Knowledge that Transforms

ABSTRACT We study the stock and audit market effects associated with a widely publicized accounting scandal involving a public company (ComROAD AG) and a large, reputable audit firm (KPMG) in a country (Germany) that has long provided auditors with substantial protection from shareholder legal liability. We use this event to study whether an auditor's reputation helps to ensure audit quality, a rationale for which recent literature and events provide scant support. Given the absence of a strong insurance rationale for audit quality, Germany permits a relatively clean test of whether auditor reputation matters. We find that KPMG's clients sustain negative abnormal returns of 3% at events pertaining to ComROAD, and that these returns are more negative for companies that are likely to have higher demands for audit quality. We also find an increase in the number of clients that drop KPMG in the year of the ComROAD scandal (mostly smaller, recently public companies that are similar to ComROAD). Overall, our results provide support for the reputation rationale for audit quality.

ABSTRACT Regulation Fair Disclosure (FD), imposed by the Securities and Exchange Commission in October 2000, was designed to prohibit disclosure of material private information to selected market participants. The informational advantage such select participants gain is unclear. If multiple “insiders” receive identical information, private information is immediately incorporated in price and each insider has zero expected profit. If, on the other hand, Regulation FD has curtailed the flow of information from firms, private information becomes longer‐lived and more valuable. Hence, market makers will demand increased compensation by widening the adverse selection component of the bid‐ask spread. We identify the cost components of the bid‐ask spread for a sample of NASDAQ stocks surrounding the implementation of Regulation FD. Controlling for other factors affecting the spread, we find that adverse selection costs increase approximately 36% after Regulation FD. We interpret our finding as Regulation FD failing to achieve one of its desired objectives.

ABSTRACT The adoption of business risk audit (BRA) approaches during the 1990s by several leading audit firms has been the subject of considerable scrutiny and commentary. Under BRA, the auditor responds to the increasing complexity of auditee financial reports by acquiring a deep and comprehensive understanding of the auditee's industry, strategy, business models, and processes—tasks best accomplished by higher‐ranked labor—and by employing this understanding to make audit labor allocations. Using proprietary data for 165 audits conducted in 2002, we investigate three propositions about audit labor use under BRA. First, relative to pre‐BRA benchmarks for the same auditor, we expect BRA audits to use a greater proportion of higher‐ranked labor. Second, we expect engagements with high assessed auditor business risk (ABR), a summary risk assessment that reflects the BRA auditor's rich understanding of the auditee, to be allocated more labor and more higher‐ranked labor than pre‐BRA benchmarks. Third, at all ranks of labor, we expect a positive association between assessed ABR and levels of labor use. We find empirical evidence consistent with these propositions. We also find that total labor use in our sample is only modestly lower than pre‐BRA norms. Analysis of fee data from these engagements suggests that audit fees in 2002 are substantially less than would be expected under pre‐BRA benchmarks. After controlling for audit labor use, both total fees and fees per hour increase with assessed ABR for first‐year auditees but not for continuing auditees. Overall, our results provide evidence on the impact of the BRA audit regime and speak to the likely impact of BRA on audit effectiveness and efficiency.

ABSTRACT We investigate how both the ownership structure and explicit contractual structure of syndicated loan deals are shaped by the debt‐contracting value (DCV) of borrowers' accounting information. DCV captures the inherent ability of firms' accounting numbers to capture credit quality deterioration in a timely fashion. We hypothesize and document that when a borrower's accounting information possesses higher DCV, information asymmetry between the lead arranger and other syndicate participants is lower, allowing lead arrangers to hold a smaller proportion of new loan deals. Further, we document that the influence of DCV on the proportion of the loan retained is conditional on the lead arranger's reputation, the existence of a credit rating, and the lead arranger's previous relationships with the same borrower. Finally, we find that when loans include performance pricing provisions, the likelihood that the single performance measure used is an accounting ratio, rather than a credit rating, is increasing in DCV.

ABSTRACT This paper considers the potential for public information disclosures to complement the existing private information of financial analysts. In such a setting, analysts allowed to participate during earnings conference calls by asking questions receive public signals that can facilitate the generation of new and valuable private information for the asking analyst. Realizing these public signals are valuable for the asking analyst, managers can use their discretion to discriminate among analysts by granting more participation to more favorable analysts. I use post–Regulation Fair Disclosure conference call transcripts to document that the probability of an analyst asking a question during an earnings conference call is increasing in the favorableness of the analyst's outstanding stock recommendation. I also find that downgrades are associated with decreases in access to management during the conference call relative to other recommendation change activity. Analyst prestige moderates these effects. Favorable and prestigious analysts have higher participation probabilities than favorable and unprestigious analysts. Further, downgrades result in participation decreases only for unprestigious analysts. These findings are consistent with practitioner and regulatory concerns that managers discriminate among analysts by allowing more management access to more favorable analysts.

ABSTRACT In this paper we examine the effect of managerial ownership on financial reporting conservatism. Separation of ownership and control gives rise to agency problems between managers and shareholders. Financial reporting conservatism is one potential mechanism to address these agency problems. We hypothesize that, as managerial ownership declines, the severity of agency problem increases, increasing the demand for conservatism. Consistent with our hypothesis, we find that conservatism as measured by the asymmetric timeliness of earnings declines with managerial ownership. The negative association between managerial ownership and asymmetric timeliness of earnings is robust to various controls, in particular, for the investment opportunity set. We thus provide evidence of a demand for conservatism from the firm's shareholders.

ABSTRACT We assess the impact of Regulation Fair Disclosure (Reg FD) on the trading behavior of transient institutional investors in the quarter prior to a bad news break in a string of consecutive earnings increases. Bad news breaks are defined as breaks that are by growth firms, preceded by longer strings of consecutive earnings increases, followed by longer strings of consecutive earnings decreases, and associated with larger declines in earnings. Pre–Reg FD transient institutions have abnormal selling of stocks in the quarter immediately preceding a bad news break. This abnormal selling is confined to firms that hold conference calls in the pre–Reg FD period. However, in the post–Reg FD period transient institutions do not exhibit similar abnormal selling of stocks in the quarter before a bad news break. Furthermore, after Reg FD transient institutions allocate less of their stock portfolios to conference call firms relative to non–conference call firms in the quarters prior to a bad news break. These results demonstrate that Reg FD has had an impact on management's selective disclosure behavior and significantly changed the trading behavior of transient institutions.

ABSTRACT We examine whether application of International Accounting Standards (IAS) is associated with higher accounting quality. The application of IAS reflects combined effects of features of the financial reporting system, including standards, their interpretation, enforcement, and litigation. We find that firms applying IAS from 21 countries generally evidence less earnings management, more timely loss recognition, and more value relevance of accounting amounts than do matched sample firms applying non‐U.S. domestic standards. Differences in accounting quality between the two groups of firms in the period before the IAS firms adopt IAS do not account for the postadoption differences. Firms applying IAS generally evidence an improvement in accounting quality between the pre‐ and postadoption periods. Although we cannot be sure our findings are attributable to the change in the financial reporting system rather than to changes in firms' incentives and the economic environment, we include research design features to mitigate effects of both.

ABSTRACT We examine how worker productivity differs when compensation is based on quantity, creativity, or the product of both measures. In an experiment in which participants design “rebus puzzles,” we find that combining quantity and creativity measures in a creativity‐weighted pay scheme results in creativity‐weighted productivity scores that are significantly lower than those generated by participants with quantity incentives alone. Follow‐up analysis indicates that relative to participants in the quantity‐only condition, participants in the creativity‐weighted condition produce approximately the same number of high‐creativity puzzles, but produce significantly fewer puzzles overall. Thus, while participants rewarded for creativity‐weighted output tend to restrict their production to high‐creativity efforts, they are unable to translate this focus into a greater volume of high‐creativity output. Implications address a possible explanation for firms' reluctance to incorporate creativity measures within multidimensional performance measurement systems, notwithstanding published suggestions to do so.

ABSTRACT This paper analyzes how board independence affects the CEO's ability to extract rents from the firm. The CEO is assumed to possess private information about his ability, which the board needs in order to decide whether to replace him. If the board is more active in removing low quality CEOs, the incumbent is better able to use his information advantage to extract rents. Since the board cannot commit not to renegotiate the contract, a board that is fully independent from the CEO is more active than is efficient ex ante. For this reason, shareholders are better off if the board of directors lacks some independence. The model predicts that a trend toward greater board independence is associated with subsequent trends toward higher CEO turnover, more generous severance packages, and larger stock option grants.