Knowledge that Transforms

This study investigates the effect of managerial sentiment on corporate disclosure decisions. Using terrorist attacks in the United States as adverse shocks to managerial sentiment, we find that firms located in the metropolitan areas attacked issue more negatively biased earnings forecasts. The effect is stronger for firms with higher operating uncertainty and firms with younger, inexperienced, or less confident executives and it is weaker for firms located in states with increasing violent crime rates. A potential alternative explanation is that managers strategically bias earnings forecasts downward and attribute the poor performance to terrorist attacks. To address this issue, we conduct a battery of additional analyses and find results more consistent with managerial sentiment than strategic attribution. In addition, we show that our results are unlikely to be driven by any economic effects of terrorist attacks. Finally, firms in attacked areas exhibit a more pessimistic tone in 10-K/10-Q filings.

ABSTRACT This paper investigates the impact of increased audit market competition on audit quality and auditor choice. I develop a model comprising two auditors who compete for a new client by choosing the audit quality for their respective existing clients and using the audited report as a signal. I identify factors that influence auditor quality decisions, as well as the behavior of clients, who potentially misstate their reports. Auditors are tempted to alter audit quality because they are eager to appear desirable from a new client's perspective. Interestingly, while recipients of the audited report adjust their conjectures about audit quality, there are conditions under which auditors lower their audit quality to increase the likelihood of being hired. The analysis extends the existing literature by describing a new approach to modeling the auditors' motivation to signal reputation for certain behavior. JEL Classifications: M40; M42; C72.

ABSTRACT This study examines whether disruptive life events affect how analysts assess risk. We exploit the staggered arrival of hurricanes between 1996 and 2009 at analysts' office locations across the United States as a plausibly exogenous shock in the analysts' experience of disruptive life events. We show in a difference-in-differences setting that relative to non-affected analysts, analysts in states affected by hurricanes issue less optimistic forecasts for non-affected firms after hurricanes. The temporary effects are strongest for affected analysts who had never before experienced a hurricane in their office location. The evidence suggests that analysts use the availability heuristic to assess risk. We observe the same effects in recent years, as our analysis based on Superstorm Sandy in 2012 yields similar results. Overall, our evidence indicates that disruptive life events affect analysts' judgments. JEL Classifications: D81; D83; G02; G24; G29.

ABSTRACT Using data from 19 countries over the 1990–2015 period, we examine how economic policy uncertainty (EPU) affects accounting quality. We find that accounting quality, measured based on Nikolaev's (2018) model, increases during periods of high policy uncertainty. This relation is confirmed by the negative association between EPU and performance-adjusted discretionary accruals in a multivariate setting, and it extends to various alternative measures of earnings properties. We also find that the positive relation between EPU and accounting quality is more pronounced for government-dependent firms and firms with higher political risk. Additional analyses based on institutional investors' trading behavior, media freedom, and press circulation suggest that market participants' attention is a mechanism through which EPU affects accounting quality. Further, we find evidence that high accounting quality can mitigate the negative effects of EPU on corporate investment and valuation. Data Availability: All data are publicly available from sources indicated in the text.

ABSTRACT Social hierarchy theory predicts that the power and status of an organizational function have a first-order effect on the function's ability to influence outcomes. We find that the rank of the title of the top tax executive is positively associated with tax planning after controlling for treatment effects. Our inferences remain when (1) using changes in the size of the c-suite as a shock to the relative power and status of the tax function, and (2) examining promotions and demotions in title rank. Point estimates suggest that tax function power and status are up to 2.6 times as important as tax planning resources, up to 4.0 times as important as tax function-specific expertise, and, more often than not, more important than manager fixed effects. Overall, results suggest that the power and status of the tax function is often what matters most in determining tax outcomes. JEL Classifications: H25; L22; M41.

ABSTRACT Periodic demand forecasts are the primary planning and coordination mechanism within organizations. Because most demand forecasts incorporate human judgment, they are subject to both unintentional error and intentional opportunistic bias. We examine whether a disaggregation of the forecast into various sources of demand reduces forecast error and bias. Using proprietary data from a manufacturing organization, we find that absolute demand forecast error declines following the implementation of a disaggregated forecast system. We also find a favorable effect of forecast disaggregation on finished goods inventory without a corresponding increase in costly production plan changes. We further document a decline in positive forecast bias, except for products whose production is limited owing to scarce production resources. This implies that disaggregation alone is not sufficient to overcome heightened incentives of self-interested sales managers to positively bias the forecast for the very products that an organization would like to avoid tying up in inventory. Data Availability: Data are the property of the research partner and may not be redistributed by the authors.

ABSTRACT We experimentally examine how nonprofit pay levels affect nonprofit managers' misreporting and how different types of penalties deter such behavior. Absent any penalties for misreporting, we find similar levels of, but different mechanisms for, misreporting by managers who select into lower- versus higher-paying nonprofits. Specifically, lower-paying nonprofits attract mission-focused managers who misreport to advance their nonprofit's mission and justify doing so by their personal sacrifice of wealth, whereas higher-paying nonprofits attract a majority of self-focused managers who justify misreporting by focusing on their personal outcomes. Because managers who select into their nonprofit at different pay levels have different motivation and justification for misreporting, we predict and find that penalizing the nonprofit is more effective in deterring misreporting in lower-paying nonprofits, while penalizing the manager is more effective in higher-paying nonprofits. Our study contributes to theory on the behavioral drivers of nonprofit misreporting and informs practice of ways to deter it. JEL Classifications: D91; J31; L31; M40.

ABSTRACT This study examines how an increase in tick size affects algorithmic trading (AT), fundamental information acquisition (FIA), and the price discovery process around earnings announcements (EAs). Leveraging the SEC's randomized Tick Size Pilot experiment, we show that a tick size increase results in a decline in AT and a sharp drop in absolute cumulative abnormal returns and volume around EAs. More importantly, we find increased FIA in the preannouncement period. Specifically, we show: (1) treatment firms' pre-announcement returns better anticipate next quarter's standardized unexpected earnings; (2) these firms experience an increase in EDGAR web traffic prior to EAs; and (3) they exhibit a drop in price synchronicity with index returns. Taken together, our evidence suggests that while an increase in tick size reduces AT and abnormal market reaction after EAs, it also increases FIA activities prior to EAs. JEL Classifications: M40; M41; G12; G14.

ABSTRACT Firms provide convexity in managers' compensation plans (vega) to induce risk-averse managers to pursue risky, positive net present value projects. The resulting alignment of managers' and shareholders' incentives creates conflicts with lenders, who face an increased risk of default when managers pursue risky investments. We hypothesize that lenders would respond by stepping up their monitoring and threatening foreclosure to inhibit managers from acting on their vega incentives. Strong lender monitoring should, thus, reduce the efficacy of vega incentives. We test this hypothesis in a unique setting, where lenders purchase credit insurance, reduce their exposure to downside risk, and lower their monitoring. Afterward, we find a stronger association between vega incentives and the firms' risky investments. We contribute to the literature by showing that strong lender monitoring reduces the effectiveness of vega incentives and, thus, of the compensation mechanisms that boards of directors put in place to resolve manager-shareholder conflicts. JEL Classifications: G32; G33; M41; M48.

ABSTRACT Most accounting studies use only public enforcement actions (SEC cases) to measure accounting fraud. However, private cases (securities class actions) also play an important enforcement role. We discuss the legal standards and processes for both public and private enforcement regimes, emphasize the importance of screening cases for credible fraud allegations, and show both yield credible fraud measures. Further, we demonstrate these research design choices affect inferences from prior research and a hypothetical research setting. Finally, we show common measures of accounting irregularities using Audit Analytics to proxy for fraud result in significant false positives and negatives and develop a fraud prediction model for use in future research. We recommend using both public and private enforcement with appropriate screening when examining accounting fraud to reduce Type I and II errors, or reporting the sensitivity of findings across regimes. This is particularly important given the reduction in accounting-related enforcement after 2005. JEL Classifications: G38; K22; K41; K42; M41; M42; M48.