Knowledge that Transforms

ABSTRACT I empirically investigate the impact of an organization's creativity dependency on the design of its incentive system. In firms for which the primary source of value creation is the creativity of core employees, the designs of incentive systems are particularly challenging. The nature of creative work constrains the feasibility of extrinsic incentives, but at the same time creates a need for them. Accordingly, there is concern that the use of incentives renders people not creative enough, but a lack of incentives makes employees “too creative.” I argue that a solution to this dilemma is the acknowledgment that the decision to use performance-based pay is not made in isolation, but as part of a set of complementary choices. I theoretically argue and empirically show that subjective evaluations of non-task-related performance and performance-based pay are complements in a creativity-dependent setting. I further argue that the intense use of both control mechanisms is the incentive system that best accommodates the control requirements of creativity-dependent firms, and show that the likelihood of choosing this system increases with the creativity dependency.

ABSTRACT: Our paper examines three related questions: Will directors who have friendship ties with the CEO manage earnings to benefit the CEO in the short term while potentially sacrificing the welfare of the company in the long term? Will public disclosure of friendship ties mitigate or exacerbate such behavior, and will disclosure of friendship ties influence investors' perceptions of director decisions? We conduct an experiment involving 56 active and experienced corporate directors from U.S. firms and a second experiment with M.B.A. students. We find that friendship ties caused directors to be more willing to approve reductions to research and development (R&D) expenses that cause earnings to rise enough to meet the CEO's minimum bonus target more often than when the directors and CEO were not friends. However, disclosing friendship ties resulted in even greater reductions in R&D expenses and higher CEO bonuses than not disclosing friendship ties. In a second experiment, we find that shareholders were more likely to agree with directors' decisions to approve cuts to R&D when friendship ties were disclosed. These findings have potentially important implications for corporate governance because they suggest that friendship ties between the CEO and board members can impair the directors' independence and objectivity, and that disclosure of the relationships can worsen this effect.

ABSTRACT: This study examines the impact of mandatory IFRS adoption on IPO underpricing and the relative amount of IPO capital raised in foreign markets. Using a difference-in-differences design, we find a decrease in IPO underpricing and an increase in the relative proceeds from foreign markets following mandatory IFRS adoption. We also find that mandatory IFRS adoption has a greater impact on IPO underpricing and relative foreign proceeds for firms in countries with a larger number of accounting changes, and this relation is more pronounced among firms in countries with stronger implementation credibility. In addition, we find that the decrease in underpricing associated with mandatory IFRS adoption holds for both domestic IPOs and global IPOs, and this effect is more pronounced for global IPOs than for domestic IPOs. Overall, our study contributes to the literature by documenting the impact of changes in financial accounting standards on IPO underpricing and capital market globalization.

ABSTRACT According to auditing standards, explanatory language added at the auditor's discretion to unqualified audit reports should not indicate increased financial misstatement risk. However, an auditor is unlikely to add language that would strain the auditor-client relationship absent concerns about the client's financial statements. Using a sample of 30,825 financial statements issued with unqualified audit opinions during 2000–2009, we find that financial statements with audit reports containing explanatory language are significantly more likely to be subsequently restated than financial statements without such language. We find that this positive association is driven by language that references the division of responsibility for performance of the audit, adoption of new accounting principles, and previous restatements. In addition, we find that (1) “emphasis of matter” language that discusses mergers, related-party transactions, and management's use of estimates predicts restatements related to these matters, and that (2) the financial statement accounts noted in the explanatory language typically correspond to the accounts subsequently restated. In sum, our results suggest that present-day audit reports communicate some information about financial reporting quality.

ABSTRACT There is a large body of accounting research literature examining the use of analytical procedures by auditors and proposing either new types of analytical procedures or more effective ways of implementing existing procedures. In this paper, we demonstrate—using procurement data from a leading global bank—the value added in an audit setting of a new type of analytical procedure: process mining of event logs. In particular, using process mining, we are able to identify numerous transactions that we consider to be audit-relevant information, including payments made without approval, violations of segregation of duty controls, and violations of company-specific internal procedures. Furthermore, these identified anomalies were not detected by the bank's internal auditors when they conducted their examination of that same data using conventional audit procedures, thus establishing the benefits of using process mining to complement existing audit methods. Process mining is a very different approach to evidence collection and analysis as it does not focus on the value of transactions and its aggregations, but on the transactional processes themselves. In addition to demonstrating the benefits of process mining in an audit context, this paper also discusses the contributions that process mining can make both to accounting research and auditing practice.

ABSTRACT This paper examines determinants of sticky cost behavior, costs that increase faster than they decrease as demand fluctuates. The majority of the literature infers that sticky costs arise because managers retain idle capacity as demand falls, but add capacity as demand grows. I use United States Air Transportation industry data to confirm that managers do retain idle capacity when demand falls. However, I also find that sticky costs arise because managers lower selling prices to utilize existing capacity when demand falls, but add capacity (rather than raise selling prices) when demand grows. Finally, I find that sticky costs arise because managers incur more cost when adding capacity as demand grows than they incur when they add capacity as demand falls. Conversely, I find evidence of anti-sticky costs that occur because managers save more cost by removing capacity when demand falls than they save by removing capacity when demand grows. Data Availability: Data are available from the author upon request.

ABSTRACT: Regulators and the financial press have criticized credit rating agencies (CRAs) for exacerbating the financial crisis by providing overly optimistic debt ratings. Allegedly, CRAs departed from their quantitative models in order to please security issuers with higher credit ratings. In response, the Dodd-Frank Act of 2010 required the Securities and Exchange Commission to conduct a study on alternative models for compensating CRAs. We conduct an experiment exploring how the credit ratings of M.B.A. students, who assume the role of credit rating analysts, are affected by two proposals for reform: (1) changing who pays the CRAs, and (2) requiring analysts to justify departures from a quantitative model. We find that credit ratings are highest when the borrower pays CRAs for ratings and a justification requirement is not in place. Implementing either proposed reform independently reduces credit ratings, but credit ratings are not further reduced when both reforms are implemented together. Data Availability: Data are available from the authors upon request.

ABSTRACT Does the placement of a line item in the income statement matter to investors? The passage of Statement of Financial Accounting Standards (SFAS) No. 145 (Financial Accounting Standards Board [FASB] 2002) affords a quasi-experimental setting to answer this question, because pre-SFAS No. 145, gains/losses from early debt extinguishments were reported below the line, while post-SFAS No. 145, they were reported above the line. After controlling for other identified changes that occur during our sample period, we find that, pre-SFAS No. 145, the market does not respond to these gains/losses, whereas post-SFAS No. 145, it does. This suggests that the market response to gains/losses is associated with their placement in the income statement. Our findings contribute to the literature on the importance of income statement presentation by demonstrating that a line-item position in the income statement has important valuation implications. JEL Classifications: G12; G14; M41.

ABSTRACT: We examine the readability of text and the use of numbers in the annual filings and earnings press releases of foreign firms listed on U.S. stock exchanges. We find that foreign firms generally write clearer text and present relatively more numerical data than their U.S. firm counterparts. More importantly, we find that the readability of the text and use of numbers increases as the foreign firms get geographically further from the U.S. It also increases as the foreign firm's home country has greater differences in accounting standards or investor protection laws relative to the U.S. Further corroborating our results, we also find that these communication efforts are partially successful. Within a country, firms that produce relatively more readable disclosures attract relatively more U.S. institutional ownership. Collectively, our results suggest that foreign firms are responding to a perceived reluctance on the part of U.S. investors to own them and attempt to lower the investors' information disadvantage or psychological distance by providing clearer and more concrete disclosures.

ABSTRACT We find evidence that investors misprice information contained in book-tax differences (BTDs), measured as the ratio of taxable income to book income, TI/BI. Low TI/BI predicts worse earnings growth and abnormal stock returns than high TI/BI. We find that short sellers and insiders arbitrage BTD mispricing, but the arbitrage is imperfect because of constraints on short selling and insider trading. Under SFAS No. 109 the predictability is stronger for TEMP/BI, the temporary component of TI/BI, which reflects greater managerial discretion. The results are incremental to a large set of known accruals-based anomaly predictors. We suggest that a sunshine policy of disclosing a reconciliation of book and taxable incomes can reduce mispricing of BTDs and improve capital market resource allocation. Data Availability: Data are obtained from the public sources as indicated in the text.