Knowledge that Transforms

Hybrid financial instruments contain features of both liabilities and equity. Standard setters continue to struggle with “getting the classification right” for these complex instruments. In this paper, we experimentally test whether the features of hybrid instruments affect the credit-related judgments of experienced finance professionals, even when the hybrid instruments are already classified as liabilities or equity. Our results suggest that getting the classification right is not of primary importance for these experienced users, as they largely rely on the underlying features of the instrument to make their judgments. A second experiment shows that experienced users’ reliance on features generalizes to several features that often characterize hybrid instruments. However, we also find that experienced users vary in their beliefs about which individual features are most important in distinguishing between liabilities and equity. Together, our results highlight the importance of effective disclosure of hybrid instruments’ features.

ABSTRACT We use a shock to the public scrutiny of firm subsidiary locations to investigate whether that scrutiny leads to changes in firms’ disclosure and corporate tax avoidance behavior. ActionAid International, a nonprofit activist group, levied public pressure on noncompliant U.K. firms in the FTSE 100 to comply with a rule requiring U.K. firms to disclose the location of all of their subsidiaries. We use this setting to examine whether the public pressure led scrutinized firms to increase their subsidiary disclosure, decrease tax avoidance, and reduce the use of subsidiaries in tax haven countries compared to other firms in the FTSE 100 not affected by the public pressure. The evidence suggests that the public scrutiny sufficiently changed the costs and benefits of tax avoidance such that tax expense increased for scrutinized firms. The results suggest that public pressure from outside activist groups can exert a significant influence on the behavior of large, publicly traded firms. Our findings extend prior research that has had little success documenting an empirical relation between public scrutiny of tax avoidance and firm behavior.

ABSTRACT This study examines the costs and benefits of uniform accounting regulation in the presence of heterogeneous firms that can lobby the regulator. A commitment to uniform regulation reduces economic distortions caused by lobbying by creating a free‐rider problem between lobbying firms at the cost of forcing the same treatment on heterogeneous firms. Resolving this tradeoff, an institutional commitment to uniformity is socially desirable when firms are sufficiently homogeneous or the costs of lobbying to society are large. We show that the regulatory intensity for a given firm can be increasing or decreasing in the degree of uniformity, even though uniformity always reduces lobbying. Our analysis sheds light on the determinants of standard‐setting institutions and their effects on corporate governance and lobbying efforts.

ABSTRACT Despite debate on the desirability of rules‐based standards, no studies provide evidence on why accounting standards take on rules‐based characteristics. We identify and test five theories from prior research (litigation risk, constraining opportunism, complexity, transaction frequency, and age) that could explain why some U.S. accounting standards contain rules‐based characteristics. Litigation risk and complexity are most consistently related to cross‐sectional and time‐series variation in rules‐based characteristics. We find more limited evidence that frequent transactions, age, and desires by regulators to constrain opportunistic reporting are related to rules‐based standards. We note, however, that our findings are necessarily descriptive because standards arise endogenously from market and political forces, limiting causal interpretation. Further, it is difficult to perfectly separate rules‐based characteristics of the standard from both the complexity of the standard and the characteristics of the underlying transaction, including the complexity of the transaction.

Effective consultation is critical for improving the audit of estimates. In an experiment where audit managers acted as consultants to other auditors, we examine conditions in which consultants either recommend estimates that differ substantially from advice-seekers’ assessments (contrariness) or recommend narrower reasonable ranges of estimates (precision). Psychology theory argues that both of these attributes can improve estimates. We examine whether these attributes depend on consultants' status motives, that is, the desire to gain respect from or power over others. We find that active status motives lead consultants with higher specialized knowledge to provide recommendations that are less contrary, but more precise. However, consultants increase precision by tightening range bounds in a manner that is not counter to management's preference and thus unlikely to prompt the audit team to challenge the estimate. We also find that higher consultant decision authority constrains precision. Our findings suggest limits to consultation's potential effectiveness in improving estimates. For instance, our findings suggest that firms and standard setters direct consultants to focus scrutiny on the range bound that is most likely to constrain management opportunism.

ABSTRACT To extend and monitor loans, banks collect detailed and proprietary information about the financial prospects of their customers, many of whom are local businesses and households. Therefore, banks’ loan portfolios contain potentially useful information about local economic conditions. We investigate the association between information in loan portfolios and local economic conditions. Using a sample of U.S. commercial banks from 1990:Q1 to 2013:Q4, we document that information in loan portfolios aggregated to the state level is associated with current and future changes in statewide economic conditions. Furthermore, the provision for loan and lease losses contains information incremental to leading indicators of state‐level economic activity and recessions. Loan portfolio information also helps to improve predictions of economic conditions at more granular levels, such as at the commuting zone level. We discuss the relevance of these findings for economic analysis and forecasting, and the relation of our study to prior work on the informativeness of accounting information about the macroeconomy.

This paper studies how bias in nonaccounting and in accounting information should be related. Bias in accounting information is modeled, as in some recent literature, as an alteration in the relative information content of accounting numbers. The optimal bias in one type of information is shown to be a complement of the bias in the other type. This result can be applied in various settings to explain a number of phenomena.

ABSTRACT The use of accounting measures and disclosures in banks’ contracts and regulation suggests that the quality of banks’ financial reporting is central to the efficacy of market discipline and nonmarket mechanisms in limiting banks’ development of debt and risk overhangs in economic good times and in mitigating the adverse consequences of those overhangs for the stability of the financial system in downturns. This essay examines how research on banks’ financial reporting, informed by the financial economics literature on banking, can generate insights about how to enhance the stability of the financial system. We begin with a foundational discussion of how aspects of banks’ accounting and disclosures may affect stability. We then evaluate representative papers in the empirical literature on banks’ financial reporting and stability, pointing out the research design issues that empirical accounting researchers need to confront to develop well‐specified tests able to generate reliably interpretable findings. To this end, we provide examples of settings amenable to addressing these issues. We conclude with considerations for accounting standard setters and financial system policy makers.

ABSTRACT Institutional differences between countries result in additional information risks between borrowers and lenders in cross‐border private loans. This study examines the effect of these information risks on the structure of optimal debt contracts in international (cross‐border) versus domestic private debt markets. Using mandatory IFRS adoption as an indicator for institutional changes that reduced differences between countries, I compare attributes of international versus domestic loans before and after IFRS adoption. I find that, in the pre‐IFRS period, international loans are associated with a higher credit spread, a weaker relationship between the bank and the borrower, a more diffuse loan syndicate, and less reliance on accounting‐based covenants than domestic loans. These results are consistent with incremental information risks in international debt markets that make it more costly for lenders to screen and monitor borrower credit quality, resulting in a more arm's‐length relationship between borrowers and lenders. Many of these associations attenuate after IFRS adoption, suggesting that the pre‐IFRS differences in contract terms are driven by incremental information risks related to institutional differences between countries. My findings imply that incremental information risks result in a different optimal contract in international debt contracts compared to domestic debt contracts.

ABSTRACT We estimate the dynamics of recommendations by financial analysts, uncovering the determinants of inertia in their recommendations. We provide overwhelming evidence that analysts revise recommendations reluctantly, introducing frictions to avoid frequent revisions. More generally, we characterize the sources underlying the infrequent revisions that analysts make. Publicly available data matter far less for explaining recommendation dynamics than do the recommendation frictions and the long‐lived information that analysts acquire but the econometrician does not observe. Estimates suggest that analysts structure recommendations strategically to generate a profitable order flow from retail traders. We provide extensive evidence that our model describes how investors believe analysts make recommendations, and that investors value private information revealed by analysts' recommendations.