Knowledge that Transforms

ABSTRACT: To curb opportunism in financial reporting, researchers and regulators have proposed that firms be required to report reconciliations of prior year estimates. We provide experimental evidence that such disclosures are not sufficient for nonprofessional investors to identify firms that are opportunistic in their estimates. We also offer evidence suggesting that the value of these disclosures can be enhanced when nonprofessional investors seek out information about the estimate accuracy of other firms in the industry (i.e., consensus information). Our study provides insights about these disclosures and the mechanisms that enhance their effectiveness. Our findings have broad implications for standard-setters and future research designed to assist in identifying opportunistic management behavior.

ABSTRACT: Examining corporate investment in low-income housing tax credits reveals that firms are willing to incur costs in order to manage the income statement classification of an expense. Accounting rules allow investors who purchase a tax benefit guarantee to amortize their equity in a real estate partnership as a tax expense, rather than as an operating expense, thus avoiding a reduction in pre-tax earnings. Using confidential data from tax credit syndicators, I model the market price of a tax credit as a function of the existence of the guarantee, controlling for foreclosure risk on the underlying real estate. The results are consistent with the hypothesis that an economically significant amount of the guarantee fee is paid by corporate investors for the right to use an accounting method that avoids reductions in pre-tax earnings.

ABSTRACT: This study examines the effects of financial reporting complexity on investors’ trading behavior. I find that more complex (longer and less readable) filings are associated with lower overall trading, and that this relationship appears due to a reduction in small investors’ trading activity. Additional evidence suggests that the association between report complexity and lower abnormal trading is driven by both cross-sectional variation in firms’ disclosure attributes and variations in disclosure complexity over time. Given regulatory concerns over plain English disclosures and the trend toward more disclosure, my investigation into the effects of reporting complexity on small and large investors should be of interest to regulators concerned with reporting clarity and leveling the playing field across classes of investors.

ABSTRACT: The accounting profession has raised concerns that excessive liability exposure renders audit firms unwilling to provide audit services to risky clients, limiting the prospective clients' ability to raise external capital. We address this concern in a model in which the auditor evaluates the riskiness of the client before accepting the client engagement. We consider a setting in which a shift to stricter legal liability regimes not only increases the expected damage payments from the auditor to investors in case of audit failure, but also increases litigation frictions such as attorneys' fees. The main finding is that the relationship between the strictness of the legal regime and the probability of client rejection is U-shaped. Our model suggests that in environments with moderate legal liability regimes, the client rejection rate is lower than in environments with relatively strong or relatively weak legal regimes.

ABSTRACT: This study examines the interdependence between institutional ownership and the speed with which Standard & Poor's disseminates corporate accounting information. From the demand-side perspective, we find that quasi-indexers, who rely on corporate accounting information as a low-cost monitoring system, are the key driver of the institutional demand for speedy information dissemination. In addition, dissemination speed increases substantially for stocks listed in major market indices but decreases with high arbitrage risk or transaction costs. From the consequences perspective, we find that both transient investors and quasi-indexers gravitate to stocks with faster information dissemination, consistent with the latter using accounting information as a low-cost performance-monitoring mechanism, and the former being better enabled to implement their trading strategies in a richer information environment. Overall, this study provides new insights into the capital market information infrastructure by examining how information intermediaries and sophisticated investors impact each others' resource allocation decisions.

ABSTRACT: The literature addresses optimal contract design issues that the principal must address to provide proper incentives to the agent. However, there has been limited empirical assessment of how agents actually respond to the performance-evaluation schemes in the contracts offered them. Moreover, the literature overlooks factors, other than those from the pay-for-performance context, that may impact the effectiveness of incentive provisions. This study considers the effect of discriminability on agent performance. We find that (1) agent performance improvement is positively associated with the degree of discriminability, (2) subjective measures are inferior to objective measures in providing incentives to the agent because of the lack of discriminability, and (3) the inferiority of subjective measures for incentive purposes is exacerbated in circumstances in which the discriminability gap between objective and subjective measures is significant. Our findings suggest that, in order to have subjective measures effectively complement objective measures, the accounting profession must develop sound performance measurement systems that define and measure subjective performance with sufficient discriminability.

ABSTRACT: We examine auditor independence in the banking industry by analyzing the relation between fees paid to auditors and the extent of earnings management through loan loss provisions (LLP). We also examine whether this relation differs across large banks whose managements are required under the Federal Deposit Insurance Corporation Improvement Act to evaluate internal control over financial reporting and whose auditors must attest to the effectiveness of such internal controls, and small banks that are not subject to those requirements. We find that unexpected auditor fees are unrelated to earnings management for large banks. For small banks, we find greater earnings management via under-provisioning of LLP by banks that pay higher unexpected total and nonaudit fees to the auditor. These results suggest that auditor fee dependence on the audit client is associated with earnings management via abnormal LLP and is a potential threat to auditor independence for small banks. Our findings are relevant to policymakers contemplating new regulations in light of the recent banking crisis.

ABSTRACT: This study examines whether the mandatory adoption of International Financial Reporting Standards (IFRS) in the European Union (EU) in 2005 reduces the cost of equity capital. Using a sample of 6,456 firm-year observations of 1,084 EU firms during the 1995 to 2006 period, I find evidence that, on average, the IFRS mandate significantly reduces the cost of equity for mandatory adopters by 47 basis points. I also find that this reduction is present only in countries with strong legal enforcement, and that increased disclosure and enhanced information comparability are two mechanisms behind the cost of equity reduction. Taken together, these findings suggest that while mandatory IFRS adoption significantly lowers firms' cost of equity, the effects depend on the strength of the countries' legal enforcement.