Knowledge that Transforms

ABSTRACT Using a financial reporting and valuation model, we investigate the construct validity of Basu's (1997) asymmetric timeliness (AT) regression coefficient as a measure of conditional conservatism in corporate financial reporting. We predict that the AT coefficient will be positive even in the absence of conditional conservatism, and it will vary with non-accounting factors even if the degree of conditional conservatism is held constant. Our empirical analysis shows that AT coefficient estimates vary in directions predicted by our theory. Specifically, we find that AT coefficient estimates increase with expected returns and asymmetry in the distribution of returns, and decrease with cash flow persistence. Importantly, we identify the spread between the variances of bad news and good news accruals as an alternative measure of conditional conservatism that is free of the effects confounding the AT coefficient. Consistent with a key implication of conditional conservatism, we find that the variance of bad news accruals is significantly higher than the variance of good news accruals primarily due to conditionally conservative accruals related to inventory write-downs, long-term asset write-downs, and goodwill impairments. A series of placebo tests provides additional support for the construct validity of our alternative measure of conditional conservatism. Data Availability: Data are publicly available from the sources indicated in the text.

ABSTRACT Overconfident CEOs are more willing to initiate investment projects that require experimentation, yet tend to defer responding to the bad news when the project is not performing as planned. Accounting conservatism accelerates the recognition of the bad news and its dissemination to gatekeepers, making it more likely that the CEO will acknowledge the problem earlier and start searching for solutions. Therefore, firms where both characteristics—CEO overconfidence and accounting conservatism—are present should perform better. Our empirical tests confirm this prediction: firms that practice conservative accounting and are run by overconfident CEOs exhibit better cash flow performance. Our results continue to hold in a variety of settings, including market reactions to acquisitions, cash flow downside risk, and analyst following. Further, the joint positive effect of CEO overconfidence and accounting conservatism on firm performance is stronger in high-uncertainty environments and in firms facing less stringent financing constraints, consistent with theoretical predictions.

ABSTRACT We investigate the effects of audit partner rotation among U.S. publicly listed firms, utilizing the fact that audit partners are periodically copied by name in public correspondence between issuers and the Securities and Exchange Commission. Relative to non-rotation firms, we find no evidence of a change in the frequency of misstatements following the partner rotation; however, there is an increase in the frequency of restatement discoveries and announcements. We also find an increase in deferred tax valuation allowances. Overall, the results provide some evidence suggesting that U.S. partner rotations support a fresh look at the audit engagement. JEL Classifications: M41; M42; M48. Data Availability: Data are publicly available from sources identified in the article.

ABSTRACT Although balanced budget rules are widely used throughout the world, there is considerable debate on whether and how they impact fiscal outcomes. Existing research shows that states with strict balanced budget rules address deficits by raising taxes and curbing expenditures. However, little is known about whether politicians can meet budget rules by shifting resources inter-temporally or by transferring revenues from funds not subject to balanced budget rules into funds that are required to meet a balanced budget. We show that, in addition to increasing taxes and cutting expenditures, states with strict balanced budget rules sell public assets and transfer resources across government funds to close the budget shortfall. Our findings suggest that current budget deficits not only influence the current-period taxpayers, but also impact future taxpayers and other funds within the government. The results complement existing research by expanding our understanding of the effects of balanced budget restrictions on politicians' fiscal actions.

ABSTRACT A fundamental accounting question is whether investors perceive low risk when earnings are smooth relative to the volatility of operating cash flows. We conduct two experiments to examine this question. Absent additional information concerning the likelihood of earnings management, our first experiment finds that investors give managers the benefit of the doubt and perceive low risk when earnings are relatively smooth. Given this finding, our second experiment examines whether additional information that supports investors' suspicions of earnings management affects investors' risk judgments when earnings are relatively smooth. We find that investors no longer give managers the benefit of the doubt when additional information suggests that managers have either the opportunity or the incentive to report smooth earnings. Our study provides important insights to the literature concerning both “whether” and “when” relatively smooth earnings affect investors' risk judgments. Data Availability: Contact the authors.

ABSTRACT This study shows that the recent trajectory of a firm's profits predicts future profitability and stock returns. The predictive information contained in the trend of profitability is not subsumed by the level of profitability, earnings momentum, or other well-known determinants of stock returns. The profit trend also predicts the earnings surprise one quarter later, and analyst forecast errors over the following 12 months, suggesting that sophisticated investors underreact to the information in the profit trend. On the other hand, we find no evidence of investor overreaction, and our results cannot be explained by well-known risk factors. JEL Classifications: G12; G14.

ABSTRACT We investigate the effects of tangible versus cash rewards in a repeated tournament setting. Firms frequently use tangible rewards to motivate employees, but minimal research has examined their effects relative to cash rewards. We conducted a field experiment at a rug wholesaler that held two consecutive sales tournaments for its retailers. The top three retailers in each tournament received either cash rewards or tangible rewards (gift cards) to be distributed to sales staff. We do not find significant effects of reward type in the first tournament. However, in the second tournament, retailers eligible for tangible rewards significantly outperformed those eligible for cash rewards, and this effect is driven by Tournament One losers. Our results are consistent with the theory that Tournament One losers competing for tangible rewards increased sales effort in the second tournament significantly more than their counterparts competing for cash rewards. Our results have practical and theoretical implications.

ABSTRACT Propensity score matching (PSM) has become a popular technique for estimating average treatment effects (ATEs) in accounting research. In this study, we discuss the usefulness and limitations of PSM relative to more traditional multiple regression (MR) analysis. We discuss several PSM design choices and review the use of PSM in 86 articles in leading accounting journals from 2008–2014. We document a significant increase in the use of PSM from zero studies in 2008 to 26 studies in 2014. However, studies often oversell the capabilities of PSM, fail to disclose important design choices, and/or implement PSM in a theoretically inconsistent manner. We then empirically illustrate complications associated with PSM in three accounting research settings. We first demonstrate that when the treatment is not binary, PSM tends to confine analyses to a subsample of observations where the effect size is likely to be smallest. We also show that seemingly innocuous design choices greatly influence sample composition and estimates of the ATE. We conclude with suggestions for future research considering the use of matching methods. Data Availability: All data used are available from sources cited in the text.

ABSTRACT Accountants examine multiple indicators when assessing whether individual assets are impaired. Different indicators predict cash flows over varying time horizons, and their importance varies with how far into the future individual assets are expected to generate cash flows. We predict that earnings exhibits asymmetric timeliness with respect to multiple indicators, including stock return, sales change, and operating cash flow change, which differentially explain write-downs of current assets, long-lived tangible assets, and indefinite-lived goodwill. We predict an interaction effect between indicators, such that the total impact of several consistent indicators is greater than the sum of their individual impacts. Empirical estimates for U.S. firms are consistent with our predictions and yield new insights about the effects of multiple indicators for both conservatism and impairment research. Our multi-indicator asymmetric models also change inferences about the relative explanatory power of economic factors versus reporting incentives in asset impairments. JEL Classifications: G32; L25; M41; M42.

ABSTRACT In this study, we examine whether sell-side security analysts gain access to value-relevant information through political connections. We measure analysts' political connections based on political contributions at the brokerage-house level. We argue that if brokerages are able to obtain private information through their political connections, then analysts at politically connected brokerages should issue more profitable stock recommendations, and this increased profitability should be more pronounced for politically sensitive stocks. Our evidence is consistent with these predictions. Analyses of recommendations issued surrounding the Affordable Care Act further support our main inferences. Moreover, our findings hold after we employ numerous tests to address correlated omitted variables and endogeneity. Collectively, these results suggest that brokerages obtain value-relevant, nonpublic information from their political connections. JEL Classifications: G24; G38; G14.