Knowledge that Transforms

ABSTRACT The primary objective of the current study is to empirically reexamine the relation between material weaknesses in internal control (MW) and cost of equity (CE). We direct particular emphasis to the way non-remediation, as well as remediation, of MW affects a firm's CE. This study utilizes a dataset that contains a large sample of second-year MW non-remediation cases, as well as third-, fourth-, and fifth-year non-remediation cases. The findings provide evidence that reporting MW, absent any remediation, in multiple consecutive years has a significant negative impact on CE. However, the current study also shows that the market views favorably a reduction in the number of MW (i.e., partial remediation). Our study helps to reconcile conflicting results in the literature devoted to the relation between MW and CE. JEL Classifications: M41; M42. Data Availability: Available from sources identified within the article.

ABSTRACT We use survey data to examine firms' propensity to rely on financial measures in evaluating local business unit managers. We find that firms rely less on financial measures (and more on nonfinancial measures or subjective evaluations) in determining local managers' bonuses when those managers have greater influence over the design of internal accounting systems. At the same time, we find no significant association between the choice of performance measures and local managers' authority to make operating decisions. Instead, we find that local authority to make operating decisions is positively associated with local managers' influence over accounting systems. Taken together, our findings suggest that the design of internal accounting systems is an important dimension of overall organizational design. Our findings also cast doubt on the maintained assumption in prior work that major organizational design choices are complementary. Data Availability: Data used in this study cannot be made public due to confidentiality agreements with participating firms.

ABSTRACT This study examines the sources of credit risk associated with asset securitizations and whether credit-rating agencies and the bond market differ in their assessment of this risk. Measuring credit risk using credit ratings, we find the securitizing firm's credit risk is positively related to the firm's retained interest in the securitized assets and unrelated to the portion of the securitized assets not retained by the firm. Measuring credit risk using bond spreads, we find the securitizing firm's credit risk is positively related to both the firm's retained interest in the assets and the portion of the securitized assets not retained by the firm. Additionally, our findings indicate the bond market does not distinguish between the retained and non-retained portions of the securitized assets when assessing the credit risk of the securitizing firm. These different assessments of sources of credit risk associated with asset securitizations provide insight into ongoing controversies surrounding the financial reporting for asset securitizations and the efficacy of credit ratings.

ABSTRACT This study examines whether the adoption in 2003 of FASB Interpretation No. 46/R (FIN 46), Consolidation of Variable Interest Entities—An Interpretation of ARB No. 51, changed the cost of capital for affected firms. Using comparative analysis on a broad sample of 11,719 firm-quarter observations for 1,389 firms during the period 1998 through 2005, we find evidence that FIN 46 significantly increased the cost of equity capital for firms with affected variable interest entities (VIEs), an increase of approximately 50 basis points relative to firms reporting no material effect from the standard. Further, firms consolidating these formerly off-balance sheet structures experienced the largest increase. Taken together, these results suggest that FIN 46 reduced the opportunity for firms to use off-balance sheet structures to artificially reduce their cost of capital, a matter of regulatory concern. Data Availability: All data are available from public sources.

ABSTRACT This paper develops a simple methodology based on the earnings response coefficient framework that allows decomposing realized returns into cash flow shocks and returns excluding cash flow shocks. I find that stocks with poor (good) accrual quality were on average subject to relatively lower (higher) cash flow shocks over the past 37 years. These lower (higher) cash flow shocks offset the higher (lower) expected returns of poor (good) accrual quality firms. After excluding cash flow shocks, future realized returns are negatively associated with accrual quality. The premiums pertaining to accrual quality are both statistically and economically significant in standard asset-pricing tests when cash flow shocks are excluded by firm-specific return decomposition. Overall, this paper provides evidence on the existence of a priced accrual quality risk factor, and underscores the importance of controlling for cash flow shocks in asset-pricing tests that use realized returns.

ABSTRACT I investigate the possibility that recent price movements include significantly larger speculative components than those observed historically, where speculation is defined as the component of price that does not co-move with fundamentals. Specifically, at the aggregate level, price and accounting fundamentals co-move historically (1979–1993) but do not co-move recently (1994–2008). The lack of co-movement in recent periods is accompanied by a significant reduction in the positive association between ratios of accounting fundamentals-to-price with future market returns. Changes in measurement error in accounting fundamentals do not appear to cause the lack of co-movement in recent periods, and risk- and growth-based explanations are not supported by the data. The results of this study provide evidence of a structural change in the long-run association between price and accounting fundamentals. Data Availability: Data are available from public sources identified in the study.

ABSTRACT We conduct an experiment with 749 mock jurors to examine whether juries evaluate auditors differently under precise versus imprecise standards when the client reporting is held constant. We find that the impact of standard precision on jury verdicts depends on the aggressiveness of the audit client's financial reports and on the industry reporting norm. When the client's reporting is more aggressive and violates the precise standard, juries return fewer verdicts against auditors under the imprecise standard, especially when the reporting complies with the industry norm. When the client's reporting is less aggressive and complies with the precise standard, juries return more verdicts against auditors under the imprecise standard, but only when the client's reporting is more aggressive than the industry norm. Compliance with industry reporting norms appears to provide auditors with safe harbor protection from negligence verdicts when accounting standards are imprecise.

ABSTRACT This study explains the challenges associated with the Heckman (1979) procedure to control for selection bias, assesses the quality of its application in accounting research, and offers guidance for better implementation of selection models. A survey of 75 recent accounting articles in leading journals reveals that many researchers implement the technique in a mechanical way with relatively little appreciation of important econometric issues and problems surrounding its use. Using empirical examples motivated by prior research, we illustrate that selection models are fragile and can yield quite literally any possible outcome in response to fairly minor changes in model specification. We conclude with guidance on how researchers can better implement selection models that will provide more convincing evidence on potential selection bias, including the need to justify model specifications and careful sensitivity analyses with respect to robustness and multicollinearity. Data Availability: Data used are available from public sources identified in the study.

ABSTRACT Evidence evaluation in accounting often involves both the assessment of evidence relevance and the combination of its relevance and source to assess overall strength. We decompose this strength-assessment judgment into its components—relevance assessment and source and relevance combination—and consider the effects of experience. Participants in our experiment assess the strength and relevance of tax authorities in relation to a client scenario. Contrary to prior research, we find that more-experienced participants exhibit greater use of analogical reasoning when evaluating tax-authority relevance than do less-experienced participants. We find a similar experience effect in the use of configural information processing to combine authority source and relevance, a judgment not previously considered in tax. The effects of experience are particularly important in the current environment as the tax function is a leading cause of material weaknesses and restatements under Sarbanes-Oxley and tax executives cite increasing difficulty in hiring and retaining qualified professionals. Data Availability: Data are available from the authors on request.

ABSTRACT We examine whether three tax system characteristics—required book-tax conformity, worldwide versus territorial approach, and perceived strength of enforcement—impact corporate tax avoidance across countries after controlling for firm-specific factors previously shown to be associated with tax avoidance (i.e., performance, size, operating costs, leverage, growth, the presence of multinational operations, and industry) and for other cross-country factors (i.e., statutory corporate tax rates, earnings volatility, and institutional factors). We find that, on average, firms avoid taxes less when required book-tax conformity is higher, a worldwide approach is used, and tax enforcement is perceived to be stronger. However, the relations between tax avoidance and all three tax systems characteristics are contextual and depend on the extent to which management compensation comes from variable pay, including bonuses, stock awards, and stock options. Data Availability: Data are available from sources identified in the text.