Knowledge that Transforms

We provide results from an experiment designed to assess whether mandatory rotation and/or retention of auditors increases auditors' independence by reducing their willingness to issue reports biased in favor of management. Auditors' reporting is compared across the following four regimes: one that does not require either rotation or retention, a second that requires retention only, a third that requires rotation only, and a fourth that requires both rotation and retention. We find that the rotation requirements in the third and fourth regimes decreased auditor‐subjects' willingness to issue biased reports, relative to the two regimes in which rotation was not imposed. In these other two regimes, however, many manager‐subjects voluntarily retained the same auditor‐subjects over multi‐periods. While the long running interactions between manager‐ and auditor‐subjects resulted in more favorable reports by auditor‐subjects (a lower level of independence), the established relationships also induced manager‐subjects to make higher investments.

We investigate (1) whether the variation in accounting standards across national boundaries relative to International Accounting Standards (IAS) has an impact on the ability of financial analysts to forecast non‐U.S. firms’ earnings accurately, and (2) whether analyst forecast accuracy changes after firms adopt IAS. IAS are a set of financial reporting policies that typically require increased disclosure and restrict management’s choices of measurement methods relative to the accounting standards of our sample firms’ countries of domicile. We develop indexes of differences in countries’ accounting disclosure and measurement policies relative to IAS, and document that greater differences in accounting standards relative to IAS are significantly and positively associated with the absolute value of analyst earnings forecast errors. Further, we show that analyst forecast accuracy improves after firms adopt IAS. More specifically, after controlling for changes in the market value of equity, changes in analyst following, and changes in the number of news reports, we find that the convergence in firms’ accounting policies brought about by adopting IAS is positively associated with the reduction in analyst forecast errors.

An implicit assumption of prior literature on strategic behavior of auditors is that auditors know the preferences of their colleagues. In this study, we conduct an experiment to investigate the validity of this assumption. In our experiment, we match a manager with a pair of top and mediocre audit seniors, as assessed by their firm. Each auditor predicts the choices that will be made by other auditors on two tasks that differ in their level of ambiguity. Our results show no difference in the accuracy among managers, top seniors, and mediocre seniors when they predict the choices made by specific individual auditors for both tasks. When predicting the number of managers and seniors who will choose a specific option on the high‐ambiguity task, managers outperform top seniors, who in turn outperform mediocre seniors. For the low‐ambiguity task, we find no difference among managers, top seniors, and mediocre seniors. Our results provide some limited support for models of strategic auditor behavior, and indicate that the ability to predict the choices of others is a dimension of an auditor’s expertise.

We examine whether tax incentives influence where U.S. multinationals locate their interest deductions worldwide. Our sample includes international bond offerings by U.S. multinationals during 1987–1997 denominated in the currencies of Australia, Canada, France, Germany, Italy, Japan, or the United Kingdom. Our results suggest that U.S. multinationals’ debt location decisions take into account the effect of jurisdiction‐specific tax‐loss carryforwards and binding foreign tax credit limitations on the value of debt tax shields. Our results are also consistent with U.S. multinationals locating interest deductions in different tax jurisdictions as a mechanism to achieve tax‐motivated income shifting.

In this study, we propose an alternative technique for estimating the cost of equity capital. Specifically, we use a discounted residual income model to generate a market implied cost‐of‐capital. We then examine firm characteristics that are systematically related to this estimate of cost‐of‐capital. We show that a firm's implied cost‐of‐capital is a function of its industry membership, B/M ratio, forecasted long‐term growth rate, and the dispersion in analyst earnings forecasts. Together, these variables explain around 60% of the cross‐sectional variation in future (two‐year‐ahead) implied costs‐of‐capital. The stability of these long‐term relations suggests they can be exploited to estimate future costs‐of‐capital. We discuss the implications of these findings for capital budgeting, investment decisions, and valuation research.

This paper extends prior studies that attempt to explain the existence of unique securities, particularly Engel, Erickson, and Maydew [1999], by investigating why firms issue non‐voting, non‐convertible preferred stock (PS) instead of other securities. We find that the choice of PS is influenced by tax and regulatory changes imposed by the Tax Reform Act of 1986 (TRA86) and the 1989 Basle Banking Accord as well as various firm specific incentives. We find that industrials issue PS to preserve tax attributes by avoiding an ownership change and to maximize foreign tax credit utilization. In addition, we find that the regulatory requirements of the Basle Accord influence the choice by banks to issue PS. Finally, we show that although firms could have issued alternative securities that would have allowed them to achieve the same tax or regulatory goals, firm specific factors limit their ability to do so. For example, firms can also avoid triggering an ownership change by issuing straight debt, however, financial distress considerations may constrain their ability to issue additional debt. Therefore, we demonstrate that the final choice of PS is influenced by a combination of tax, regulatory, and firm specific incentives.

This study examines the relation between analysts' incentives to cover firms and the extent of their intangible assets. Because intangible assets typically are unrecognized and estimates of their fair values are not disclosed, absent analyst coverage firms with more intangible assets likely have less informative prices. Accordingly, we expect analysts have greater incentives to cover firms with more intangible assets and, thus, predict they have higher analyst coverage. As predicted, we find that analyst coverage is significantly greater for firms with larger research and development and advertising expenses relative to their industry, and for firms in industries with larger research and development expense. We also predict and find that analyst coverage is increasing in firm size, growth, trading volume, equity issuance, and perceived mispricing, and is decreasing in the size of the firm's analysts' brokerage houses and the effort analysts expend to follow the firm. These findings indicate that analyst coverage depends on private benefits and costs of covering a firm. We also test hypotheses related to analyst effort. We predict and find that analysts expend greater effort to follow firms with more intangible assets, after controlling for other factors associated with analyst effort. Our evidence indicates that intangible assets, most of which are not recognized in firms' financial statements, are associated with greater incentives for analysts to cover such firms, and greater costs of coverage. An open question is whether financial statement recognition of intangible assets could more efficiently provide information about such assets to investors.

We incorporate information and managerial incentives into the analysis of a common cost‐management tool—activity‐based costing (ABC). We study the choice of a costing system in a firm where the owners contract with a manager to use either a traditional or an ABC system and make production decisions. We show that, as commonly argued in managerial‐accounting literature, in a first‐best setting with no informational asymmetries the ABC system is always preferred to the traditional costing one. However, when the firm’s manager has relevant private information, the owners’ choice of a costing system is not as clear. We demonstrate that the firm earns higher expected profits under the ABC system when the uncertainty about the manager’s private information is high. Conversely, the firm's expected profit is higher under the traditional costing system when the uncertainty surrounding the manager’s private information is low because the gross benefits of better information provided by ABC are exceeded by the additional informational rents the owners must pay the manager under this system. Our results provide a formal explanation of the coexistence of traditional and ABC systems in practice.

The proliferation of alternative information sources has reduced the relevance of corporate annual reports. This paper examines economic outcomes in an oligopolistic industry as investors become better informed but financial reports convey a smaller portion of the total information. Results show that an increase in alternate sources of information, and the resulting decline in relevance of financial reports, leads to a loss in economic efficiency despite the presence of additional information. Investors benefit, but at the expense of consumers and social welfare. Investors benefit not necessarily because the amount of information in the economy increases, but because there is a change in the channels through which the same information is communicated.

This paper reports the results of an experimental economics study designed to examine reputation building by information verifiers (auditors). The results identify boundary conditions to reputation formation and supply insight into auditors’ incentives to form reputations. Reputations form in all sessions of treatments that supply nearly immediate rewards to participants who adopt reputation equilibrium strategies. In contrast, reputations form in less than half of the sessions of a treatment where participants have to maintain reputation equilibrium strategies for number of periods before the market rewards their effort. The results suggest the immediacy of rewards for adopting reputation strategies is a critical determinant of reputation formation.