Knowledge that Transforms

We predict that access to cross-border financing by the industrial sector reduces firms' reliance on domestic banks, thereby leading to lower rents for banks and greater competition in the domestic banking sector. We also predict that banks take on more risk to offset these lost rents and remain competitive. Using mandatory adoption of International Financial Reporting Standards (IFRS) to identify variation in cross-border financing, we find evidence consistent with our hypotheses. Additional tests verify that the effects emanate from the demand side (i.e., firms not relying on banks) rather than the supply side (i.e., banks not willing to lend to firms). Overall, we document how competition from overseas financial markets influences the domestic banking sector.

Prior research examining the ASC 820 fair value hierarchy concludes that Level 3 fair value measurements are significantly less value-relevant than Level 1 and Level 2 fair value measurements. We reevaluate this conclusion using the closed-end fund setting, in which fair value measurements are available for substantially all assets. Contrary to prior research, we find that Level 3 fair values are of similar value relevance to Level 1 and Level 2 fair values. Our findings suggest that the results in previous research are attributable to correlated omitted variable bias arising from the absence of fair value data for most assets. JEL Classifications: M41; G12; G29. Data Availability: Data are publicly available from sources identified in the article.

The emergence of double entry bookkeeping marked the shift in bookkeeping from a mechanical task to a skilled craft, and represented the beginnings of the accounting profession. This study seeks to identify what caused this significant change in bookkeeping practice. I do so by adopting a new accounting history perspective to investigate the circumstances surrounding the emergence of double entry in early 13th century Italy. Contrary to previous findings, this paper concludes that the most likely form of enterprise where bookkeeping of this form emerged is a bank, most likely in Florence. Accountability of the local bankers in Florence to the Bankers Guild provided a unique external impetus to generate a new form of bookkeeping. This new bookkeeping format provided a clear and unambiguous picture of the accounts of all debtors and creditors, along with the means to check that the entries between them were complete and accurate.

Basu (1997) proposes a measure of financial reporting conservatism based on asymmetry in the conditional earnings/returns relation. Patatoukas and Thomas (2011) show upward bias in this measure, because a placebo—lagged earnings—also exhibits similar asymmetry. Ball, Kothari, and Nikolaev (2013a) and Collins, Hribar, and Tian (2014) propose alternative explanations for the bias and offer revised measures to overcome the bias. However, we find that both revised measures remain substantially upward-biased. In particular, a placebo based on lagged share price mimics time-series and cross-sectional variation observed for the revised measures. More generally, we find biases in the asymmetric timeliness specification because earnings, accruals, and other measures of performance are often related to second and higher moments of the distribution of returns. In addition to suggesting that the asymmetric timeliness specification be used with caution, our study illustrates the useful role placebos can play in archival studies. Data Availability: Data are available from the sources identified in the text.

This study examines local characteristics associated with non-Big 4 local market leadership and the impact of non-Big 4 local market leadership on competition. We identify non-Big 4 local market leaders by collecting accounting firm rankings from business publications for 46 of the largest metropolitan statistical areas from 2005–2010. These rankings are based on the number of local office employees and provide a more holistic measure of office size than measures based on public company audit fees. We find local supply and demand factors are significantly associated with non-Big 4 local market leadership and that non-Big 4 leadership is associated with lower overall audit fees in the local market. We also find that non-Big 4 leaders earn a fee premium over other non-Big 4 auditors. Our results imply that non-Big 4 leaders increase local market competition. Data Availability: All data are publicly available from sources identified in the study.

We examine the effects of the auditor's insurance role on audit quality and reporting conservatism. The investor pays for the auditor's penalty through the audit fees and expects to collect a portion of it—when the investor recovers the entire expected penalty, the insurance role is perfect. When the investment is exogenous, consistent with Watts' (2003a, 2003b) argument, we find that an increase in the auditor's insurance role improves audit quality and conservatism, because conservatism helps to reduce the auditor's legal liability. However, when the investment level is endogenous, we find that the investment level and conservatism decrease with increases in the auditor's insurance role, because conservatism helps to mitigate the deadweight loss of the legal liability cost.

This study investigates whether banks respond to financial misreporting as the borrowing firms release misstated financial reports, i.e., in the misreporting period. Drawing upon finance theory that recognizes banks' superior information access and processing abilities, this study predicts and finds that banks adjust loan contract terms in response to the ongoing misreporting. Compared with loans issued in the prior period, loans issued in the misreporting period have higher interest spread, are more likely to be secured by collateral, and have more restrictive covenants. Further analyses show that banks acquire indirect, rather than direct, information about the misreporting and that they do not fully adjust loan pricing until after the restatement announcement. Together, these findings suggest that banks make timely, but insufficient, adjustments during the misreporting period. Nevertheless, banks' early reactions appear to be unique, as equity investors do not respond to the ongoing misreporting, but react to the loan information when it becomes public.

Deloitte's 2007 PCAOB Part II report identifies, among other issues, concerns related to the audit firm's quality controls with respect to auditing income tax accounts. We investigate whether Deloitte's actions to remediate the PCAOB's concerns are associated with changes to their clients' financial reporting for income taxes. We find that Deloitte's clients increased the reported valuation allowance on deferred tax assets and increased the reported reserve for uncertain tax benefits (UTBs) in response to increased auditor scrutiny over income tax accounts. Additionally, we find that in subsequent periods, Deloitte's clients report valuation allowances and UTB balances that are not significantly different than other annually inspected auditors, consistent with Deloitte changing the quality controls related to audits of income tax accounts after the failed remediation of the 2007 Part II report.

Audit practitioners, academics, and attorneys have expressed concern that disclosing critical audit matters (CAMs) will increase jurors' auditor liability judgments when auditors fail to detect misstatements. In contrast, this study provides theory and experimental evidence that CAM disclosures, under certain conditions, reduce auditor liability judgments as jurors perceive that undetected fraudulent misstatements were more foreseeable to the plaintiff (i.e., the financial statement user suing the auditor). However, we find that CAM disclosures only reduce auditor liability for undetected misstatements that, absent CAM disclosure, are relatively difficult to foresee. Finally, CAM disclosures that are unrelated to subsequent misstatements neither increase nor reduce auditor liability judgments relative to the current regime (i.e., where CAMs are not disclosed), but reduce liability judgments relative to reporting that there were no CAMs. As such, we find that, relative to stating there were no CAMs, disclosure of any CAM (i.e., related or unrelated) provides litigation protection in cases of undetected fraud. Consequently, the CAM requirement could incentivize auditors to disclose innocuous boilerplate CAMs, thereby diluting the impact of more warranted CAM disclosures. Data Availabliity: Available from authors upon request.

Using newly available materiality classifications of sustainability topics, we develop a novel dataset by hand-mapping sustainability investments classified as material for each industry into firm-specific sustainability ratings. This allows us to present new evidence on the value implications of sustainability investments. Using both calendar-time portfolio stock return regressions and firm-level panel regressions, we find that firms with good ratings on material sustainability issues significantly outperform firms with poor ratings on these issues. In contrast, firms with good ratings on immaterial sustainability issues do not significantly outperform firms with poor ratings on the same issues. These results are confirmed when we analyze future changes in accounting performance. The results have implications for asset managers who have committed to the integration of sustainability factors in their capital allocation decisions.