Knowledge that Transforms

We examine how coproduction develops between auditors and clients and its potential impact on the professional skepticism (PS) of auditors. We mobilize Knechel, Thomas, and Driskill’s (2020) theoretical framework and Social Exchange Theory to analyze interviews with 24 audit partners and 26 chief financial officers and controllers. We find that auditors and clients share a view that they cocreate audits as they each contribute and combine competencies. Coproduction redresses information asymmetries, which enables PS. Although auditor-client relationships (ACRs) facilitate coproduction through reciprocity and trust, coproduction fosters conditions where auditors must balance exercising skeptical judgments and actions and abdicating professional responsibilities that result in impaired PS. The findings are useful for audit practitioners, standard-setters, and regulators as they will help strengthen policies, standards, and regulations on managing ACRs to enhance PS. The study offers theoretical and methodological directions for future research. Data Availability: Data are protected by confidentiality agreements with the interviewees.

Evidence reveals that managers exercise discretion over budget estimates, but little is known about whether revenues or expenses are more susceptible to budget discretion. Drawing upon regulatory focus theory, we predict a pattern of budget discretion that has not previously been identified. To test our theory, we conduct a series of experiments where managers face a goal to either minimize the performance metric to avoid missing the target (minimal budget goal) or maximize the performance metric to achieve a desired outcome (maximal budget goal). When managers face a minimal budget goal, they are more likely to make self-interested budget estimates for uncertain expenses than monetarily equivalent uncertain revenues. Conversely, when managers face a maximal budget goal, they are more likely to make self-interested budget estimates for uncertain revenues than monetarily equivalent uncertain expenses. Thus, managers prefer acts of inclusion over acts of exclusion when pursuing their budget goals.

This study focuses on the effect of disclosure processing frictions in labor markets. We go back in time 30 years ago and examine whether firms facing strong organized labor strategically responded to the implementation of the Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system, which substantially reduced labor unions’ information processing costs. Consistent with firms having incentives to maintain an information advantage over unions for bargaining purposes, we find that they reduce financial statement disaggregation, the likelihood and frequency of management forecasts, and the proportion of good news forecasts. Our study is the first to investigate the implications of information processing costs for labor markets and suggests that an SEC mandate intended to reduce disclosure processing costs for investors caused unintended strategic responses by firms facing proprietary cost of disclosures in other markets. Data Availability: Data are available from sources identified in the text.

This study investigates the impact of the harmonization of tax transfer pricing across jurisdictions on multinational companies’ reporting and tax authorities’ auditing strategies. Applying a game-theoretical approach, we assess how enhancing standards consistency and global tax transparency influences tax avoidance and double taxation, producer and consumer surplus, and countries’ tax revenue. Although increasing transparency is generally perceived to discourage tax avoidance, we show that this effect vanishes when standards are inconsistent. We demonstrate that high global tax transparency and consistent standards maximize global social welfare. However, from the perspective of multinational companies or individual countries, the optimal mix of consistency and transparency may differ. These findings highlight why transfer pricing harmonization is difficult and how single-player incentives undermine the envisioned benefits of tax harmonization. This study offers valuable insights for policymakers who aim to curb tax avoidance and mitigate the risk of double taxation.

Firm disclosures are observed by multiple audiences with diverse interests. Recognizing this practical feature, studies have examined how conflicting incentives provided by the multiple recipients of the information affect disclosure outcomes. Understandably, studies have not examined scenarios wherein disclosure incentives from recipients align in the same direction. With aligned incentives, disclosure incentives are presumably “additive.” This paper challenges such thinking. We model a firm that faces a potential entrant and a scrutinizing regulator so each individually incentivizes the firm to withhold favorable market news. However, we show that their joint presence can drastically change the disclosure equilibrium: the firm may voluntarily disclose good news seemingly in self-sabotage. Such disclosures attract entry, compelling the firm to yield its monopoly position. However, by ceding market power, the firm boosts consumer surplus and soothes regulatory concerns. The ensuing reduction in regulatory costs borne by the firm can then increase the firm’s overall value.

Nonactivist investors that own more than 5 percent of a firm must report their holdings by filing a 13G in which they must commit to not influencing control of the firm. Mutual fund families are the most common investors filing 13Gs. I study whether the 13G requirement affects mutual fund families’ voting in proxy contests. I find mutual fund families that file the form are less likely to vote for activist proposals than are those that do not, suggesting that the requirement discourages mutual fund families from supporting activists who seek to influence control of the firm. The effects strengthen when vote outcomes directly affect the firm’s control and when activists pose a higher threat to the firm. I further document that the aggregate voting power of 13G-filing mutual fund families correlates with management winning contested votes and retaining board seats during proxy contests. Data Availability: Data are available from the public sources cited in the text.

I explore the real effects of an update in loan loss accounting, the current expected credit loss (CECL) model. Although CECL’s predecessor only required banks to recognize losses after an event that made a loan uncollectible, CECL requires banks to recognize expected lifetime credit losses when originating loans. CECL’s earlier recognition of loan losses increases the cost of reserving regulatory capital for loans, decreasing banks’ willingness to lend. Empirically, I find that, following CECL’s approval, capital-constrained banks reduce their growth of total loans and residential loans. I also find that, for the residential loans banks continue to make, they choose to sell more shortly after origination, increasing the size of their originate-to-distribute (OTD) business. The increase in OTD mortgages is more pronounced for public banks, implying that their need to adopt CECL earlier than private banks outweighs the fact that they have better access to additional capital. Data Availability: Data are available from the public sources cited in the text.

Guided by the performance feedback literature, we study PCAOB inspections as a nonstandard feedback event. We use an experiential questionnaire to collect and analyze perceptions, reactions, and responses to inspection feedback from 120 partners and managers subject to a recent PCAOB inspection. Despite varying perceptions, we find on average auditors perceive strong firm support but also that firms acquiesce to inspectors. Generally, the feedback source, inspectors, are perceived as professional, organized, and knowledgeable and auditors agree with the feedback message, perceiving it as consistent and well reasoned. We observe a range of auditor reactions (satisfaction with and motivated to use inspection feedback), responses at the engagement level (improvements to audit quality and inspection risk or impression management), and individual responses. Multivariate analyses show more positive feedback perceptions improve reactions, which enhance desirability of responses and are robust to considering the inspection outcome, offering insights for refining inspection interactions and processes.

In 2014, the PCAOB adopted a new auditing standard, AS 18 Related Parties, with the intention of enhancing auditors’ performance in auditing related-party transactions (RPTs). Using hand-collected data, we find significant reductions in both firms’ restatement risk and their engagement in RPTs following the AS 18 adoption. Such reductions are especially pronounced for smaller firms and firms having RPTs with principals, in which related persons in the counterparty of RPTs are the primary beneficiaries, such as CEOs, board chairs, or primary shareholders. We also find that smaller firms having RPTs with principals tend to pay higher audit fees post-AS 18. Our study responds to the PCAOB’s call to assess the economic consequences of AS 18. The findings suggest that AS 18 is associated with improved audit quality and reductions in auditees’ opportunistic RPT activities. Data Availability: Data are available from public sources as cited in the article and from the authors upon request.

The impact of earnings announcements (EAs) on investor uncertainty depends not only on how much new information they contain but also on how long it would take comparable information to arrive in the future through alternative sources, which I term “earnings horizon.” Using a structural model of periodic EAs, I show that earnings horizon is not captured by standard empirical measures of earnings informativeness or timeliness based on the event-study approach. However, earnings horizon can be estimated using patterns in return volatility over firms’ reporting cycles, which indicate that EAs have a short horizon and thus reduce investor uncertainty by one-third the amount suggested by event studies. Moreover, these patterns indicate that it takes investors considerably longer than the three- to five-day windows commonly applied in event studies to fully process EAs and that more frequent financial reporting may significantly enhance EAs’ informativeness. Data Availability: Data are available from the public sources cited in the text.