Knowledge that Transforms

We investigate the joint effects of auditors' reporting choice and audit committee effectiveness on management disclosures about complex estimates. A new PCAOB standard requires auditors to report on Critical Audit Matters (CAMs): issues “communicated or required to be communicated to the audit committee” about accounts or disclosures that (1) “are material to the financial statements,” and (2) “involved especially challenging, subjective, or complex auditor judgment” (PCAOB 2017a, 11). Consistent with investor arguments, we find that audit committee effectiveness and more detailed CAM reporting encourage managers' disclosures of the risk underlying complex estimates. When the auditor's report is more informative about a complex estimate and the audit committee is more effective, management's related financial disclosures are more forthcoming. However, less informative auditor disclosures or more effective audit committees alone do not prompt greater management disclosure. Thus, expanded auditor reporting and more effective audit committees, together, can enhance the disclosures investors value.

We use the staggered adoption of the Universal Demand Laws (UD Laws) to examine the effect of an exogenous reduction in shareholders' ability to litigate on the extent of accounting conservatism. On average, we find an increase in reporting conservatism post-UD. The increased conservatism is concentrated in firms that contemplate equity issuance, with a high proportion of monitoring investors, and high corporate governance quality. In contrast, firms with specific short-term incentives for aggressive accounting—such as those narrowly beating benchmarks, those with abnormal insider trading, and those likely to violate debt covenants—weakly governed firms, and firms with high ex ante litigation risk decrease reporting conservatism after UD. Our results suggest that the relation between the litigation environment and reporting conservatism is complex and dependent on specific characteristics and unique circumstances of the firms.

We show that the number of governance provisions imposed on a firm by a strategic alliance partner decreases with the firm's accounting quality. This effect is weaker when the firm has greater bargaining power and stronger when the alliance project is riskier. Moreover, the net benefit to an alliance partner of imposing an additional governance provision on its counterparty apparently increases when the counterparty accounting quality is low, resulting in an enhancement of the partner's market value and a reduction in its bankruptcy risk. Furthermore, alliance partners adopt fewer provisions based on their counterparties' accounting numbers when the counterparties' accounting quality is poor.

We examine whether PCAOB inspection reports increase auditors' litigation risk. We find that inspection reports with audit deficiencies are positively associated with the number of lawsuits subsequently filed against the inspected auditor. These results are strongest when client-level lawsuit-triggering events have already occurred and when PCAOB inspection content is arguably more persuasive. Importantly, these results pertain exclusively to triennially inspected audit firms for which the set of other publicly available signals of audit quality is limited. Furthermore, we do not argue that inspection reports in isolation trigger lawsuits. Instead, once events such as restatement announcements or bankruptcies create the potential for legal action against the auditor, inspection reports provide a public signal about past noncompliance with auditing standards. This signal likely increases lawyers' perceived strength of case against the auditor before the lawsuit is filed and before lawyers have access to the audit workpapers.

We study how home-market reporting requirements and listing choices associate with ongoing SEC disclosures by foreign firms and the investor response. The SEC defers material event and interim financial disclosure obligations to foreign firms' home-market regulator or exchange. We find that a growing number of foreign firms incorporate in disclosure havens and have few or no event-driven disclosure obligations. These firms furnish fewer 6-K disclosures, but experience greater investor interest and market response to each filing. There is little evidence that the SEC substitutes for lower information flow with additional monitoring. Our results indicate that the SEC's one-size-fits-all approach to foreign firm disclosure has led to increasing disparity in information flow, despite the strong demand for and reaction to disclosures by firms from weaker regimes.

The Patient Protection and Affordable Care Act (ACA) requires that insurers spend a minimum amount of their premium revenue on policyholder benefits. The Act specifies enforcement via a combination of insurer self-reporting, government examinations, and payment of policyholder rebates in cases where insurers fail to meet the required spending amount. We find that insurers' reported estimates are consistently overstated in situations in which more accurate estimates would have triggered rebate payments; publicly traded insurers (particularly those exhibiting poor financial reporting quality) exhibit the strongest evidence of strategic over-estimating. In aggregate, we estimate that approximately 14 percent of insurers engage in strategic over-estimates, and that insurer over-estimates resulted in hundreds of millions of dollars in underpaid policyholder rebates. Our study illustrates how a combination of regulatory design choices and lax oversight can weaken the effectiveness of accounting-based regulation and have substantial economic consequences.

I investigate the incentives provided by performance-vested stock awards (PVSAs) and the accuracy of ex ante PVSA valuations. In PVSAs, the number of shares awarded to the CEO varies based on how firm performance compares to target performance levels. The incentives provided by PVSAs and their valuations depend on the difficulty of the performance targets, which cannot be easily determined using ex ante disclosures. Using a hand-collected dataset of PVSA outcomes, I find that target difficulty is such that CEOs have incentives to earn additional shares from improved firm performance in 75 percent of PVSAs. In contrast, findings in prior studies using methodologies that rely on comparisons of PVSA targets to similarly named financial statement metrics suggest only 12 percent of awards provide such incentives. I further find that, on average, PVSAs pay out 115 percent of shares disclosed in ex ante valuations, suggesting the valuations of awards are understated. Data Availability: Data are available from sources cited in the text. PVSA outcome data are available upon request from the author.

We experimentally examine the effects of trait professional skepticism on fraud brainstorming performance. We find that groups with a minority, but not a majority, of high trait skeptics develop more fraud ideas than control groups with no high trait skeptics. Mediation analyses indicate that minority high trait skeptic groups also assess higher fraud risk, in part because they consider more fraud ideas. Low trait skeptics who brainstorm in groups with a minority of high trait skeptics tend to view the minority high trait skeptic as the best member of the group because of that member's unique insights. Their individual, post-brainstorming fraud risk assessments remain high, indicating conversion to the minority (skeptical) viewpoint. Our study contributes to the brainstorming literature by highlighting the importance of group composition. It suggests that firms can promote skeptical team judgments by leveraging individuals' high trait skepticism in thoughtfully composed interacting groups.

We study a dynamic timing game between multiple firms, who decide when to go public in the presence of possible information externalities. A firm's IPO pricing is a function of its privately observed idiosyncratic type and the level of investor sentiment, which follows a stochastic, mean-reverting process. Firms may wish to delay their IPOs in order to observe the market reception of the offerings of their peers. We characterize the unique symmetric threshold equilibrium, whereby pioneer firms with high idiosyncratic types endogenously emerge. The results provide novel implications regarding variation in IPO timing, sequential clustering, IPO droughts, the composition of new issues over time, and how IPO volume fluctuates over time. These include, among others, that in more populated industries, a lower proportion of firms emerge as industry pioneers, but follower IPO volume is intensified. Additionally, heightened uncertainty over investor sentiment exacerbates delay and leads to lower IPO volume.

We investigate whether firms manage stock prices in anticipation of share issuance. Warrant exercise results in share issuance and warrant expiration dates are fixed years in advance, which precludes market timing. We predict firms manage stock prices to prevent (induce) warrant exercise when exercise is dilutive (anti-dilutive) to existing shareholders. To test our prediction, we examine stock returns around warrant expiration dates. We find that the difference between out-of-the-money (OTM) and in-the-money (ITM) firms' return patterns (i.e., post-expiration minus pre-expiration returns) is positive, and OTM (ITM) firms' return pattern is positive (negative). Return patterns of three sets of pseudo warrant firms differ from patterns of warrant firms. Return patterns are stronger when more feasible price changes are required to affect warrant expiration status, and firm-issued news items is a mechanism for price management. Thus, our findings provide evidence that firms engage in stock price management in anticipation of share issuance.