Knowledge that Transforms

ABSTRACT Using SASB’s materiality framework, prior research finds alpha for the portfolio of firms with improving ratings on material ESG issues. We replicate this finding and provide a fundamentals-based perspective on why the materiality portfolio outperforms. Our basic premise is that changes in material ESG issues reflect fundamental firm characteristics. More financially established firms—firms with larger size, lower growth, and higher profitability relative to their sector—are more likely to not only create material strengths but also resolve material weaknesses in their ESG scoring. This fundamental link dictates that one should comprehensively control for fundamental determinants of stock returns before attributing portfolio outperformance to improving material ESG scores. Indeed, we find that the materiality portfolio does not generate alpha after we account for its exposure to profitability and growth factors. Our evidence underscores the issue of correlated omitted fundamental factors in the debate of ESG alpha. Data Availability: Data are available from the sources cited in the text. JEL Classifications: G11; G12; G14; M14; M41; Q51.

ABSTRACT We develop and evaluate an accounting-based Loan Portfolio Risk (LPR) variable that captures time-varying contagion effects in default risk for a portfolio of bank loans. Our results show that an Equity-to-LPR ratio (ELPR) is additive in predicting bank failure up to five years in advance, after controlling for all the capital adequacy, asset quality, management experience, earnings, liquidity, and sensitivity to market risks (CAMELS) variables as well as other fundamental-based bank risk measures from prior studies. Further, we find that publicly listed banks with higher ELPR have lower market-implied costs of capital, especially under market stress conditions. We conclude that ELPR captures key aspects of bank risk that are missing in current Basel Committee risk-weighted-asset calculations. JEL Classifications: E32; G14; G21; K23; M41; M48.

ABSTRACT Prior research suggests that (1) politically active firms have an information advantage over firms that do not engage in the political process but also that (2) politically active firms are more likely to disclose policy-related information. We examine whether there are externalities associated with the processing of political information by politically active firms. We study this question in the setting of intraindustry information transfers around earnings announcements. Measuring firms’ political activism using campaign contributions, we find stronger intraindustry information transfers from politically active firms to their industry peers. These information transfers are stronger when there is more discussion during conference calls of political topics that have industry- or market-wide implications. Similarly, these information transfers are also stronger when there is greater political uncertainty. Our paper highlights an important information externality related to politically active firms’ disclosures and improves our understanding of how politically active firms affect their industries’ information environment. Data Availability: The data used in this study are publicly available from the sources cited in the text. JEL Classifications: D72; M41; M48.

ABSTRACT I examine the real effects of a disclosure mandate that, with the aim of enhancing performance reporting, requires a subset of London Stock Exchange (LSE) firms to describe operational and strategic aspects of value creation, such as business operations and strategies, in their annual reports. Using an instrumented difference-in-differences design, I find that compliance with this initiative, evidenced by more disclosures of performance measures and commentaries relating to business operations and strategies, promotes intangible investments. My analysis of external and internal control systems suggests that enhanced performance reporting promotes investments because it attracts long-term investors and reduces CEO pay sensitivity to earnings performance. JEL Classifications: D22; D82; O30; M41.

ABSTRACT The disclosure requirements of ASC 606 significantly expanded the volume and granularity of revenue information. However, because of the significant judgment associated with the standard, it is unclear whether the new disclosures increased the decision-usefulness of financial reports. To shed light on this question, we investigate the revenue disaggregation requirements of ASC 606. These requirements had significant disclosure consequences, illustrated by an over two-fold increase in the median number of revenue items in disaggregating firms’ reports. Consistent with enhanced decision-usefulness, we find higher (lower) analyst sales forecast accuracy (dispersion) for disaggregating firms. These benefits are primarily present when disaggregation is accompanied by detailed qualitative disclosures, when disaggregated revenues are comparable, and when the granularity of segment information is low. Our study contributes to research evaluating ASC 606 and offers valuable insights to standard-setters currently considering broader disaggregation of income statement items (Financial Accounting Standards Board (FASB) 2022). Data Availability: Data are available from the sources identified in the paper. JEL Classifications: G24; G30; G34.

ABSTRACT This study provides evidence that private loan issuance offers opportunities for borrowers to learn new information about their own risks and subsequently disclose such information in their risk factor disclosures (RFDs) to satisfy lenders’ demand for transparency about borrowers’ risks. This loan issuance effect on risk disclosures is more pronounced when greater learning opportunities are present and when lenders have a stronger demand for borrowers’ risk information transparency. Further analyses suggest that the enhanced risk disclosures following loan issuance not only benefit lenders by reducing the costs of accessing the secondary credit markets, but also create spillover benefits for equity investors by increasing risk information about the borrower and reducing uncertainty about the borrower’s risk. Taken together, these findings suggest that borrowers’ private interactions with lenders provide new opportunities for managers to generate and reflect fresh information in corporate risk disclosures, ultimately benefiting a wide range of capital market participants. Data Availability: Data are available from the sources identified in the paper. JEL Classifications: G21; G32; M41.

ABSTRACT We investigate the role of financial analysts in product quality failures. Relying on information about product recalls, we first show that analyst coverage on average reduces product quality, particularly when managers face greater short-term pressure from institutional investors. However, after identifying a subgroup of analysts who raise questions on product-related issues in earnings conference calls, we find that coverage by these “product analysts” enhances rather than compromises product quality. Firms with greater product analyst coverage are also more likely to retire low-quality products. Additional analysis demonstrates that product analysts help safeguard product quality by further probing into product-related matters and issuing more timely recommendation downgrades after firms announce product deficiencies. Data Availability: Data are available from the public sources cited in the text. JEL Classifications: G24; G34; G38; L15.

ABSTRACT This study examines whether information revealed by firms’ earnings announcements (EAs) forecasts short-run market-wide volatility in equity index prices. Using an exponential generalized autoregressive conditional heteroskedasticity model that includes controls for the information in an array of macroeconomic announcements, we find that EA information aggregated across firms forecasts market volatility at daily and weekly intervals. EA information’s forecasting power is greatest when more firms announce earnings on a given day, when EAs convey negative news, and for EA information about core earnings. Out-of-sample tests confirm that forecasts incorporating EA information better predict short-run market volatility than forecasts omitting EA information. We conclude that firm-level EAs are a significant source of systematic, market-wide information relevant for predicting near-term market volatility. Data Availability: All data are publicly available from sources cited in the text. JEL Classifications: E44; G12; M41.

ABSTRACT We study the real effects on innovation of a transformative change in corporate disclosure dissemination, the implementation of the SEC’s EDGAR system. On the one hand, increased disclosure dissemination can lower firms’ cost of capital, thereby stimulating innovative activity. On the other hand, increased dissemination can exacerbate proprietary disclosure costs, reducing firms’ incentives to innovate. We show that treated firms reduce innovation investment following EDGAR’s implementation. In contrast, EDGAR reporting firms’ innovation investment cuts are met with an increase in innovation investment by their technology rivals. Consistent with an increase in proprietary costs, EDGAR-filers disclose less about their innovation activities. We also find evidence of a redistribution of innovative activity from public to private firms not subject to EDGAR disclosure requirements. Overall, our results are consistent with increased disclosure dissemination crowding out investment in innovative projects, whose returns negatively depend on information spillovers. JEL Classifications: D23; L86; M40; M41; O30; O31; O32; O34.

ABSTRACT We examine the relationship between audit quality and office-level auditor turnover. Using resumes of over 106,000 Big 4 auditors, we find that audit offices with higher turnover have a greater likelihood of client annual report restatements. This detrimental effect is more pronounced when the departing auditors are more experienced and when the office faces tighter human capital constraints and is primarily attributable to voluntary turnover. Further, such negative effect is borne mostly by complex clients and intangible-intensive clients but is weakened for clients with greater product similarity to the client portfolio of the audit office. Last, the impact of office-level turnover on audit quality persists after controlling for firm-level turnover. Our findings inform the current policy debate on whether and to what extent audit firms should disclose auditor turnover as a potential indicator of audit quality. Data Availability: Data are available from the public sources cited in the text. JEL Classifications: M42.