Knowledge that Transforms

We examine how state liability regimes within the United States affect auditor reporting decisions. We exploit variation across state-level common law in two aspects of auditor liability: the extent to which auditors can be held liable by third parties for negligence, and rules for apportioning liability across multiple defendants. We find that auditors are more likely to issue a modified going-concern (GC) report to financially distressed clients from high-liability states than to those from low-liability states. We sharpen inferences using a natural experiment that examines the causal effects of two exogenous shocks to auditor third-party liability standards, which dramatically restricted auditors' liability in New Jersey in 1995 and in California in 1992. Results from difference-in-differences tests imply that auditors' propensity to issue a modified opinion for client firms in New Jersey and California decreases significantly after the decline in auditors' litigation exposure, relative to control firms from other jurisdictions. These findings add to our understanding of how litigation risk affects auditor behavior and highlight an important source of variation in litigation risk within the U.S. that has seldom been studied to date.

Based on Lambert, Leuz, and Verrecchia's (2007) derivation of the cost of equity capital in terms of expected cash flows, we generate a testable hypothesis that relates tax avoidance to a firm's cost of equity capital. Using three broad measures of tax avoidance—book-tax differences, permanent book-tax differences, and long-run cash effective tax rates—to test our hypothesis, we find that the cost of equity is lower for tax-avoiding firms. This effect is stronger for firms with better outside monitoring, firms that likely realize higher marginal benefits from tax savings, and firms with higher information quality. Overall, our results suggest that equity investors generally require a lower expected rate of return due to the positive cash flow effects of corporate tax avoidance.

When using a tournament in multi-period settings, firms have discretion in selecting the tournament horizon. For example, firms can use a single tournament (a grand tournament) or a sequence of multiple tournaments, each with a shorter horizon than a grand tournament (a repeated tournament). Firms have also begun to use a combination of both in which a repeated tournament is embedded within a grand tournament (a hybrid tournament). Using an experiment, we investigate whether the effect of tournament horizon on performance depends on the dynamic complexity of the task, which reflects the potential for effort in one period to influence the link between effort and performance in future periods. When dynamic task complexity is low, we find that performance is greatest in the hybrid tournament, followed by the repeated and then the grand tournament. In contrast, when dynamic task complexity is high, we find that performance is greatest in the repeated tournament, followed by the grand and hybrid tournaments, with similar performance in the latter two tournaments. More generally, the results of our experiment suggest that the effect of tournament horizon on performance depends on dynamic task complexity. These results can help firms make better decisions when designing their tournaments by reinforcing the need to align the tournament horizon with the task.

This paper presents a comprehensive analysis of the role of credit default swaps (CDS) in information production surrounding earnings announcements. First, we demonstrate that the strength of CDS price discovery prior to earnings announcements is related to the presence of private information and the illiquidity of the underlying corporate bonds, consistent with the CDS market being a preferred venue for informed trading. Next, we ask how the information revealed through CDS trading influences the output of equity and credit rating analysts. We find that post-CDS trading, the dispersion and error of earnings per share forecasts are generally reduced, and downgrades by both types of analysts become more frequent and more timely before large negative earnings surprises, suggesting that the CDS market conveys information valuable to financial analysts.

Allowing CEOs to hedge the risk in the compensation contracts their firms give them has been controversial because such hedging allows the executives to undo some of the incentive effects of those contracts; it also results in a divergence between the compensation firms pay their senior executives and the compensation those executives effectively receive. We analyze these personal hedging activities of CEOs and identify when firms may gain or lose by allowing or prohibiting such hedging. We also describe variations in CEOs' demands for various compensation hedges, and how firms will restructure their CEOs' compensation contracts in anticipation that the CEOs will engage in such hedging.

This study examines the role of the external audit in management's decision about the amount of GAAP financial statement information to disclose in the annual earnings announcement. The earnings announcement is a key disclosure provided by public companies. Yet, there is no requirement that earnings announcements contain audited GAAP numbers; in fact, recent trends indicate that a majority of companies release earnings before the completion of year-end audit fieldwork. I predict and find that companies that wait until the audit is more complete at the earnings announcement date and receive higher quality audits provide more detailed balance sheet, cash flow statement, and overall GAAP disclosures. I also provide evidence that complete audits and higher quality audits impact the information content of the earnings announcement. The combined results indicate that audit completeness and quality help facilitate more detailed earnings announcement disclosures and have implications for the equity market. Data Availability: Data are publicly available from sources identified in the text.

Securitizations are complex and opaque transactions. We hypothesize that bank insiders trade on private information about banks': (1) securitization-related recourse risks, (2) not-yet-reported current-quarter securitization income, and (3) securitization-based business model sustainability. We provide evidence that proxies for each of these types of insider information are positively associated with insider trading. Specifically, we find that net insider sales in the 2001Q2–2007Q2 pre-financial crisis quarters predict not-yet-reported non-performing securitized loans and securitization income for those quarters, and that net insider sales during 2006Q4 predict write-downs of securitization-related assets during the 2007Q3–2008Q4 crisis period. We find that net insider sales are more negatively associated with banks' subsequent stock returns in their securitization quarters than in other quarters. In supplemental analysis, we show that the above findings are driven by trades by banks' CEOs and CFOs, and that insiders avoid larger stock price losses through 10b5-1 plan sales than through non-plan sales. Data Availability: All data are available from public sources.

This study examines the effect of the mandatory adoption of International Financial Reporting Standards (IFRS) on voluntary disclosure. Using a difference-in-differences analysis, we document a significant increase in the likelihood and frequency of management earnings forecasts following mandatory IFRS adoption, consistent with the notion that IFRS adoption alters firms' disclosure incentives in response to increased capital-market demand. We find the increase to be larger among firms domiciled in code-law countries, suggesting a catching-up effect among firms facing low disclosure incentives pre-adoption. We then propose and test three channels through which IFRS adoption could alter firms' disclosure incentives: improved earnings quality, increased shareholder demand, and increased analyst demand. We find evidence consistent with all three channels.

We investigate the effects of dividend taxes on foreign equity portfolio holdings. Based on the extension of an equilibrium model with risky assets to an international setting, we predict that a change in the tax rate on dividends of a country's domestic investors is positively related to changes in foreign investors' portfolio holdings in that country. The evidence from two research settings, which exploit changes in the national tax policies of different countries, supports this prediction. More generally, the model predicts that a foreign investor's equilibrium portfolio holdings in a country are negatively related to the dividend tax rate that she directly pays on assets in that country and positively related to the weighted-average dividend tax rate of worldwide investors in that country. Results from analyses using panel data provide empirical support for these predictions.

This study investigates the role of employment policies in reducing internal control ineffectiveness and financial restatements. We provide new evidence that employee treatment policies are an important predictor of ineffective internal control. We also find that employee-friendly policies significantly reduce the propensity for employee-related material weaknesses. These results suggest that greater employee benefits facilitate the acquisition, development, and motivation of the workforce and ameliorate the loss of valuable human capital, thereby mitigating employee failures to implement internal control tasks properly. Moreover, we document novel results that financial restatements, especially those caused by unintentional errors, are less likely to arise in firms that invest more in employee benefits. Collectively, our emphasis on the effect of employee treatment policies on the integrity of internal control and financial reporting distinguishes our paper from previous studies that focus on the role of top executives in accounting practices. Data Availability: Data are available from public sources indicated in the text.