The executive compensation literature presumes that shareholders offer risk‐averse managers stock options to entice them to take on more risk, resulting in riskier investment decisions and thus a greater return on investment. However, recent empirical work challenges this assumption, and theoretical research even argues that high levels of option‐based compensation for generally under‐diversified managers may actually lead to greater risk aversion . We evaluate the incentive structure of employee stock options by examining the level of R&D investment and the return on that investment conditional on the portfolio “vega,” which captures the sensitivity of option value to stock price volatility. Our results suggest that both investment in R&D and the return on R&D, as measured by future earnings and patent awards, varies concavely with vega. That is, low to moderate levels of vega correspond to increasing investment in and returns on R&D, consistent with vega inducing more profitable investments, but marginal returns decline as vega increases. Collectively, these results, bolstered by several supplemental analyses, suggest that this surprising relation between vega and risky investment is driven by greater risk aversion at higher levels of vega. Overall, our results imply that employee stock options may not always align the incentives of managers and shareholders.

The SEC reviews firm filings and issues comment letters on those filings. These comment letters play an important role in the assessment of firm value. These activities are seasonally compressed because over 70 percent of registrants have a December fiscal year‐end. Research in other settings finds that busyness leads to negative outcomes. We examine how busyness impacts the frequency, scope, and timeliness of comment letters. We find that the SEC issues fewer comment letters when busy, focuses its limited resources on the most severe cases of disclosure noncompliance, and extends the amount of time between receiving a firm's filing and issuing a comment letter. Despite this, we find no evidence that the SEC misses more serious compliance issues when busy. Our results have implications for policymakers responsible for allocating resources to the SEC.

In an experiment including experienced managers, we investigate how supervisor and subordinate narcissism influence a supervisor's review of a subordinate's accounting estimate. While narcissistic supervisors express greater liking for narcissistic subordinates (narcissistic tolerance), they nonetheless reject and revise the accounting estimates of narcissistic subordinates to a greater extent than they reject estimates of non‐narcissistic subordinates (narcissistic hypocrisy), even when doing so inhibits the supervisor's ability to reach a profit target. Our findings contribute to extant research in accounting and psychology. We demonstrate that narcissistic hypocrisy extends beyond the evaluation of others and alters narcissists' willingness to rely on other narcissists in a meaningful financial reporting decision. We also find that narcissistic hypocrisy is robust across age, gender, and supervisory experience.

The current audit environment encourages auditors to conduct defensive auditing procedures in lieu of using new, innovative, and potentially more effective audit procedures, due to concerns these procedures may be second‐guessed in litigation or by audit inspectors such as the PCAOB. As a result, auditors may prefer traditional “generally accepted” procedures over innovative procedures that are potentially more effective. We test recent proposals that an Audit Judgment Rule (AJR) encourages the use of innovative, and potentially more effective, audit procedures analogous to the similar Business Judgment Rule that affords legal protections to corporate directors. Under an AJR, litigators or audit inspectors could not second‐guess auditor judgments, even if they perceive that alternate judgments would have ordinarily been reached, provided the auditor's judgment was made in good faith and in a rigorous manner. However, the AJR's requirements that auditors must defend the rigor of their innovative judgments could potentially backfire and lead auditors to select more traditional procedures. Under the framework of goal activation theory, we conduct an experiment with audit managers and seniors and find that an AJR makes auditors less likely to select innovative audit procedures, particularly when audit risk is high. They do so despite believing the innovative procedures to be more effective than the traditional procedures. Findings from a supplementary experiment with experienced auditors further suggest that national office affirmation of the reasonableness of the procedures does not help overcome this effect. Overall, our findings suggest that an AJR may have the unintended consequence of further increasing auditors' focus on more traditional, and potentially less effective, audit procedures.

This study investigates the relation between audit regulation and cost of equity capital. There is scant empirical evidence on this relation because changes in audit regulation are frequently accompanied by other major regulatory changes. We exploit variation in the timing of regulatory changes induced by foreign governments' staggered allowance of PCAOB inspections. Using a difference‐in‐differences design, we find that foreign SEC registrants with auditors from countries that allow PCAOB inspections enjoy a lower cost of capital, relative to foreign SEC registrants with auditors from countries that prohibit inspections. Furthermore, we find that this cost of capital effect is attenuated for companies with higher‐quality governance mechanisms. Finally, we document that inspection access is associated with higher‐quality analyst forecasts, which suggests that this change in audit regulation reduces information risk for market participants.

Technological advances are creating a shift in the information disclosure environment allowing more investors to interact with management. We examine three key levels of trader‐management interaction to assess the accuracy of traders' market‐tested value estimates and resulting market price. These data require an engaging experiment and a complex, contextually rich asset, which we create by playing a popular gaming app before the experiment. Participants view financial information, ask management questions, estimate value, and trade. We find that receiving non‐personalized question responses improves trader estimates of value and market price efficiency relative to when traders ask questions but do not expect a response. This occurs because traders exert more effort estimating value and trading. However, receiving personalized versus non‐personalized responses harms value estimates and market efficiency. This occurs because traders receiving personalized responses fixate on the interaction with management, dividing their attention and diverting it away from valuing and trading the asset.

Prior research documents that auditors fail to revise audit plans to effectively address identified fraud cues. While auditors may understand what evidence would address such cues, we propose that auditors fail to apply this understanding because they use implemental mindsets when making decisions for themselves (i.e., deciding). However, we also propose that auditors use deliberative mindsets when advising. To test our predictions, we assign auditors to a decider or an advisor role in a realistic case that contains seeded fraud cues and asks them to consider revising last year's plan. We also manipulate whether the case prompts auditors to revise the plan unconventionally . Results indicate decider‐condition auditors use implemental mindsets: Prompted deciders follow the unconventional plan without regard to underlying fraud risk and unprompted deciders stick with the same‐as‐last‐year plan. Advisor‐condition auditors use more deliberative mindsets: In the prompt and no prompt conditions, they identify plans that are strongly linked to their own fraud risk assessments and that better align with experts' recommended plan for effectively addressing the seeded fraud cues. Supplemental analyses suggest deciding and advising auditors both follow the experts' plan when they believe in its potential effectiveness but, after controlling for the influence of perceived effectiveness, deciding auditors follow it to a greater extent simply because they believe the PCAOB wants it. By contrast, advising auditors do not exhibit signs of excessive PCAOB influence. Our findings provide evidence that seeking informal advice (or thinking like an advisor) helps auditors to effectively revise audit plans in response to identified fraud risk—it helps when a prompt is present or not, suggesting it complements rather than merely substitutes for interventions meant to improve auditors' judgment and decision making.

The SEC has long asserted that earnings management practices result in adverse consequences for investors. We examine whether SEC oversight affects firms' accounting quality in terms of earnings management trade‐offs. We expect that increased firm‐specific regulatory scrutiny, in the form of an SEC comment letter, will induce management to switch from accrual‐based earnings management (AEM), which is a main focus of the SEC, to real‐activities‐based earnings management (REM), which is not likely to be commented on in the SEC's review process. Consistent with our predictions, we find that AEM is lower and REM is higher following the receipt of a comment letter, relative to non‐comment‐letter years and a propensity‐score‐matched sample of non‐comment‐letter firms. However, we do not find a significant difference in total earnings management (i.e., the sum of AEM and REM), suggesting that the higher REM acts as a substitute for lower AEM activity. We further find that our results are driven by accounting comments relating to estimates and accruals and not by classification‐only comments, which suggests that a comment letter that does not question specific issues associated with estimates and accruals is not a strong enough signal to induce the firm to change earnings management behavior. Additionally, the shift to REM is attenuated for firms with high institutional ownership. These results collectively suggest that the comment letter process effectively constrains AEM but has the unintended consequence of firms, on average, switching to REM.

In measuring tunneling with intercorporate loans disclosed by Chinese listed companies, we analyze the underlying channels through which aggressive tax planning facilitates the diversion of corporate resources by firm insiders. Using path analysis, we document that the path from tax aggressiveness to related loans is mediated by both the additional cash flows from tax savings and the increased financial opacity from tax planning, and that additional cash flows plays a much more important role than opacity in helping controlling shareholders to divert corporate resources under the guise of tax aggressiveness. Beyond the two mediated paths, we also detect a residual, direct path from tax aggressiveness to related loans. After an exogenous shock from the government crackdown on diversionary related loans, we find the direct path is fully mediated by the two indirect paths, suggesting that tunneling via related loans only occurs at firms where insiders can mask tunneling under the cover of opacity or can justify related loans on grounds of abnormal cash flows from tax savings. Our evidence supports the notion that greater outside scrutiny increases the hurdle for, but does not entirely eradicate, diversion facilitated by tax aggressiveness. Collectively, our research lends some support to recent theory on the importance of taxes to corporate governance by demonstrating how the agency costs of tax planning allow certain shareholders to benefit from firm activities at the expense of others.