Knowledge that Transforms

We address whether SOX 404(b) internal control audits under two auditing standards regimes and SOX 404(a) management assessments are associated with improved internal control system quality, an important and largely unstudied potential benefit. In 2013, the PCAOB disclosed that 15 percent of inspected control audits were ineffective, suggesting that the current control auditing standard may not be sufficient to induce implementation of high-quality control systems. We use an indirect measure of internal control system quality—future unaudited accruals quality—to proxy for internal control quality because sustained internal control improvements should be exhibited in future quarterly financial reports unaltered by contemporaneous financial statement audits. We find that internal control audits initially provided internal control quality benefits. After the 2007 auditing standards change, internal control quality deteriorated for ICFR audited versus unaudited firms. Finally, we find limited evidence that management assessments affect internal control quality. Results indicate that recent PCAOB concerns may have merit. Data Availability: Data are publicly available from the sources identified in the text.

This study evaluates alternative measures of the tone of financial narrative. We present evidence that word-frequency tone measures based on domain-specific wordlists—compared to general wordlists—better predict the market reaction to earnings announcements, have greater statistical power in short-window event studies, and exhibit more economically consistent post-announcement drift. Further, inverse document frequency weighting, advocated in Loughran and McDonald (2011), provides little improvement to the alternative approach of equal weighting. We also provide evidence that word-frequency tone measures are as powerful as the Naïve Bayesian machine-learning tone measure from Li (2010) in a regression of future earnings on MD&A tone. Overall, although more complex techniques are potentially advantageous in certain contexts, equal-weighted, domain-specific, word-frequency tone measures are generally just as powerful in the context of financial disclosure and capital markets. Such measures are also more intuitive, easier to implement, and, importantly, far more amenable to replication.

When a U.S. multinational corporation shifts income from the U.S. to foreign jurisdictions, it incurs costs and reaps benefits. The benefits may be reduced if the shifted income must be returned to the U.S. as a dividend in the short term and face the same U.S. tax it would have if the income had not been shifted. Firms, then, have incentive to defer repatriation of earnings and to fund domestic cash needs with external financing. The cost of external financing, however, is increasing in financial constraints, leading to the prediction that constrained firms will be unable to defer repatriation and, therefore, will reap no benefits from shifting. Using a new methodology for measuring income shifting, we find, consistent with predictions, that financially constrained firms shift less income from the U.S. to foreign countries than their unconstrained peers. We estimate that financially constrained firms shift out 20 percent less of pre-shifted income than unconstrained firms. Translating this percentage to dollar values, the mean (median) constrained firm shifts $16 million ($7 million) out of the U.S. each year, while the mean (median) unconstrained firm shifts $321 million ($134 million) out of the U.S. each year. Assuming that the inability to defer repatriation is the primary constraint preventing the U.S. worldwide tax system from being a de facto territorial system, we use our findings to estimate that changing to a pure territorial tax system would increase outbound income shifting by U.S. multinationals by 8 percent.

Despite the importance placed on professional skepticism by the accounting profession and regulators, the failure of auditors to exercise an appropriate level of skepticism continues to be a global issue. We experimentally test a potential barrier to skepticism. We find that outcome knowledge biases supervisors' evaluations of skeptical behavior. Holding a staff member's skeptical judgments and acts constant, superiors on the engagement team evaluate the staff's skeptical behavior based on whether the staff's investigation of an issue ultimately identifies a misstatement. Our evidence suggests that evaluators penalize auditors who employ an appropriate level of skepticism, but do not identify a misstatement. Although consultation with their superiors while exercising skepticism improved staff auditors' performance evaluations, consultation did not effectively mitigate the outcome effect on their evaluations. Last, we observe that auditors in the field anticipate that their superiors will be influenced by outcome knowledge when they evaluate their skeptical behavior. Collectively, our results depict an evaluation system that may inadvertently discourage skepticism among auditors in the field. Data Availability: Contact the authors.

I investigate whether corporate accountability reporting helps protect firm value. Specifically, I examine (1) whether corporate accountability reporting helps firms prevent the occurrence of high-profile misconduct (e.g., bribery, kickbacks, discrimination), and (2) whether prior corporate accountability reporting reduces the negative stock price reaction when high-profile misconduct does occur. Using multiple methods to address self-selection, I find that, on average, firms that report on their corporate accountability activities are less likely to engage in high-profile misconduct, consistent with the reporting process helping firms to manage their operations better. Additionally, I find that when high-profile misconduct does occur, firms that have previously issued corporate accountability reports experience a less negative stock price reaction, consistent with corporate accountability reports influencing perceptions of managerial intent, which, in turn, influences expected punishments.

We investigate the relation between corporate tax payments and corporate social responsibility. Because existing theory and empirical studies find inconsistent evidence on the relation between these constructs, we investigate whether the two activities act as complements or substitutes. We estimate the relation between measures of corporate social responsibility and (1) the amount of corporate taxes paid, and (2) the amount invested in tax lobbying activities using both ordinary least squares and a system of simultaneous equations. We find consistent evidence that corporate social responsibility is negatively related to five-year cash effective tax rates and positively related to tax lobbying expenditures. Our evidence suggests that, on average, corporate social responsibility and tax payments act as substitutes. Data Availability: Data are available from sources identified in the paper.

This study investigates the performance effects of the combined use of three reinforcers, or incentive motivators, commonly used by companies: monetary incentives, feedback, and recognition. Using a field experiment in a retail services company, I test whether these incentives, which appeal to diverse motivation mechanisms—tangible payoffs, self-regulation, and social esteem—and, hence, have different utilities, are complements or substitutes. The results of the hard performance data collected, in the form of a ratio of sales relative to goals, show that monetary incentives and recognition are substitutes, while feedback is independent of the other incentives. The negative interaction between monetary incentives and recognition is evidence of crowding out between tangible payoffs and social esteem motivations. Individually, these two incentives have a positive impact on performance of about 13 percentage points, which corresponds to a 32.5 percent performance increase. Feedback interactions and main effects are not statistically significant, which suggests that, in this setting, providing feedback in the form of knowledge of results has no impact.

The Public Company Accounting Oversight Board recently proposed amendments to the standard audit report that would require the disclosure of critical audit matters (CAMs), and the Securities and Exchange Commission continues to evaluate the use of principles-based (imprecise) accounting standards within U.S. generally accepted accounting principles. We assert that jurors perceive precise accounting standards to constrain auditors' control over financial reporting outcomes, resulting in a lower propensity for negligence verdicts when the accounting treatment conforms to the precise standard. However, we hypothesize that the use of either imprecise standards or CAMs reduces the extent to which jurors perceive this constraint to exist, leading to increased auditor liability. We present experimental evidence supporting this argument. Our results highlight the similarities between the effects of imprecise accounting standards and CAMs on negligence assessments. These results provide insight for regulators and the auditing profession about the potential consequences of the proposed regulatory changes.

This study examines how the incentives related to ownership structure influence labor cost management decisions in publicly traded and privately held organizations. I document that public banks have more elastic labor cost structures than private banks, which suggests that public bank managers prefer greater flexibility to remove labor resources when desired. Consistent with public banks facing greater financial reporting pressures, I find that they reduce labor costs to avoid earnings declines. However, I also find that the use of labor cost reductions to manage required regulatory capital is more pronounced in private banks. Consistent with the explanation that access to the equity markets allows public firms to sell equity in lieu of cutting costs, I find that the use of labor cost reductions to manage capital requirements is concentrated in the subsample of banks with lower equity issuances. These findings suggest that while public ownership induces financial reporting pressure, it may also alleviate regulatory pressure through greater ability to sell equity.

This paper examines whether market participants infer negative information about future unexpected firm performance when managers adhere to predetermined scripts when responding to questions during earnings conference calls. I argue that managers respond to questions from prepared scripts to avoid the disclosure of bad news. Using a measure of the adherence to predetermined language, I provide evidence that a lack of spontaneity is negatively associated with the market reaction to the call and with the abnormal returns in the subsequent quarter. I further find that analysts downgrade their forecasts following these calls. I also provide evidence that adherence to predetermined language is negatively associated with future unexpected firm accounting performance, supporting investors' negative response to it. Finally, I find that bid-ask spreads increase and firms are less likely to guide future earnings when managers adhere to the predetermined language of a script, suggesting that firms provide less information, not more, during these calls.