empirical support for the monitoring view under which better‐informed directors narrow the scope for bad news hoarding evident in stock price crash risk. In another series of tests, we fail to find evidence consistent with the information leakage view under which directors pass sensitive firm‐specific information to connections that trade on the information before its public release. Other analysis helps dispel the concern that the endogenous match between directors and companies is spuriously responsible for our core results. Our empirical findings have important implications on how social networks affect the proper functioning of capital markets.

ABSTRACT We study three elements of management control: incentive compensation, performance monitoring, and delegation of authority to managers to contract with lower‐level employees. Using a principal‐agent model, we highlight important direct and indirect interactions between and among these endogenous control elements, themes often emphasized in the economics and accounting literatures using the analogy of a three‐legged stool. We identify circumstances in which control elements are complements or substitutes and exhibit a coherent pattern of practices observed together. For instance, contrary to typical predictions that quality monitoring complements steep effort incentives, we find that when contracting authority adjusts easily to changes in firm circumstances, then both incentive pay and contracting authority substitute for monitoring quality, while incentive pay complements contracting authority. Overall, our findings suggest a number of empirical implications and generally inform a growing literature that documents the presence or absence of complementarities among management control elements.

ABSTRACT Starting in October 2013, auditors of premium‐listed firms in the United Kingdom are mandated to prepare an expanded auditor's report that provides details on audit procedures, risks of material misstatement (RMMs), and materiality thresholds. This regulatory change is important to study, because it aims to increase the informational value of the traditional, highly standardized, pass‐or‐fail auditor's report. We examine whether the disclosures in the expanded auditor's report provide information that is relevant for adopting firms' loan contracting terms in the post‐adoption period. Our results indicate that the introduction of the expanded auditor's report is associated with reduced loan spread and longer maturity for loan facilities of adopting firms relative to non‐adopting UK firms. When we focus on adopting firms in the post‐adoption period, we find that the number of “unique RMMs” mentioned in the auditor's report, but not in the audit committee report, are positively associated with loan spread but are not associated either with loan maturity or the number of lenders in the loan syndicate. Additional tests show that the benefits, in terms of a reduced spread, of having a lower number of “unique RMMs” accrue mostly to adopters with a poor information environment. Taken together, our results provide preliminary evidence that the expanded auditor's report disclosures contain relevant information for loan contracting in the United Kingdom. This study highlights the unique role of the expanded auditor's report in providing information relevant to lenders and supports standard setters' efforts to enrich its informational content.

ABSTRACT This study investigates how sophisticated market participants use tax‐based information by examining whether analysts' street effective tax rates (ETRs) are informative. When assessing firm performance, analysts exclude items they believe do not reflect current performance, resulting in “street” metrics such as street ETR. However, evidence on the properties of the components of street earnings is limited. Examining the informativeness of street ETRs is important because taxes are a significant component of earnings, and the extent to which analysts understand taxes and incorporate them into their analyses is not clear. Using a hand‐collected sample of analyst reports, we find that while approximately 35% of street ETRs have at least one tax‐specific exclusion, over 90% reflect the tax effects of pre‐tax exclusions. Further, both tax‐specific exclusions and the tax effects of pre‐tax exclusions significantly contribute to differences between GAAP and street ETRs. Consistent with analysts' understanding of the implications of tax and nontax exclusions, our results suggest that street tax metrics exhibit greater predictive ability about future tax outcomes and provide more information to investors than GAAP tax metrics. We also find that ETR exclusions are of higher quality when the magnitude of the potentially excluded item is greater and when managers disclose pro forma earnings. Collectively, our findings suggest that analysts understand taxes, but selectively exert effort to incorporate tax‐based information into their assessment of firm performance. Our study should be informative to regulators and users of financial information because it provides evidence regarding the usefulness of street earnings metrics.

ABSTRACT We show that when banks and borrowers share the same audit firm, borrowers receive lower interest rates, after controlling for potentially confounding director connectedness. The common auditor effect is observed only for opaque borrowers, and is greatest when the same audit engagement office audits the bank and borrower. A common auditor connection also matters more for longer‐tenured auditors, for geographically proximate borrowers, and when the syndicate involves fewer lenders. The effect does not hold for auditors recently sanctioned by the PCAOB. Finally, the interest rate discount is not the consequence of homophily or biased decision making, based on a comparison of postloan performance of firms with common auditor loans versus those with noncommon auditor loans.

ABSTRACT This study investigates the mispricing of market‐wide investor sentiment by exploring the relation between sentiment and investor expectations of future earnings. Prior research argues that sentiment‐driven mispricing should be most pronounced for hard‐to‐value firms, such as those reporting losses (Baker and Wurgler 2006). Using investor expectations of future earnings, we provide empirical results consistent with this behavioral finance theory. We predict and find that investors perceive losses to be more (less) persistent during periods of low (high) sentiment; that (in contrast) investors perceive profit persistence to be lower (higher) during periods of low (high) sentiment; and that the effects appear stronger for loss firms relative to profit firms. We also document predictable cross‐sectional variation within losses (with the mispricing mitigated for losses associated with activities expected to generate future benefits), R&D, growth, large negative special items, and severe financial distress. Overall, our results document a new and important channel—investor expectations of future earnings—to explain sentiment‐driven mispricing.

ABSTRACT Cash flow hedge derivatives are an example of an economic transaction that is not fully portrayed in the financial statements in two key ways. First, while changes in the fair value of the derivative are recorded at each reporting date, changes in the value of the underlying purchase or sale commitment are not recorded or disclosed until that transaction occurs. Therefore, until the purchase or sale occurs, the financial statements only portray half of the economic transaction. Second, the gains/losses associated with these derivatives provide an inverse signal about the persistence of firm profitability. We document a method by which financial statement users can partially adjust for these distortions and find evidence that debt investors incorporate information conveyed by cash flow hedge gains/losses into their pricing of new debt issuances. We also find evidence that credit analysts incorporate these adjustments into their firm‐level credit ratings but are unable to find consistent evidence of similar adjustments to credit ratings on new debt issuances. Overall, our results suggest that a subset of sophisticated investors (i.e., those in public debt markets) appear to incorporate information from cash flow hedge accounting into their assessments of firm risk, and that users may benefit from enhanced disclosure about the amount and timing of a firm's future transactions that are exposed to foreign currency, interest rate, or commodity price risk as well as the amount and timing of derivatives that protect the firm from those risks.

ABSTRACT I conduct an experiment with senior executives (CEOs, CFOs, controllers) to examine how their risk disclosure quality, with respect to disclosure volume and specificity, is influenced by three factors: first, whether the disclosure behavior is framed internally by the firm as obtaining a gain or avoiding a loss from disclosure; second, whether the external disclosure regime mandates risk mitigation disclosures that explain how a risk is handled; and third, whether the risk under consideration for disclosure is weakly or strongly mitigated. This research question is important because high‐quality risk disclosures are challenging to regulate and changing how disclosure behavior is framed could substitute for costly disclosure regulations. I predict and find that a gain frame prompts managers to make more detailed risk disclosures than a loss frame, regardless of the disclosure regime. I also predict and find that a loss frame leads to less detailed and more boilerplate disclosure of weakly mitigated risks when risk mitigation plans are mandated. Given that the SEC is considering mandating risk mitigation disclosures similar to the practice in other regimes, my findings provide insights on the limitations of mandating these disclosures. My results suggest that changing managers' disclosure frame internally through firm initiatives could be more effective in prompting higher‐quality risk disclosures.

ABSTRACT In this study, we investigate whether the increase in regulatory scrutiny epitomized by the initial PCAOB inspection impacted audit quality differentially for Big 4 and non–Big 4 auditors to better understand the consequences of PCAOB inspections for different audit firm types. Because of competing views on the effect of PCAOB inspections, the relation between PCAOB inspections and the audit quality differential between Big 4 and other auditors is an empirical issue. Empirically, we take the endogenous choice of auditor as a given and utilize a difference‐in‐differences specification that takes into account the staggered timing of the initial PCAOB inspection for different‐sized auditors in the United States. Our results suggest that the initial PCAOB inspection improved audit quality more for Big 4 auditors than for other annually inspected or triennially inspected non–Big 4 auditors. We also examine annually and triennially inspected non–Big 4 auditors separately, and find that the pre‐post Big 4/non–Big 4 differential audit quality effect is more pronounced for the triennially inspected non–Big 4 firms. In the larger context of the highly concentrated US audit market, our findings that PCAOB inspections accentuate the Big 4/non–Big 4 audit quality differential are of potential interest to public company audit clients contemplating an auditor change, investors interested in learning about the consequences of PCAOB inspections, regulators concerned about the Big 4 dominance of the US audit market, and academics investigating audit quality differences.