Knowledge that Transforms

ABSTRACT We examine whether proxy advisory firms (PAs) serve primarily an information intermediary role by providing research and voting recommendations to shareholders, or directly influence executive compensation by exerting pressure on firms to adopt preferred pay practices. Through a field study, we find that PAs are perceived as both information intermediaries and agenda setters and that these roles provide leverage to enable PAs to exercise significant influence over executive pay practices. Boards feel, and sometimes yield to, pressure to conform to PA “best” practices despite their own preferred compensation philosophies, even in the absence of overt PA scrutiny or negative shareholder votes. We also find that PAs are susceptible to conflicts of interest and generally use a “one‐size‐fits‐all” approach to voting recommendations. Overall, however, PAs are viewed as improving compensation practices by increasing transparency and accountability and fostering dialogue between firms and their shareholders.

ABSTRACT Prior research demonstrates that a strong institutional infrastructure in a country moderates self‐serving behavior of market participants. Cross‐country economic activities have increased significantly, presenting a research opportunity to examine the relative influence of local versus foreign institutional infrastructure on individual market participants. We utilize variation in analyst‐country location relative to covered firm location to examine institutional determinants of optimism in analyst research. Focusing on target prices, where persistent optimism is well documented, we find that analysts domiciled in countries with stronger institutional infrastructures exhibit significantly attenuated target price optimism and more value‐relevant target prices. Our results demonstrate the importance of domestic country‐level institutional factors in moderating self‐serving behavior of market participants engaged in cross‐country activities.

ABSTRACT We examine whether stress tests distort banks' risk‐taking decisions. We study a model in which a regulator may choose to rescue banks in the event of concurrent bank failures. Our analysis reveals a novel coordination role of stress tests. Disclosure of stress‐test results informs banks of the failure likelihood of other banks, which can reduce welfare by facilitating banks' coordination in risk‐taking. However, conducting stress tests also enables the regulator to more effectively intervene banks, coordinating them preemptively into taking lower risks. We find that, if the regulator has a strong incentive to bail out, stress tests improve welfare, whereas if the regulator's incentive to bail out is weak, stress tests impair welfare.

ABSTRACT We analyze data made available through the PCAOB (Public Company Accounting Oversight Board) to provide descriptive evidence on the properties of auditors’ actual quantitative materiality judgments and the implications of those judgments for financial reporting. Auditors’ quantitative materiality judgments do not appear to result simply from applying conventional rules of thumb (e.g., 5% of pretax income), but instead are associated with size‐related financial statement outcomes (income, revenues, and assets), where the relative importance of the size‐related outcomes varies with client characteristics such as financial performance. Using the distribution of actual materiality amounts reported by auditors to the PCAOB as part of the audit‐inspection process, we construct a materiality‐judgment measure that locates a specific materiality amount within a normal range that is both comparable across varying client characteristics and supported by guidance in audit firm internal policy manuals. We find that looser materiality (an amount closer to the high end of a normal materiality range) is associated with fewer audit hours and lower audit fees, supporting the construct validity of this measure. We also find that looser materiality is associated with lower amounts of proposed audit adjustments and, in extreme cases, with a greater incidence of restatements, highlighting the importance of auditor materiality assessments for financial reporting reliability.

ABSTRACT We examine whether financial advisors with pre‐advisor criminal records pose a greater risk to investors than those without. We find that financial advisors with pre‐advisor criminal records are more likely to receive future customer complaints. Their complaints are more likely to receive arbitration awards or settlements and are more likely to involve large settlements exceeding $100,000. Finally, clients are more likely to suffer service disruptions from engaging advisors with pre‐advisor criminal records, even incremental to the brokerage firm being high‐risk. Although we do not have performance data of individual advisors, mutual funds of those firms that employ advisors with criminal records do not provide their clients with superior returns nor charge lower fees, suggesting that there are not compensating benefits to offset the investor harm. Overall, pre‐advisor criminal record serves as an important ex ante characteristic available to regulators, investors, and employers for risk‐assessment purposes.

ABSTRACT This paper uses three alternating changes in hedge fund regulation to study whether regulation reduces hedge funds’ misreporting, and, if so, why regulation is effective. Relative to public companies, hedge fund regulation is relatively light. Much of the regime is a “comply‐or‐explain” framework that allows funds to forego compliance with governance rules, providing that they disclose their lack of compliance. The results show that regulation reduces misreporting at hedge funds. Further analysis suggests that the disclosure requirements led funds to make changes in their internal governance, such as hiring or switching the fund's auditor, and that these changes induced funds to report their financial performance more accurately.

ABSTRACT We investigate the role that regulatory strictness plays on the enforcement of financial reporting transparency in the U.S. banking industry. Using a novel measure of regulatory strictness in the enforcement of capital adequacy, we show that strict regulators are more likely to enforce restatements of banks' call reports. Further, we find that the effect of regulatory strictness on accounting enforcement is strongest in periods leading up to economic downturns and for banks with riskier asset portfolios. Overall, the results from our study indicate that regulatory oversight plays an important role in enforcing financial reporting transparency, particularly in periods leading up to economic crises. We interpret this evidence as inconsistent with the idea that strict bank regulators put significant weight on concerns about the potential destabilizing effects of accounting transparency.

ABSTRACT We analyze the expected value of information about an agent's type in the presence of moral hazard and adverse selection. Information about the agent's type enables the principal to sort/screen agents of different types. The value of the information decreases in the variability of output and the agent's risk aversion, two factors that are typically associated with the severity of the moral hazard problem. However, the value of the information about agent type first increases but ultimately decreases in the severity of adverse selection. The decrease comes about because the means available to the principal to induce effort—namely, the pay–performance sensitivity—must also be used to sort/screen agents, and these two goals conflict. This decline in value occurs despite the monotonically increasing importance of the information in determining the principal's expected profits. Further, we show that the peak value of information occurs at a predictable level of adverse selection. These results imply that over some range, the importance of the information will be increasing, and the value of the information will be simultaneously decreasing, in the severity of adverse selection.

ABSTRACT Drawing on the political theory of judicial decision making, our paper proposes a new and parsimonious ex ante litigation risk measure: federal judge ideology. We find that judge ideology complements existing measures of litigation risk based on industry membership and firm characteristics. Firms in liberal circuits (the third quartile in ideology) are 33.5% more likely to be sued in securities class action lawsuits than those in conservative circuits (the first quartile in ideology). This result is stronger after the U.S. Supreme Court's ruling in the Tellabs case. We next show that the effect of judge ideology on litigation risk is greater for firms with more sophisticated shareholders and with higher expected litigation costs. Furthermore, judicial appointments affect litigation risk and the value of firms in the circuit, highlighting the economic consequences of political appointments of judges. Finally, using our new measure, we document that litigation risk deters managers from providing long‐term earnings guidance, a result that existing measures of litigation risk cannot show.

ABSTRACT Exploiting the staggered enactment of country‐level mergers and acquisitions (M&A) law as an exogenous increase in corporate takeover threat, this paper examines how a disciplinary market for corporate control affects accounting conservatism. Following M&A law adoption, we find increased accounting conservatism, with more pronounced effects in countries with weak shareholder protection and in those experiencing larger growth in takeover activity. Further analysis reveals that elevated takeover threats increase conservatism through changes in capital structure and investment decisions as well as improvements in board monitoring. Our findings highlight the importance of the market for corporate control in shaping financial‐reporting outcome.