Knowledge that Transforms

Abstract Recent work in accounting suggests that managerial optimism can lead managers to escalate income‐increasing earnings management. In this paper, I examine how a fundamental attribute of the earnings management setting—the amount of time between the earnings management decision and the future reversal—serves as one potential source of managerial optimism. I conduct two experiments to test whether the amount of time between the earnings management decision and the future reversal systematically induces optimism that increases participants’ propensity to engage in behavior that is analogous to accruals‐based earnings management and to real earnings management, holding constant incentives, agency frictions, and the information environment. My results indicate that, independent of their innate optimism, the time between the earnings management decision and the future reversal likely encourages managers to overestimate their ability to compensate for current‐period earnings management through strong future performance. This optimism, in turn, likely increases managers’ propensity to engage in both forms of earnings management.

Abstract This paper examines how auditors prepare for the annual general meeting ( AGM ) and how they report their work to the shareholders there. Prior literature has suggested—but not explicitly studied—that the endpoint of an audit is a state of comfort between the auditor and the management and audit committee members, but also is potentially fragile. The fragility can arise from a failure to relay trust to the investor community, which may initiate or increase doubts about the financial report and/or the auditor's independence. We build the case that an AGM is an event to study how the endpoint of an audit engagement is both a state of collective comfort and a fragile state. The analysis is based on ten interviews and three workshops with auditors as well as observations at 67 AGM s. To analyze the field material, the paper draws on Goffman's idea of face‐work, which requires backstage preparations, notably with management, and a front stage performance as an independent auditor to relay trust to the shareholders. The paper details how auditors at the AGM perform as independent verifiers of the management's financial report. Although we recorded that auditors were typically successful in preventing the backstage activities from becoming visible to the shareholders, we found incidents that challenged both the auditors' and the managements' face. In analyzing these incidents, we found that auditors reinforced their image as independent to regain both their own face and the management's face. The management did not take a similar collective responsibility for the auditor's face, which implies that auditors were asymmetrically committed to the management. As a take‐away, the paper discusses how governance mechanisms backstage are linked and can surface front stage at the AGM .

ABSTRACT I investigate the information content of income tax expense using variance decomposition to separate stock returns into cash flow and discount rate news components. While prior literature has focused on linking tax expense with expected future cash flows, I argue that tax expense should also be informative about discount rates because of its ability to summarize fundamental economic performance. Consistent with my arguments, I find that tax expense surprises are correlated with both revisions in future cash flows and revisions in discount rates; however, the economic magnitude of tax expense's impact on returns is primarily through the discount rate channel. I also perform cross‐sectional tests, which reveal that the discount rate implications of tax expense are due not only to its ability to capture fundamental economic performance but also to its ability to convey information about a firm's earnings management and tax avoidance activities.

Abstract This study examines the impact of director tenure diversity on board effectiveness. We find that tenure‐diverse boards exhibit significantly higher CEO performance‐turnover sensitivity and that firms with tenure‐diverse audit committees are less likely to experience accounting restatements. Furthermore, we document that tenure‐diverse compensation committees also award less excess compensation and are less likely to overcompensate. Even though tenure‐diverse boards seem to exhibit superior monitoring performance, there is limited evidence that their firms exhibit superior financial performance. The findings suggest that recent calls for board renewal, to the extent that it would increase tenure diversity rather than just decrease average board tenure, may help enhance board monitoring.

Abstract We study the influence of perceived auditor quality on investment decisions by bond mutual fund investors. Audits of bond mutual funds require significant auditor expertise. Fund managers estimate daily the fair market values of holdings that are often opaque and illiquid. Managers can use their discretion to manipulate their fund's performance results. While it is known that investment flows into funds that report good past performance, little evidence exists about whether investors' confidence in the reliability of fund financial reports is influenced by auditor quality. Using hand‐collected data from SEC filings, we find that the positive association between reported performance and investment flows is stronger for funds with auditors who are industry specialists and are longer‐tenured, as well as for funds that pay higher audit fees. We do not find that auditor office size strengthens the association. We also find that the presence of industry‐specialist auditors, long‐tenured auditors, and higher audit fees lead to additional disclosure in the form of emphasis‐of‐matter. This study contributes to the streams of research investigating perceived audit quality, fund investment decisions, and auditing for financial services.

ABSTRACT This study examines the relation between narrative risk disclosures in mandatory reports and the pricing of credit risk. In particular, we investigate whether and how the Securities and Exchange Commission ( SEC ) mandate of risk factor disclosures ( RFD s) affects credit default swap ( CDS ) spreads. Based on the theory of Duffie and Lando (2001), we predict and find that CDS spreads decrease significantly after RFD s are made available in 10‐K/10‐Q filings. These results suggest that RFD s improve information transparency about the firm's underlying risk, thereby reducing the information risk premium in CDS spreads. The content analysis further reveals that disclosures pertinent to financial and idiosyncratic risk are especially relevant to credit investors. In cross‐sectional analyses, we document that RFD s are more useful for evaluating the business prospects and default risk of firms with greater information uncertainty/asymmetry. Overall, our findings imply that the SEC requirement for adding a risk factor section to periodic reports enhances the transparency of firm risk and facilitates credit investors in evaluating the credit quality of the firm.

ABSTRACT This paper examines the monitoring effect of disclosure frequency from a shareholder perspective. For our analyses, we use a setting in the European Union in which reporting frequency requirements differed across and within countries before being harmonized by a directive requiring the implementation of quarterly disclosure. We investigate how both cross‐sectional differences in reporting frequency and their harmonization affect shareholders' ability to monitor managers. To gauge monitoring effects, we use shareholders' valuation of cash assets. We find that semi‐annual reporters exhibit lower cash valuation than quarterly reporters. Using a difference‐in‐differences approach, we show that these differences recede after semi‐annual reporters implement a higher reporting frequency. Our results are consistent with the notion that more frequent disclosure reduces expected agency costs by providing shareholders with the opportunity for timelier monitoring to constrain managers from expropriating corporate resources. In additional analyses, we find that this monitoring effect is robust to using alternative measures of the change in cash and agency costs as well as alternative benchmark groups. Further, we find stronger effects when corporate governance or earnings quality is low.

Abstract We find evidence consistent with Italian nonlisted subsidiaries engaging in accrual and real earnings management, so that their listed parents can meet or beat benchmarks. Thus, the parent firm drives the earnings management of the subsidiaries. We identify parents that are more likely to have managed earnings as the ones that avoid a small loss or meet or beat analyst forecast by a few cents. Cross‐sectional analysis reveals that Big 4 auditors mitigate accrual earnings management at the subsidiary level and that family‐owned firms use earnings management through nonlisted subsidiaries mainly to avoid reporting losses. Finally, we find that parent firms communicate earnings management strategies to their subsidiaries using board proximity. Our evidence shows that business groups manage earnings differently from single firms, pushing earnings management down to subsidiaries. It also supports the monitoring role of Big 4 auditors in a business group setting and contributes to understanding financial reporting decisions in family‐owned firms.

Abstract Recent theoretical and empirical studies suggest that blockholders (shareholders with ownership ≥ 5 percent) exert governance through the threat of exit. Blockholders have strong incentives to gather private information and sell their shares when managers are perceived to underperform. To prevent blockholders from selling their shares and the firm from suffering a stock price decline, managers align their actions with the interests of shareholders. As a result of the greater manager‐shareholder alignment, managers' actions are more likely to be in shareholders' best interest, and consequently there is less need for managers to manipulate earnings. Consistent with these predictions from economic theory, we find evidence that as exit threat increases, firms have higher financial reporting quality. Theory also predicts that the impact of blockholders' exit threat on financial reporting quality (FRQ) should increase as the manager's wealth is tied more closely to the stock price, and this is what we find. Our study contributes to the research on the impact of shareholders on FRQ and to an emerging literature on the impact of blockholders in financial markets. Blockholders play an important role in managers' reporting outcomes through their actions as informed investors.

Abstract We study the role of borrowers’ balance sheet conservatism (i.e., conservatism in asset values) in debt contract design. We find that borrowing costs are decreasing in the degree of balance sheet conservatism, and this effect is stronger for firms with lower credit quality. This is consistent with balance sheet conservatism reducing lenders’ uncertainty about the liquidation value of assets, thus facilitating the ex ante screening of borrowers. We predict that better ex ante screening also reduces the need for ex post monitoring, and find that balance sheet conservatism is associated with less restrictive covenant terms. Further, we find that asymmetric timeliness in earnings is associated with lower borrowing costs only when balance sheet conservatism is not high. This result suggests that lenders appear to recognize the constraining effect of high balance sheet conservatism on future conservatism in earnings.