Knowledge that Transforms

ABSTRACT This paper analyzes the effects of forward-looking metrics on employee decision-making. We use data from a bank that started providing branch managers with the customer lifetime value (CLV)—an estimate of the future value of the customer relationship—of mortgage applicants. The data allow us to gauge the effects of enriching the employees' information set in an environment where explicit incentives and decision rights remained unchanged. On average, customer value increased 5 percent after the metric's introduction. The metric's availability resulted in a significant shift in attention toward more profitable client segments and some improvement in cross-selling. However, the use of CLV did not negatively impact pricing or default risk, as the literature predicts. Finally, branch managers with shorter tenure displayed a stronger response, consistent with information substituting for experience.

ABSTRACT We examine the impact of distance on internet search, and the effect of the “local bias” in search on the stock market response around earnings announcements. We find significant local bias in search behavior. Motivated by theories explaining local bias, local information advantage, and familiarity bias, we predict and find that firms with higher local bias in search experience higher bid-ask spreads, lower trading volumes, and lower earnings response coefficients at the time of earnings announcements, consistent with non-local investors relying more than locals on public information announcements. Consistent with local information advantage, we find that in the week prior to the announcement, firms with higher local bias have higher bid-ask spreads, higher trading volumes, and returns that are more predictive of the coming earnings surprise. Consistent with familiarity bias, firms with higher local bias in search experience stronger post-earnings announcement drift. We use unique predictions, propensity score matching, and two-stage least squares to identify the effects of local bias separately from the effects of overall visibility. Overall, we show there is significant local bias in search, and that this local bias has a significant impact on the market response around earnings announcements.

ABSTRACT This study investigates whether and when differences in the credit rating agencies' methodologies result in differences in rating properties. In particular, this study focuses on differences in information processing constraints between a rating agency that utilizes qualitative analysis and direct access to borrowers' management in its rating process (Standard & Poor's) compared to one that does not (Egan Jones Ratings Company) and how these differences affect rating quality. We find that as information uncertainty about borrowers increases, Egan Jones's rating accuracy, informativeness, and timeliness decrease relative to Standard & Poor's. Our findings suggest that Egan Jones's more restricted rating methodology can lead to limitations in information processing and, thus, reductions in Egan Jones's rating quality advantage for borrowers with greater information uncertainty. JEL Classifications: G10; G24.

ABSTRACT This paper develops a Bayesian persuasion model that examines a manager's incentives to gather information when the manager can disseminate this information selectively to interested parties (“users”) and when the objectives of the manager and the users are not perfectly aligned. The model predicts that if the manager can choose the subset of users to receive the information, then the manager may gather more precise information. The paper identifies conditions under which a regime that allows managers to grant access to information selectively maximizes aggregate information. Strikingly, this happens when the objectives of managers and users are sufficiently misaligned. This finding is robust to variations of the model, such as information acquisition cost, unobservable precision, sequential noisy actions taken by the users, and delayed choice of the subset of users in “the know.” These results call into doubt the common belief that forcing managers to provide unrestricted access to information to all potential users is always beneficial.

ABSTRACT This study examines the relation between the audit failures of individual auditors and the quality of other audits performed by these same auditors. Employing a Chinese setting where audit reports reveal the identities of engagement auditors, we find that auditors who have performed failed audits also deliver lower-quality audits on other audit engagements, with this “contagion” effect spreading both over time and to other audits performed by these same auditors in the same year. However, we find little evidence that an audit failure also casts doubt on the quality of audits performed by “non-failed” auditors who are same-office colleagues of a “failed” auditor. We further discover that the contagion effect is attenuated for female auditors, auditors holding a master's degree, and auditors with more auditing experience. Our results underscore the usefulness of disclosing the identity and personal characteristics of individual auditors to investors and regulators.

ABSTRACT In this paper, we examine how CEO succession and succession planning affect perceptions of financial reporting risk among stakeholders who are responsible for and oversee firms' financial reporting (e.g., auditors, management, and audit committees). Management succession introduces uncertainty about firms' future operations, financial policies, and potential motivation for earnings management, which we predict elevates the perceived risk of financial reporting improprieties. Consistent with this prediction, we find that audit fees are higher for firms with new CEOs. Importantly, however, we note that careful CEO succession planning (i.e., promoting an “heir apparent”) attenuates perceptions of higher risk, as evidenced by a lack of an audit pricing adjustment. These results are robust to several alternative specifications and analyses designed to mitigate the concern that the association between audit fees and CEO succession and succession planning is driven by factors leading to the CEO change. We also show that audit fee increases dissipate over time as the new, non-heir CEO stays longer at the firm, reinforcing the inference that audit fees increase in response to the uncertainty surrounding a new CEO. Additionally, we do not find evidence of a deterioration in audit quality with new CEOs, independent of the succession plan. JEL Classifications: G30; M12; M41; M42.

ABSTRACT We examine whether social ties between engagement auditors and audit committee members shape audit outcomes. Although these social ties can facilitate information transfer and help auditors alleviate management pressure to waive correction of detected misstatements, close interpersonal relations can undermine auditors' monitoring of the financial reporting process. We measure social ties by alma mater connections, professor-student bonding, and employment affiliation, and audit quality by the propensity to render modified audit opinions, financial reporting irregularities, and firm valuation. Our evidence implies that social ties between engagement auditors and audit committee members impair audit quality. In additional results consistent with expectations, we generally find that this relation is concentrated where social ties are more salient, or firm governance is relatively poor and agency conflicts are more severe. Implying reciprocity stemming from social networks, we also report some suggestive evidence that audit fees are higher in the presence of social ties between an engagement auditor and the audit committee. Collectively, our analysis lends support to the narrative that the negative implications—namely, worse audit quality and higher audit fees—of these social ties may outweigh the benefits.

ABSTRACT Based on the theoretical framework of Lambert, Leuz, and Verrecchia (2007), I predict that higher earnings quality of economically related public firms reduces a firm's systematic market risk. Using alternative sets of economically related firms, this study provides significant evidence consistent with my prediction. Specifically, a conditional CAPM regression shows that not only a firm's earnings quality, but also the earnings quality of related public firms lowers the loading of firm excess return on the market factor. Regressions based on the three-factor model provide similar results. Further, I provide evidence on cross-sectional variations in the effect of related firms' earnings quality. These results are economically significant and robust in several additional tests. Overall, this study contributes to the literature by providing the first evidence on the long-term externalities of financial information quality in the capital market. Data Availability: All analyses are based on publicly available data.

ABSTRACT This study exploits the implementation of IRS Schedule UTP to examine how linking tax return disclosures to financial reporting for income taxes affects firms' reporting decisions. Using confidential tax return data and public financial statement data, I find that after imposition of Schedule UTP reporting requirements, firms report lower financial reporting reserves for uncertain income tax positions, but do not claim fewer income tax benefits on their federal tax returns. The reduction in reserves is concentrated among multinational firms and firms with larger reserves prior to Schedule UTP. These findings suggest that some firms changed their financial reporting for uncertain tax positions to avoid Schedule UTP reporting requirements without changing the underlying positions. In contrast with prior studies, this evidence represents a permanent, rather than a temporary, tax-induced reporting change. My results imply that linking tax return disclosures to financial reporting can have unintended effects on firms' reporting decisions.

ABSTRACT Despite theoretical and anecdotal evidence highlighting the importance of industry-level analyses to lenders, the empirical literature on debt pricing has focused almost exclusively on firm-level forces that affect expected loss. This paper provides empirical evidence that industry-level characteristics relate to debt pricing through risk premiums. We address the empirical challenges that arise when testing these theories by using a proprietary dataset of time-varying and forward-looking measures of industry characteristics. These characteristics include growth, sensitivity to external shocks, and industry structure, all measured at the six-digit NAICS level. Our results show that lenders demand higher spreads to bear industry-level risk. The relation exists within subsamples with constant credit ratings, and strengthens when lenders' loan portfolios are less diversified and during periods when diversification is difficult. Therefore, our results suggest that industry characteristics relate to debt pricing by informing lenders not only about expected loss, but also about risk premiums. JEL Classifications: G31; G32; G33; M21.