Knowledge that Transforms

We provide evidence that sophisticated investors like short sellers, option traders, and financial institutions are more informed when trading stocks of companies with more connected board members. For firms with large director networks, the annualized return difference between the highest and lowest quintile of informed trading ranges from 4% to 7.2% compared to the same return difference in firms with less connected directors. Sophisticated investors better predict outcomes of upcoming earnings surprises and firm-specific news sentiment for companies with more connected directors. Changes in board connectedness are positively associated with changes in measures of adverse selection.

We examine whether directors׳ and officers׳ (D&O) liability insurance affects a firm’s cost of equity. We find a positive association between D&O insurance and the cost of equity. Information quality and risk-taking appear to be two underlying channels through which D&O insurance affects the cost of equity. Further tests suggest that this positive association is not due to optimal risk-taking, as evidenced by a negative market reaction to an increase in D&O insurance coverage, a lack of improvement in firms׳ cash flow and a low valuation associated with high D&O insurance. Overall, our evidence is consistent with the notion that D&O insurance weakens the disciplining effect of shareholder litigation, leading to an increase in the cost of equity.

Economic theory suggests that the industry-wide component of firm performance is more persistent than the firm-specific component. This paper provides evidence on this assertion and tests whether investors misprice these components of earnings. Consistent with predictions, we find greater persistence in the industry-wide component of earnings that is not fully recognized in stock prices. We show that these effects are partially driven by the market׳s inability to recognize the differential persistence of industry-wide earnings in homogenous industries or in the presence of a large business shock. Finally, we show that industry-wide cash flows is the most persistent component of earnings while firm-specific accruals is the least persistent, suggesting that economic fundamentals and accounting constructs are jointly informative about firms׳ future earnings. The market predictably misprices these components, however, significantly underweighting the persistence of industry-wide cash flows and overweighting the persistence of firm-specific accruals.

We argue that conservatism improves investment efficiency. In particular, we predict that it resolves debt-equity conflicts, facilitating a firm׳s access to debt financing and limiting underinvestment. This permits the financing of prudent investments that otherwise might not be pursued. Our empirical results confirm these predictions. We find that more conservative firms invest more and issue more debt in settings prone to underinvestment and that these effects are more pronounced in firms characterized by greater information asymmetries. We also find that conservatism is associated with reduced overinvestment, even for opaque investments such as research and development.

We identify connected auditors as those who attended the same university as the executives of their clients. Using manually collected data from China, we find that connected auditors are more likely to issue favorable audit opinions, especially for financially distressed clients. Moreover, companies audited by connected auditors report significantly higher discretionary accruals, are more likely to subsequently restate earnings downward, and have lower earnings response coefficients. Lastly, connected auditors earn higher audit fees. Collectively, our evidence suggests the impairment of audit quality when auditors and client executives have school ties and the presence of social reciprocity derived from school ties.

We hypothesize that the choice to obtain a financial statement audit provides external financiers with incremental information about the firm, which helps reduce information asymmetry and financing frictions. Using a natural experiment, we show that when external financiers observe a firm׳s choice to voluntarily obtain an audit, the firms obtaining an audit significantly increase their debt, investment, and operating performance, and become more responsive to their investment opportunities. Further, we find that these effects are stronger for firms that are financially constrained and weaker for firms with other means to reduce financing frictions. Overall, our evidence suggests that the audit choice conveys information to capital providers, which reduces financing frictions and improves performance.