Knowledge that Transforms

ABSTRACT: Short-term debt and credit ratings have benefits for financial reporting quality that may be associated with lower audit fees. Using U.S. data for 2003 through 2006, we find that short-term debt is negatively related to audit fees for firms rated by Standard & Poor’s, consistent with more monitoring and better governance mechanisms in firms with higher short-term debt. Credit ratings quality is negatively related to audit fees, consistent with ratings quality reflecting a firm’s liquidity risk, governance mechanisms, and monitoring from rating agencies. We also find that the negative relation between short-term debt and audit fees is stronger for firms with low-quality credit ratings, consistent with auditors pricing lender monitoring.

ABSTRACT: This study investigates factors influencing the use of group-based compensation in professional service partnerships and the relation between group-based compensation and performance. I use data on 11,971 physicians in 935 medical groups to expand the extant literature on group incentives by providing some of the first large-sample, empirical evidence on the role of task interdependence, income risk, mutual monitoring, and group size in a firm's choice of compensation contract. Consistent with agency theory, I find that group incentives are more prevalent in medical partnerships that practice highly task-interdependent specialties and those that face greater malpractice risk. Group-based incentives are also more common in relatively small groups in which homogeneity in training, experience, and gender facilitate mutual monitoring. Tests relating individual physician productivity to compensation method suggest that productive benefits induced by group incentives offset reductions in output associated with free-riding and effort devoted to monitoring.

ABSTRACT: We examine the issue of auditor independence in a unique setting. Specifically, we test for auditor independence impairment among (1) private client firms, for which the risk of auditor reputation loss is lower than for publicly traded firms, and (2) in a low litigation environment (i.e., Norway) that further reduces the expected costs to the auditor associated with independence impairment. We have thus chosen a setting that gives independence impairment its best chance of being detected if it exists. Using a large sample of private Norwegian firms, we analyze whether auditors who receive higher fees are less likely to issue modified opinions. Despite the low litigation risk and the reduced reputation risk, our empirical results provide no evidence that auditors compromise their independence through fee dependence. These results are robust to controlling for the expected portion of fees, to different sample specifications, to the use of both levels and changes specifications, and to a number of sensitivity analyses.

ABSTRACT: This study examines European stock market reactions to 16 events associated with the adoption of International Financial Reporting Standards (IFRS) in Europe. European IFRS adoption represented a major milestone toward financial reporting convergence yet spurred controversy reaching the highest levels of government. We find an incrementally positive reaction for firms with lower quality pre-adoption information, which is more pronounced for banks, and with higher pre-adoption information asymmetry, consistent with investors expecting net information quality benefits from IFRS adoption. We find an incrementally negative reaction for firms domiciled in code law countries, consistent with investors' concerns over enforcement of IFRS in those countries. Finally, we find a positive reaction to IFRS adoption events for firms with high-quality pre-adoption information, consistent with investors expecting net convergence benefits from IFRS adoption.

ABSTRACT: Performance-based compensation contracts can affect productivity both by motivating effort and by attracting workers whose abilities align best with the offered contracts. Using an experiment in which participants design “rebus puzzles,” this study tests whether the incremental benefits of contract self-selection extend to a multi-dimensional performance environment in which participants choose between a contract that rewards both quantity and creativity versus a contract that rewards quantity only. Findings indicate that participants who choose a creativity-weighted pay scheme perceive themselves to have greater creative potential than those who choose a quantity-only scheme. This perceived creativity advantage manifests itself in the superior initial creativity ratings of such participants’ productive output. However, in the aggregate, participants paid only for quantity eventually surpass the creativity-weighted productivity scores of participants paid for creativity-weighted productivity, whether compensation contracts are self-selected or randomly assigned. Thus, the implications of contract selection on creativity-weighted productivity hinge on the importance of the initial advantage enjoyed by participants who self-select a creativity-weighted contract.

ABSTRACT: Audit standards require auditors to conduct fraud brainstorming sessions on every audit. The Public Company Accounting Oversight Board has raised concerns about auditors’ fraud judgments and the quality of their brainstorming sessions. We develop a measure of brainstorming quality to examine how it affects auditors’ fraud decision-making processes. We test our measure using field survey data of auditors’ actual brainstorming sessions for 179 audit engagements. Respondents report considerable variation in the quality of brainstorming in practice. We find some evidence that high-quality brainstorming improves the relations between fraud risk factors and fraud risk assessments. We also determine that brainstorming quality positively moderates the relations between fraud risk assessments and fraud-related testing. Our results suggest that the benefits of brainstorming do not apply uniformly, because low-quality sessions likely incur the costs of such interactions without receiving the attendant benefits. By documenting best practices from high-quality brainstorming sessions, our findings can inform auditors on how to improve their consideration of fraud.

ABSTRACT: Firms can report comprehensive income in either an income-statement-like performance statement or the statement of equity. Traditional theories of contracting incentives cannot explain this reporting location choice that only affects where comprehensive income data appear, because the contractible values of net income, other comprehensive income items, and comprehensive income are exactly the same regardless of the location where the firm reports comprehensive income. Drawing on theory, analysis of comment letters, and results of survey-based and behavioral research, we identify two factors—equity-based incentives and concerns over job security—that help explain why most firms do not follow policymakers' preference to report comprehensive income in a performance statement. Our empirical evidence on a broad cross-section of firms shows that managers with stronger equity-based incentives and less job security are significantly less likely to use performance reporting. Overall, our study suggests that even though the reporting location choice is inconsequential in a traditional rational markets view, managers act as if they believe that comprehensive income reporting location matters.

ABSTRACT: Using an experiment, I examine whether involvement in scorecard implementation can mitigate the effects of motivated reasoning that occur when the scorecard is framed as a causal chain rather than merely as a balanced set of measures. Psychological research on motivated reasoning suggests that managers will evaluate and interpret data in ways consistent with preferences, increasing their tendency to arrive at conclusions that are consistent with their desired conclusions (Kunda 1990). Consistent with that research, results of my study show that managers who are involved in selecting strategic initiatives perceive those initiatives as having been more successful than managers who are not involved in the initiative-selection process (holding constant actual scorecard performance). Results suggest further that simply framing the scorecard as a causal chain is not sufficient to mitigate these effects. However, framing the scorecard as a causal chain, in conjunction with involving managers in the selection of scorecard measures, mitigates the effects of motivated reasoning tied to manager involvement in initiative selection.

ABSTRACT: Prior studies employ a two-period empirical model and interpret the negative association between accruals in period one and returns in period two as evidence that investors misprice the information contained in accruals. In contrast to prior studies, I employ a three-period log-linear model decomposed from a firm’s book-to-market ratio and show that investors do not misprice the information contained in accruals. My study shows that in the four-year period prior to accrual recognition, equity prices tend to be driven disproportionately by intangible returns, or returns not explained by accounting measures. Accordingly, the relation between prior period intangible returns and future period returns subsumes the relation between current period accruals and future returns. In addition, I link the accrual anomaly and the value/growth anomaly to a common economic mechanism (intangible returns) and show that a strong negative relation between external financing activities and future returns is not subsumed by the accrual anomaly.

ABSTRACT: We develop a model to examine the effects of Financial Accounting Standards Board (FASB) Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48), on the strategic interaction between publicly traded corporate taxpayers and the government. Several of our findings contradict conjectures voiced by members of the business community regarding the economic effects of implementing FIN 48. Specifically, taxpayers with strong facts obtain higher expected payoffs from uncertain tax benefits and some disclosed liabilities understate the expected tax liability. Consistent with the common conjectures, however, some taxpayers are more likely to be audited or are deterred from entering into transactions that generate uncertain tax benefits because of FIN 48.