Knowledge that Transforms

ABSTRACT We explore whether accounting fraud can be detected using the information of firms economically linked to a focal firm. Specifically, we examine whether customer information disclosed by a supplier firm, combined with customers’ accounting information, helps to detect the supplier’s revenue fraud. We first confirm the economic link between the supplier and customers by showing a strong positive correlation between the supplier’s sales growth and the growth rate of total customer purchases. We then introduce two variables based on customer accounting information—the discrepancy between supplier sales growth and customer purchase growth and customer excess purchases—and show that they are predictive of supplier revenue fraud. We conduct a battery of cross-sectional tests and generally find results to vary cross-sectionally in a predictable way. Finally, the out-of-sample tests indicate that adding the two variables to Dechow, Ge, Larson, and Sloan (2011) model increases fraud prediction accuracy. JEL Classifications: G14; M40; M41; M42.

ABSTRACT We study audit quality and investment efficiency when an analyst’s information can curb overvaluation and auditors are subject to legal liability following audit failure. With the auditor’s damage payment based on price inflation after audit failure, the analyst’s information brings prices closer to fundamentals and provides a hedge to the auditor against legal liability risk. This weakens incentives for audit quality, and the analyst responds with more information production due to the penalty for mispricing. Consequently, in equilibrium, stricter legal liability leads to higher audit quality that reduces overinvestment but also less information production that increases underinvestment. Thus, stricter liability has a nonmonotonic effect on firm value; it increases the value of firms with a high valued growth option but reduces the value of firms with a low valued growth option. The results have implications for the optimal level of legal liability that maximizes the expected value of the firm. JEL Classifications: M41; M42; G14; G23; G32.

ABSTRACT Although the shareholder benefits of investor conferences are well-documented, evidence on whether these conferences facilitate managerial opportunism is scarce. We examine whether managers opportunistically exploit heightened attention around the conference to “hype” the stock. We find that (1) managers increase the quantity of voluntary disclosure leading up to the conference, (2) these disclosures are more positive in tone and increase prices to a greater extent than post-conference disclosures, and (3) these disclosures are more pronounced when insiders sell their shares immediately prior to the conference. In circumstances where pre-conference disclosures coincide with pre-conference insider net selling, we find evidence of a significant return reversal––large positive returns before the conference and large negative returns after the conference––and that the firm is more likely to be named in a securities class action lawsuit. Collectively, our findings are consistent with some managers hyping the stock prior to the conference.

ABSTRACT We identify executives who have experienced significant accounting-related adverse events during their careers as a powerful setting to examine the extent to which prior professional experience can influence subsequent financial reporting policies. We find that firms led by senior financial executives who have experienced accounting-related adverse events during their careers exhibit greater unconditional accounting conservatism, a lower likelihood of experiencing future accounting-related adverse events, and less positive abnormal discretionary accruals. This effect tends to be stronger when the experience is more frequent, recent, severe, or proximate. Overall, our results reveal a meaningful relationship between managers’ professional experience and accounting policies. Data Availability: All data used in this study are obtained from publicly available sources. JEL Classifications: G40; M40; M41.

ABSTRACT We examine cross-sectional variation in disclosure speed by using data that allow us to measure when managers learn of SEC investigations and the time lag until subsequent disclosures. We document that external monitoring and litigation risk are associated with 99 percent and 39 percent faster disclosure, and managerial entrenchment with 28 percent slower disclosure. When revelations by external parties preempt managers’ disclosures, we observe a significant increase in bid-ask spreads that persists for at least three years following the close of the investigation and a higher likelihood of turnover for less entrenched CEOs. We also document that firms whose managers disclose investigations are subject to fewer subsequent securities class action lawsuits. Our results are consistent with managers balancing the costs of fast disclosure, including immediate stock price declines and potential reputational costs, with the risks of having external parties leak news of SEC investigations.

ABSTRACT We conduct an experiment in the securities-based crowdfunding setting to investigate whether some investors avoid accounting information for psychological reasons, even when they understand the information is useful in their decision-making. Results suggest investors who experience relatively more psychological discomfort when working with quantitative information are relatively less likely to acquire the financial statements of a potential crowdfunding investment. Importantly, this effect is incremental to any effect of investors' quantitative ability (i.e., their numeracy) and attenuates with an intervention designed to help investors overcome their psychological discomfort. Altogether, the results extend our understanding of the theory of information avoidance, provide a behavioral explanation for investors' documented underuse of accounting information, and can inform regulators as they revise crowdfunding regulations. JEL Classifications: G11; G41; M41.

ABSTRACT A growing literature provides evidence that peer considerations play a central role in shaping a firm’s behavior. This paper documents that the frequency of forced CEO turnovers by product market peer firms is negatively associated with a firm’s real earnings management. I find that the disciplinary role of forced CEO turnover explains the observed relation. These effects are stronger when firms are suspected to engage in real earnings management to meet or just beat earnings benchmarks. I find some evidence that peers’ forced CEO turnovers reveal a link between real earnings management and subsequent operating failure. Overall, my findings suggest that observing product market peers’ forced CEO turnovers provides an informative signal to discipline a firm’s real earnings management behavior. Data Availability: Data used in this study are available from public sources identified in the text. JEL Classifications: M41; M12.

ABSTRACT We examine the effects of a large number of clients in an audit office using the same enterprise-resource planning (ERP) system such as SAP or Oracle resulting in what we term “client accounting system homogeneity” on audit efficiency and effectiveness. Using a unique dataset of ERP system implementations, we find that accounting system homogeneity is positively associated with audit efficiency. Specifically, we find lower (higher) audit fees for clients using an ERP system from a vendor used by a higher (lower) proportion of clients in that office. We further document that accounting system homogeneity is associated with improved audit effectiveness as proxied by two accruals-based measures, incorrect internal control weakness reporting, and restatements. Our findings are reflective of a new form of knowledge spillover from repeated experiences auditing clients using similar accounting systems, resulting in audits that are not only less expensive but also of higher quality. Data Availability: Contact the authors.

ABSTRACT The ability to elicit information is a critical skill that many analysts and other information agents strive to master. This paper develops and validates a novel approach to measure analysts’ skill in eliciting information and studies its relation with analysts’ performance. The results suggest that analysts who are skilled in eliciting information issue more accurate forecasts and more informative stock recommendations. Further, skilled analysts’ recommendations are incrementally more informative for companies with more opaque information environments and with managers who may be delaying bad news. Finally, analysts skilled in eliciting information are more likely to be cited by journalists, recognized by the profession (Institutional Investor all-star status), and less likely to be demoted. These findings demonstrate the importance of elicitation as a distinct skill that influences analysts’ output quality, thereby extending previous research that generally focuses on the performance effects of general analyst characteristics rather than specific skills. Data Availability: Data are available from the public sources cited in the text. JEL Classifications: M41; G11; G14.

ABSTRACT Audits of internal control over financial reporting (ICFR) are typically “integrated” with the audit of the financial statements (FSs)—both audits are conducted by the same audit firm, which designs procedures to satisfy the objectives of both audits simultaneously. A common assumption is that integrating the two audits is more effective and efficient than performing them separately. However, this assumption has not been tested empirically. Using a sample of Chinese companies that employ different audit firms for their FS and ICFR audits (i.e., nonintegrated auditors), we find evidence that challenges this assumption. Specifically, we find ICFR audit quality is higher for nonintegrated audits compared to integrated audits. Moreover, total audit fees are lower for nonintegrated audits, despite higher ICFR audit fees.