Knowledge that Transforms

The wide-spread reporting of non-GAAP earnings suggests efficiency gains from doing so. By estimating a dynamic investment model, we examine the real implications of investors using both GAAP and non-GAAP earnings to value firms. When investors use the firm’s GAAP earnings only, the firm’s manager—who cares about current stock prices—underinvests, and his investment is sensitive to transitory earnings. Non-GAAP earnings can improve investment efficiency by adjusting for these transitory earnings, but can also hide inefficient investment by introducing opportunistic bias. Although non-GAAP earnings induce overinvestment, they dominate GAAP-only reporting. Counterfactual analysis reveals supplementing GAAP earnings with biased non-GAAP earnings increases firm value by 3.4 percent relative to GAAP-only reporting. Precluding bias reduces overinvestment and further increases firm value by 1 percent. Data Availability: Data are available from the sources cited in the text.

We study whether recognition versus disclosure affects debt contracting using SFAS 158 as a setting. Upon recognition of previously disclosed pension liabilities, we find that debt contracts of firms that have high pension underfunding contain relatively more covenants based on the balance sheet and a lower cost of debt. Additional analysis suggests that improved reliability of recognized information is a likely mechanism for these findings. We also document that recognition did not affect the credit risk of the borrower or the use of income statement–based covenants that were unaffected by the accounting standard change. Collectively, our evidence suggests that recognition of previously disclosed accounting information can facilitate the incorporation of that information into lenders’ screening and monitoring. Data Availability: Data used in this study are available from public sources identified in the study.

In 2010, the Municipal Securities Rulemaking Board proposed a rule change requiring the display of current credit ratings on the EMMA website, a centralized repository of municipal bond information. Before the rule change, current credit ratings were freely available on individual rating agencies’ websites or on EMMA if municipalities provided relevant continuing disclosures, making it unclear whether the rule change would benefit investors. A difference-in-differences analysis reveals the rule change is associated with a 6–8 basis-point decrease in investor transaction costs. This effect is concentrated among the intended beneficiaries (retail investors) when credit risk information demand is high (long-maturity bonds) and current credit rating information on EMMA is low (no continuing disclosure of rating changes was provided on EMMA). The rule change appears to have helped retail investors become aware of current credit ratings by filling a disclosure gap on EMMA for municipalities without continuing disclosures of rating changes.

This paper presents a unifying model of disclosure in the presence of competitors and supply market reliance to examine the role of multisegment operations on disclosure choice. A firm’s private information can have varying demand implications for its own portfolio of segments and for its competitors’ portfolios of segments. In multisegment firms, cross-firm spillovers of information discourage disclosure whereas cross-segment spillovers encourage disclosure. This suggests multisegment firms with more informationally diverse segments will have more incentives for transparency. Further, in multisegment firms, reliance on an imperfect supply market has less detrimental effects on transparency compared to single-segment firms. Supply market reliance is less detrimental for multisegment firms with a more diverse portfolio of segments. The results suggest that multisegment firms have more incentives for transparency relative to single-segment firms.

We examine the effects of mandating compensation disclosure on executive incentive contracts, earnings management, firm value, and social welfare. We develop a moral hazard model with multiple principal-agent pairs facing an external monitor who allocates resources across firms to verify earnings management. With such scrutiny allocation, contracts exhibit externalities that create a coordination problem among principals. Contract disclosure enables principals to design the contract anticipating the monitor’s reaction. However, it may also exacerbate the coordination problem among principals because they do not consider externalities on other principals caused by the effects of their contract choices on the monitor’s scrutiny allocation. If internal controls are relatively weak, contract disclosure may make contracts more strongly contingent on reported earnings, increase earnings manipulation, and nevertheless increase social welfare. Contract disclosure improves firm value only if the scrutiny resources available to the monitor are not strongly constrained.

Access to firms’ innovation outputs determines the extent of knowledge spillover that poses risk to innovation appropriability. We provide plausibly causal evidence that processing costs of financial disclosures, which inform users of the economic value of innovation, play a key role in firms’ management of knowledge spillover. We exploit an exogenous, randomly assigned, and staggered policy shock by the SEC that reduces processing costs of mandatory financial disclosures. In response, firms reduce patenting rates, with the effect concentrated among firms in more competitive industries and with lower costs of capital. Firms also reduce their patent disclosure quality. Our results suggest firms rely more on trade secrecy as their innovation property protection mechanism. Lower processing costs of financial disclosures affect neither innovation inputs nor voluntary disclosure practices. Our results show that firms strategically manage access to their innovation outputs through financial disclosures, patent disclosures, and trade secrecy to curb knowledge spillover.

As audits of public companies are labor intensive, require a variety of team members, and involve year-round work, practitioners and academics have increasingly focused on identifying audit production factors that drive audit quality. Using proprietary data, we analyze the cost-benefit tradeoffs of two audit production characteristics, client expertise and the relative amount of auditing done during the early phases of the audit, and find that both are associated with more effective audits and higher fees. We analyze whether the influence of these characteristics varies across audit team members. We find that middle manager production characteristics explain audit effectiveness and higher fees and relatively more so than those of lead/review partners. These results extend the literature and practitioner discussions about drivers of audit quality by highlighting the importance of middle management, which, to our knowledge, has largely been overlooked by the archival audit literature and regulatory guidance on audit quality indicators. Data Availability: This paper exploits proprietary PCAOB data. Data descriptions are available in the text.

Using a Supreme Court ruling that rejected the use of “bright-line” rules previously relied upon in evaluating materiality claims, this study examines how heightened materiality uncertainty impacts audit pricing. We expect the heightened uncertainty to make it more difficult for auditors and clients to assess materiality and to reach a consensus on materiality assessment, which increases audit effort and engagement risk, leading to higher audit fees. Consistent with this prediction, we find that after the ruling, audit fees increase significantly for treatment firms in the circuits using bright-line rules in the pre-ruling period, relative to control firms not affected by the ruling. This effect is stronger when auditors have lower quality or lower industry expertise, and when investors have more diverse opinions. We also find that for firms audited by low-expertise auditors, auditor turnover due to auditor-client disagreement on materiality-related issues increases significantly for treatment firms relative to control firms. Data Availability: Data are available from the public sources cited in the text.

We employ a novel machine learning technique to classify analysts’ forecast revisions into five types based on how the revision weighs publicly available signals. We label these forecast types as quant, sundry, contrarian, herder, and independent forecasts. Our tests reveal that a greater diversity of forecast types within the consensus is associated with increased consensus dispersion and improved consensus accuracy. Additionally, consensus diversity is associated with an improved information environment for firms, as reflected in reduced earnings announcement information asymmetry and volatility, higher earnings response coefficients, and faster price formation. Our study sheds light on how analysts revise their forecasts and documents capital market benefits associated with different analyst forecasting approaches.

Using a unique hand-collected dataset of purchase obligations, we find that customers’ financial reporting quality is positively associated with future supply contracts, indicating that suppliers are more willing to contract with customers who provide them with better information. Further, the association between customers’ financial reporting quality and future supply contracts is stronger for customers with strong bargaining power, which is consistent with suppliers relying more on financial reports when they have less access to customers’ private information. Collectively, our results suggest that customers’ financial reporting quality plays an important role in influencing suppliers’ decisions to contract with customers for the future supply of goods and services. Data Availability: Data for dependent variable are manually collected and data for all other variables are available from public sources cited in the text.