Knowledge that Transforms

We examine the relation between the fees paid to auditors for audit and non‐audit services, and the choice of accrual measures for a large sample of firms. Using our pooled sample, we find that the ratio of non‐audit fees to total fees has a positive relation with the absolute value of accruals similar to Frankel, Johnson, and Nelson [2002]. However, using latent class mixture models to identify clusters of firms with a homogenous regression structure reveals that this positive association only occurs for about 8.5% of the sample. In contrast to the fee ratio results, we find consistent evidence of a negative relation between the level of fees (both audit and non‐audit) paid to auditors and accruals (i.e., higher fees are associated with smaller accruals). The latent class analysis also indicates that this negative relation is strongest for client firms with weak governance. Overall, our results are most consistent with auditor behavior being constrained by the reputation effects associated with allowing clients to engage in unusual accrual choices.

ABSTRACT We empirically analyze the dynamics of executives' pay‐to‐performance sensitivities. Option pay‐to‐performance sensitivities become weaker as options fall underwater, often leading to pressures to reprice options or restore pay‐to‐performance sensitivity in other ways. Building a detailed data set on executives' portfolios of stock and options, we find that the responsiveness of pay‐to‐performance sensitivities (created by all executive holdings of stock and options) to changes in stock price is large. The elasticity of pay‐to‐performance sensitivities with respect to stock price decreases is about 0.7 and is larger for high‐option executives and for executives with high percentages of options already underwater. The dominant mechanism through which companies offset declines in option pay‐to‐performance sensitivities is larger option grants following stock price declines; on average, these larger grants restore approximately 40% of the stock‐price‐induced pay‐to‐performance sensitivity declines. Option repricings are inconsequential in this regard, despite the attention they have attracted. In looking at positive returns, we find the reverse: higher returns both directly increase pay‐to‐performance sensitivities and lead to larger option grants, which raise pay‐to‐performance sensitivities further. Thus, option grants to executives tend to be largest following large stock price increases or large stock price decreases.

ABSTRACT We examine the relation between auditor characteristics (quality and tenure) and the cost of debt financing. Consistent with the hypothesis that audit characteristics are important to the capital markets, we find that (1) auditor quality and tenure are negatively and significantly related to the cost of debt financing, (2) the relation between auditor characteristics and the cost of debt is most pronounced in firms with debt that is noninvestment grade, and (3) both the insurance and information role of audits are economically significant to the cost of debt. Overall, our results suggest that, through their dual roles of providing information and insurance, auditor quality and tenure matter to capital market participants.

ABSTRACT This paper examines the relation between accounting choice and U.S. institutional investor ownership in non‐U.S. firms. We predict that U.S. investors exhibit home bias in their preference for accounting methods conforming to U.S. Generally Accepted Accounting Principles (GAAP) because such methods are more familiar, reduce information processing costs, and are perceived as higher quality. We find that firms exhibiting higher levels (changes) of U.S. GAAP conformity have greater levels (changes) of U.S. institutional ownership. Lead‐lag regressions suggest that increases in U.S. GAAP conformity precede increases in U.S. investment, but changes in U.S. institutional holdings do not precede changes in accounting methods. We also find that the positive relation between U.S. GAAP conformity and U.S. investment holds regardless of a firm's visibility to U.S. investors (e.g., American Depositary Receipt listing, stock index membership, analyst following, firm size). However, we find that U.S. GAAP conformity has a significantly greater impact among firms already visible to U.S. investors.

ABSTRACT We analyze the optimal behavior of an organization when its employees can manipulate the organization's accounting system to their private advantage. We find that the organization may benefit by helping its employees manipulate the system. This help can reduce the employees' private returns from devoting effort to further manipulation of the accounting system, which reduces the cost of motivating the employees to devote their effort to improving the real (rather than the measured) performance of the organization.

ABSTRACT In this paper we study when it is advantageous to improve corporate transparency by allowing shareholders direct access to corporate information and when it is preferable to rely on a reporting system in which shareholders only gain access to information that management chooses to disclose. We show that in an agency model that allows for contract renegotiation, the desirability of a fully transparent reporting regime hinges on the stewardship properties of the information in question. Specifically, information that is mainly useful for predicting future events and of little use for evaluating past actions should only be made available to the public through management's self‐interested disclosures. Only if the information is useful for making inference about managerial actions can it be optimal to have full corporate transparency, so that outsiders have independent access to the same information as management.

ABSTRACT We examine whether transient institutional investors (i.e., institutions that trade actively to maximize short‐term profits) have information that allows them to predict a break in a string of consecutive quarterly earnings increases and thereby avoid the economically significant negative stock price response associated with the break announcement. We show that transient institutions predict the break at least one quarter in advance of the break quarter. We also provide evidence that is consistent with transient institutions obtaining information regarding the impending break from private communications with management.

Do fees for non‐audit services compromise auditor's independence and result in reduced quality of financial reporting? The Sarbanes‐Oxley Act of 2002 presumes that some fees do and bans these services for audit clients. Also, some registrants voluntarily restrict their audit firms from providing legally permitted non‐audit services. Assuming that restatements of previously issued financial statements reflect low‐quality financial reporting, we investigate detailed fees for restating registrants for 1995 to 2000 and for similar nonrestating registrants. We do not find a statistically significant positive association between fees for either financial information systems design and implementation or internal audit services and restatements, but we do find some such association for unspecified non‐audit services and restatements. We find a significant negative association between tax services fees and restatements, consistent with net benefits from acquiring tax services from a registrant's audit firm. The significant associations are driven primarily by larger registrants.

ABSTRACT We investigate factors associated with firms' decisions in 2002 and early 2003 to recognize stock‐based compensation expense under Statement of Financial Accounting Standards (SFAS) No. 123. We find that the likelihood of SFAS 123 expense recognition is significantly related to the extent of the firm's participation in capital markets, the private incentives of top management and members of the board of directors, the level of information asymmetry, and political costs. Although recognizing firms have significantly smaller SFAS 123 expense, we find no significant incremental relation between recognition likelihood and SFAS 123 expense magnitude after controlling for other factors that we expect explain the recognition decision. We also find positive and significant announcement returns for earlier announcing firms, particularly those stating that increased earnings transparency motivates their decision.

ABSTRACT We examine the effect of higher order beliefs on the ability of decentralized decision makers to coordinate and take advantage of improvements in information transparency that can increase welfare. Theories that address this question have not been empirically explored. We study coordination in a laboratory experiment with privately informed decision makers. Economic outcomes in the setting depend both on agents' rational beliefs regarding economic fundamentals and on their rational beliefs regarding the beliefs of other agents. Increasing information transparency mitigates uncertainty about economic fundamentals but may increase strategic uncertainty, precipitating multiple equilibria and less efficient group outcomes. We provide evidence that sometimes the equilibrium attained by creditors is inferior from a welfare perspective to other available equilibria. Risk dominance appears to determine equilibrium selection in our setting.