Knowledge that Transforms

ABSTRACT: We examine how business unit (BU) controllers balance their dual roles of providing information for both local decision-making (local responsibility) and corporate control (functional responsibility). The existing literature suggests that organizations can improve the quality of financial reporting and internal controls by increasing the emphasis on the functional responsibility of BU controllers. In this study, we rely on prior literature and insights from field interviews to argue that such an increase also leads to role ambiguity and conflict, which in turn can lead to an increased tolerance of data misreporting. We test our predictions using survey responses of 134 BU controllers. As predicted, we find that the emphasis on the functional responsibility of BU controllers is positively associated with role conflict and role ambiguity, both of which are related to data misreporting at the BU level.

ABSTRACT: This study explores how firms' ownership structures affect their earnings quality and long-term performance. Focusing on a unique sample of private firms for which there is financial data available in the years before and after their initial public offering (IPO), I differentiate between those that have private equity sponsorship (PE-backed firms) and those that do not (non-PE-backed firms). The findings indicate that PE-backed firms generally have higher earnings quality than those that do not have PE sponsorship, engage less in earnings management, and report more conservatively both before and after the IPO. Further, PE-backed firms that are majority-owned by PE sponsors exhibit superior long-term stock price performance after they go public. These results stem from the professional ownership, tighter monitoring, and reputational considerations exhibited by PE sponsors.

We develop a model of audit production based on Data Envelopment Analysis (DEA) using labor cost as input and hours spent on evidence-gathering activities that determine the level of assurance as output. Client characteristics are considered exogenous factors that affect audit production as a whole. We apply the model to a sample of U.S.-based engagements from an international accounting firm. Results indicate that a constrained DEA model using variable returns to scale is appropriate for modeling audit production. We find that audits are more efficient for clients that are larger, have a December year-end, and are highly automated. Audits are less efficient when the auditor relies on internal control, tax services are provided, and the client has subsidiaries. We also find that a well-specified regression-based production model can control for factors that influence auditor efficiency. Finally, we find that inefficiencies are impounded in fees for some industries and firm offices.

ABSTRACT:We analyze the board of directors' equilibrium strategies for setting CEO incentive pay and overseeing financial reporting and their effects on the level of earnings management. We show that an increase in CEO equity incentives does not necessarily increase earnings management because directors adjust their oversight effort in response to a change in CEO incentives. If the board's responsibilities for setting CEO pay and monitoring are separated through the formation of committees, then the compensation committee will increase the use of stock-based CEO pay, as the increased cost of oversight is borne by the audit committee. Our model generates predictions relating the board committee structure to the pay-performance sensitivity of CEO compensation, the quality of board oversight, and the level of earnings management.

ABSTRACT: The evolved brain neuronally processed information on human interaction long before the development of formal accounting institutions. Could the neuronal processes represent the underpinnings of the accounting principles that exist today? This question is pursued several ways: first as an examination of parallel structures that exist between the brain and accounting principles, second as an explanation of why such parallels might exist, and third as an explicit description of a paradigm that shows how the benefits of an accounting procedure can emerge in an experiment.

ABSTRACT: We investigate the use, determinants, and earnings effects of special purpose vehicles (SPVs). Based on a proxy of SPV activity that can be applied to a broad cross-section of firms over time, we find a two-and-a-half fold monotonic increase in the percentage of firms using at least one SPV during the eight-year period from 1997 through 2004. Tobit regressions of the determinants of SPV use show that SPV activity increases with financial reporting incentives and economic and tax motivations, but strong corporate governance tends to mitigate their use. In addition, the evidence is consistent with SPVs arranged for financial reporting purposes being associated with earnings management, whereas the same does not appear to be the case for SPVs set up mainly for economic, tax, and other reasons.

Globally, companies increasingly publish separate general purpose, non-financial (sustainability) reports. Some of these are independently assured and assurers may or may not be from the auditing profession. We seek to understand this emerging voluntary assurance market. Using a sample of 2,113 companies (from 31 countries) that produced sustainability reports between 2002-2004, we use sequential logit analysis to identify the factors associated with the decision to voluntarily purchase assurance and the choice of assurance provider. We hypothesize that a company's need to enhance credibility through assurance and choice of assurance provider will be a function of company-, industry-, and country-related factors. Our results support the argument that companies seeking to enhance the credibility of their reports and build their corporate reputation are more likely to have their sustainability reports assured, although it does not matter whether the assurance provider comes from the auditing profession. We also find that companies operating in stakeholder-orientated countries are more likely to choose the auditing profession as an assurer.

ABSTRACT: The Public Company Accounting Oversight Board recently reported that its inspections show that auditors fail to effectively modify their standard audit procedures in response to fraud risk. Prior academic research is consistent with this finding. Our study examines the effects of two interventions on auditors' planning decisions in a high-fraud-risk setting: strategic reasoning and brainstorming in groups. Both interventions are predicted to lead auditors to more effectively modify their planned audit procedures. We use a panel of fraud experts to identify effective modifications to the audit plan of a specific fraud case. The experts' recommendations are then used to evaluate the effectiveness of practicing auditors' audit plans with and without the two interventions. We predict and find that each intervention leads to more effective modifications to the standard audit procedures and that the combination of the interventions is not significantly more effective than either intervention used alone.

ABSTRACT: Using data from the EDGAR era, we find a significant market reaction surrounding quarterly periodic reports only when their filing coincides with the first public disclosure of earnings, although that for 10-K reports is not subsumed by earnings releases. However, after eliminating incidence of concurrent earnings releases, the 10-K market reaction is restricted to a quarter of the reports that are filed around calendar quarter-ends. The calendar quarter-end price and volume effects are unrelated to the filing of periodic reports and are not explained by self-selection. However, while the quarter-end volume reaction is indistinguishable between filers and non-filers, we find an incremental price reaction to 10-K filings at calendar quarter-ends in recent times. We provide evidence that the calendar-time effect is partially due to an intraindustry information transfer that is a function of the incidence of 10-K reports at quarter-ends. Finally, equity analyst reactions are muted around periodic filings, with no evidence that they contribute to quarter-end information transfer.

ABSTRACT: We investigate the association between aggressive tax and financial reporting and find a strong, positive relation. Our results suggest that insufficient costs exist to offset financial and tax reporting incentives, such that nonconformity between financial accounting standards and tax law allows firms to manage book income upward and taxable income downward in the same reporting period. To examine the relation between these aggressive reporting behaviors, we develop a measure of tax reporting aggressiveness that statistically detects tax shelter activity at least as well as, and often better than, other measures. In supplemental stock returns analyses, we confirm that the market overprices financial reporting aggressiveness. We also find that the market overprices tax reporting aggressiveness, but only for firms with the most aggressive financial reporting.