Knowledge that Transforms

This study examines the relation between the market value of equity and nonfinancial pollution measures (sulfur dioxide emissions) that capture firms' exposure to future environmental liabilities. I find that a nonfinancial pollution proxy is value-relevant for high-polluting electric utilities targeted for air pollution abatement by Phase One of the 1990 Clean Air Act Amendments (CAAA). On average, these utilities' exposure to (unbooked) future environmental liabilities decreased their mean 1990 share price by 16 percent. Moreover, the value relevance of the nonfinancial pollution proxy (1) increased in response to the passage of the stringent 1990 CAAA environmental legislation, and then (2) declined as the market subsequently reduced estimated compliance costs in response to changing economic and technological factors. Utilities not targeted by Phase One of the 1990 CAAA faced minimal exposure to future environmental liabilities and I find no significant relation between their pollution indicators and share prices. I also find that investors in the high-polluting rate-regulated utilities that were targeted by Phase One positively value a favorable regulatory climate.

Greater disclosure quality leads to higher prices and greater liquidity in a laboratory financial market, and these effects are stronger when investors face the risk of unpredictable demand shocks. These results are consistent with a broad class of theoretical and empirical studies. Disclosure has larger effects on prices and liquidity at greater market depths. We conclude that archival studies looking only at quoted transaction prices and spreads (which typically pertain to small transactions) may underestimate the potential importance of disclosure on larger transactions that occur at greater market depths.

Although firms account for entity-level taxes, they do not account for shareholder-level capital gains and dividend taxes. To account for these proprietary-level taxes, we add them to a residual-income equity valuation model. Empirical analysis supports the model's predictions. First, both capital gains and dividend taxes reduce investors' implicit valuation of the reinvested portion of earnings. Second, dividend taxes reduce the valuation of the portion of earnings distributed as dividends, but capital gains taxes do not. Third, dividend taxes reduce the valuation of retained earnings equity, but again, capital gains taxes do not. These findings suggest that investors implicitly extend entity-level accounting to the proprietary level when they value the firm. The findings also suggest that when fully accounting for the effects of implicit dividend taxes, reinvested earnings appear to be subject to three levels of taxation—corporate, dividend, and capital gains taxes. Paying earnings out as dividends eliminates the capital gains layer of tax and may provide a net wealth benefit for shareholders, rather than a tax penalty as commonly assumed.

This study examines the relation between the composition of financially distressed firms' audit committees and the likelihood of receiving going-concern reports. For firms experiencing financial distress during 1994, we find that the greater the percentage of affiliated directors on the audit committee, the lower the probability the auditor will issue a going-concern report. These results support regulators' concern about financial-reporting quality and the recent calls for more independent audit committees.

This study examines whether the reported loss reserves of property-casualty insurers contain an implicit discount for the time value of money. Reporting the present value of loss reserves enables insurers to justify the competitive level of insurance premiums to regulators. The evidence indicates that there is a positive and significant discount rate implicit in the relation between reported loss reserves and expected future claim payments. Moreover, insurers subject to relatively stringent rate regulation discount to a greater extent than do other insurers. The results also suggest that implicit discounting is distinct from solvency and tax motives to exercise discretion over the loss reserve.

This paper reports two experiments in which Big 5 audit managers estimate reported (audited) earnings conditional on analysts' consensus forecast, auditing standards, and auditor discovery of a quantitatively immaterial earnings overstatement. We find that auditors judge overstatement correction less likely if it would cause a missed forecast, even for objectively measured misstatements. This behavior is consistent with SEC Chairman Levitt's concerns about opportunistic corrections to manage earnings to forecasts. Also, SAS No. 89's mandated representations and communications do not increase corrections that would cause a missed forecast, indicating that the Auditing Standards Board has limited ability to reduce opportunistic corrections through such regulations.

We provide evidence that analysts' stock-price judgments depend on (1) the method of accounting for a business combination and (2) the number of years that have elapsed since the business combination. Consistent with business-press reports of managers' concerns, analysts' stock-price judgments are lowest when a company applies the purchase method of accounting and ratably amortizes the acquisition premium. The number of years since the business combination affects analysts' price estimates only when the company applies the purchase method and ratably amortizes goodwill—analysts' price estimates are lower when the business-combination transaction is further in the past. However, this joint effect of accounting method and timing is mitigated by the Financial Accounting Standards Board's proposed income-statement format requiring companies to report separate line items for after-tax income before goodwill charges and net-of-tax goodwill charges. When a company uses the purchase method of accounting and writes off the acquisition premium as in-process research and development, analysts' stockprice judgments are not statistically different from their judgments when a company applies pooling-of-interest accounting.

This study investigates whether providing higher quality audits increases auditors' chances of avoiding legal liability. Negligence rules hold auditors responsible for plaintiff losses only when the quality of the audit provided fails to meet standards of care. The results of my experiment suggest that the ex post observed consequences of audit failure can affect the standards of care to which jurors hold auditors. Specifically, participants serving in the role of jurors assessed higher standards of care for auditors when the consequences of audit failure were more severe. Furthermore, when the consequences of audit failure were more severe, participants' evaluations of the auditor did not depend on the quality of the audit provided—auditors who provided higher quality audits were evaluated just as negatively as those who provided lower quality audits. In contrast, when audit failure led to only moderately negative consequences, auditors who provided higher quality audits received more favorable evaluations. These results suggest that providing higher quality audits will not necessarily protect auditors from legal liability when the consequences of audit failure are severe.

This study tests whether the observed patterns in stock returns after quarterly earnings announcements are related to the proportion of firm shares held by institutional investors, a variable used by prior research to proxy for investor sophistication. Our findings show that the institutional holdings variable is negatively correlated with the observed post-announcement abnormal returns. Our findings also show that traditional proxies for transaction costs (i.e., trading volume, stock price) as well as firm size have little incremental power to explain post-announcement abnormal returns when institutional holdings is an explanatory variable. If institutional ownership is a valid proxy for investor sophistication, these findings suggest that the trading activity of unsophisticated investors underlies the predictability of stock returns after earnings announcements. However, tests evaluating the validity of institutional holdings as a proxy for investor sophistication yield only mixed results. This calls for caution in interpreting our findings.

Recent studies report an increasing use of nonfinancial measures such as product quality, customer satisfaction, and market share in performance measurement and compensation systems. A growing literature suggests that because current nonfinancial measures are better predictors of long-term financial performance than current financial measures, they help refocus managers on the long-term aspects of their actions. However, little empirical evidence is available on the relation between nonfinancial measures and financial performance, and even less is known about performance impacts of incorporating nonfinancial measures in incentive contracts. Using time-series data for 72 months from 18 hotels managed by a hospitality firm, this study provides empirical evidence on the behavior of nonfinancial measures and their impact on firm performance. The results indicate that nonfinancial measures of customer satisfaction are significantly associated with future financial performance and contain additional information not reflected in the past financial measures. Furthermore, both nonfinancial and financial performance improve following the implementation of an incentive plan that includes nonfinancial performance measures.