Knowledge that Transforms

We examine the efficacy of public enforcement in weak investor protection countries by examining the outcomes of a comprehensive public enforcement campaign in China. The campaign, launched in 2007, was designed to help enforce China's first mandatory Corporate Governance Code, issued in 2002. The 2007 campaign was characterized by several important features: (i) the campaign required firms to identify their problems before the securities regulators conducted on‐site inspections; (ii) the campaign provided a detailed checklist of the status of a firm's compliance with the Code; (iii) the campaign was transparent with regard to the disclosure and correction of identified problems; and (iv) the campaign threatened penalties for firms that failed to correct the identified governance problems in a timely manner. Our empirical analyses suggest that the 2007 campaign was effective in improving publicly listed firms' corporate governance. The corporate governance improvement was associated with a reduction in earnings management, higher earnings response coefficients, and higher operating accounting performance. In addition, we find preliminary evidence that the detailed checklist is partially responsible for the efficacy of the campaign. Our results suggest that public enforcement, if properly implemented, works in increasing shareholder value in weak investor protection countries.

We examine whether resource adjustment costs, such as installation and disposal costs for fixed assets, or hiring and firing costs for employees, impede value creation in mergers and acquisitions (M&A). We focus on M&A deals because they are major corporate investment decisions. As a proxy for adjustment costs, we use a firm‐level measure of cost stickiness. We predict that acquirers with high adjustment costs have less flexibility in restructuring resources following the acquisition and will find it more costly to merge the target firm's operations. Consistent with this prediction, we find that the acquirer's adjustment costs are negatively associated with abnormal returns around the acquisition announcement. Additionally, adjustment costs are also negatively associated with deal synergies. Relatedly, we find that acquirers with high adjustment costs purchase targets with high adjustment costs. In accordance with this finding, we show that acquirers with high adjustment costs purchase intangible‐intensive targets. Collectively, our results highlight the important implication of adjustment costs in M&A deals for managers and capital market participants.

Relationships with major customers may be advantageous to suppliers due to economies of scale and reputational benefits. In this study, we investigate whether unionization leads to disruptions in a firm's relationships with its customers. Our goal is to provide insights regarding the impact unionization has on a firm's sales relationships with its major customers. We predict that major customers will shift purchases away from suppliers that unionize to avoid potential disruptions. Using a difference‐in‐differences research design, our results show a negative association between supplier unionization and sales to major customers. Our findings are robust to addressing endogeneity concerns through a propensity score matched analysis and regression discontinuity research design. In addition, we find that supplier firm performance declines subsequent to unionization. We also find that suppliers experience significant increases in their cost of goods sold and the number of employees after supplier unionization, suggestive of higher input prices driving the disruption with major customers. Finally, we provide evidence that higher switching costs mitigate the decline in sales to major customers. Overall, our findings suggest that employee unionization can adversely affect a firm's relationships with their major customers.

Managerial career concerns could affect firm efficiency through financial reporting quality, but this important link has received relatively little attention in the literature. The present study examines this link by developing a model that has the following elements. A risk‐neutral manager provides effort to increase the market value of the firm and to favorably influence the market assessment of the manager's ability. Depending on the magnitude of career concerns, the manager either underinvests or overinvests effort relative to an efficiency‐maximizing level. The analysis identifies conditions under which higher‐quality reporting induces the manager to invest more effort. Under these conditions, the model is extended to a setting in which the manager also chooses the quality of financial reporting at some cost. In doing so, managers seek to reduce distortion in their effort investment. The equilibrium reporting quality and effort investment are determined by a trade‐off between them. In the presence of high uncertainty about the firm's future cash flows, if the manager's career concerns exceed a threshold the manager underinvests in reporting quality and overinvests effort. The empirical implication is a negative relation between managerial career concerns and financial reporting quality. To a large extent, this is consistent with findings in prior empirical studies. Thus, the present study offers a theoretical explanation for the empirical findings as an equilibrium outcome.

Motivated by the increasing influence of shareholder votes on corporate policies, we examine investors' perceptions of activism via voting. To identify instances of activism via voting, we focus on annual meetings with at least one ballot item where a substantial fraction of shareholders is expected to vote against management's voting recommendation, indicating an increase in their monitoring activity. We define such meetings as “contentious.” Using a sample of almost 28,000 meetings between 2003 and 2012, we examine stock returns over the period between the proxy filing and the annual meeting. This period captures when investors learn about the contentious nature of the upcoming meeting and form expectations about its likely impact on firms' policies. We find that abnormal stock returns prior to contentious meetings are significantly positive and higher than those prior to noncontentious meetings. These higher abnormal returns increase with the contentiousness of the meeting; are more pronounced in firms with poor past performance, which are more likely to respond to shareholder pressure; and persist after controlling for firm‐specific news and proxies for risk factors. Our results are consistent with investors' expecting activism via voting to have a positive impact on firm value, on average, and cast doubts on regulatory attempts to restrict the use of shareholder votes.

Prior research has examined target setting in market‐driven companies but has not examined target setting in state‐run companies that also have social and political objectives. I examine how Chinese state‐owned enterprises (SOEs) set and revise performance targets to motivate a balanced effort allocation. Using data on financial performance (sales) targets set by SOEs and non‐SOEs during the period 2006–2016, I predict and find that the financial targets of SOEs are easier to achieve than those of non‐SOEs, and that SOEs with easier financial targets perform better regarding corporate social responsibility. I also predict and find that SOEs ratchet financial targets upward less than non‐SOEs to keep them easy to achieve and, as a consequence, SOE managers are less likely to game performance to avoid future target increases. The results are robust to alternative measures of state influence and alternative measures of financial targets. These findings suggest that firms balance their multiple objectives through strategically setting and revising financial targets. In doing so, this study provides a better understanding of target‐setting practices in organizations pursuing multiple, sometimes conflicting, objectives.

This paper documents a differential role of R&D versus selling, general, and administrative expenses (SG&A) for real earnings management. The distinction of these two components is important because prior studies mostly examine their combined use, but firms could manipulate them differently given the differing valuation implications. Reduced SG&A is viewed positively by investors as evidence of cost reduction, while reduced R&D is viewed negatively by investors as such expenditures are critical signals of expected growth. I examine their use in the context of seasoned equity offerings (SEOs) as well as firms receiving accounting and auditing enforcement releases (AAERs). Although both groups face strong incentives to manage earnings upward by reducing expenses, I predict and find that firms will reduce SG&A but increase R&D. During the manipulation period, SEO and AAER firms exhibit lower discretionary SG&A and higher discretionary R&D, relative to control firms, and investors positively value low discretionary SG&A and high discretionary R&D. Overall, this study confirms the importance of distinguishing between R&D and SG&A in real earnings management contexts and suggests a complementary (substitutive) relation between cutting SG&A (R&D) and accruals management.

We investigate the effect of mandatory IFRS adoption on trade credit. We document that firms in countries that adopt IFRS receive more trade credit from their suppliers, consistent with improved financial reporting quality and comparability playing a role in facilitating informal financing. This increase is larger for countries with a low level of societal trust, a poor pre‐IFRS‐adoption information environment, and stronger legal enforcement. These cross‐sectional results suggest that the conditions under which higher‐quality information is made publicly available affect suppliers' decisions to provide trade credit. This increase is also larger for firms with greater exposure to foreign markets, a finding that highlights the importance of more comparable international financial reporting standards in facilitating cross‐country trade credit. We also find that IFRS adoption has a stronger positive effect on trade credit for firms with greater liquidity needs. Finally, we find that firms in countries that adopt IFRS also extend more trade credit to their customers. Overall, our results support the notion that financial reporting can have a causal effect on trade credit.

Prior research demonstrates that relative performance information affects effort and performance. However, little is known about the qualitative design parameters of these information systems. This study examines, via an experiment, how adding performance category labels to ranks (e.g., “good” ranking position and “poor” ranking position) affects effort and performance. Furthermore, we investigate the effort and performance effects of two design choices observed in practice: the type of performance category labels and the proportion of positively labeled ranks. We argue that performance category labels motivate greater effort and performance through competition for status, which varies with both the type of performance category labels and the proportion of positively labeled ranks. We find partial support for our hypothesis that adding performance category labels increases effort and performance. Specifically, we find positive effects if top ranks are positively labeled and bottom ranks are negatively labeled (combined labels) but not if only top ranks are labeled (positive‐only labels). We also find as predicted that the positive effects on effort resulting from using combined labels, instead of positive‐only labels, are stronger when the proportion of positively labeled ranks is larger. The results for performance are weaker. Our results shed new light on the usefulness of performance category labels and emphasize how firms can render relative performance information more effective.

The centrality of private information in the design of accounting institutions has been explored via agency models that address control concerns as well as disclosure models that amplify valuation issues. This paper derives disclosures by an entrepreneur‐owner when both control and valuation concerns are in play. In particular, the disclosures influence stock price not only via a direct impact on valuation of the firm's revenue but also via an indirect impact on the firm's cost of procuring inputs from a self‐interested and privately informed upstream supplier. In this setting, disclosures are judiciously designed to influence the supplier's decision to share cost information and to control information rents embedded in the procurement contract within the supply chain. Specifically, in order to convey that information rents are not in the offing and, thus, motivate information sharing by the supplier, the owner has incentives to convey a less “rosy” picture. In effect, when controlling supplier actions also becomes important, the owner discloses some unfavorable revenue news that she would have otherwise withheld and conceals some favorable revenue news that she would have otherwise revealed. Consequently, in our model, the disclosure region is either two‐tailed or intermediate, in contrast to the single‐tailed disclosure region implied by familiar valuation considerations alone.