Knowledge that Transforms

This paper explores the effect of a credit rating agency's (CRA) reputation on the voluntary disclosures of corporate bond issuers. Academics, practitioners, and regulators disagree on the informational role played by major CRAs and the usefulness of credit ratings in influencing investors' perception of the credit risk of bond issuers. Using management earnings forecasts as a measure of voluntary disclosure, I find that investors demand more (less) disclosure from corporate bond issuers when the ratings become less (more) credible. In addition, using content analytics, I find that bond issuers disclose more qualitative information during periods of low CRA reputation to aid investors in assessing credit risk. My findings are consistent with credit ratings providing incremental information to investors and reducing adverse selection in lending markets. Further, consistent with theoretical predictions, my findings suggest that managers rely on voluntary disclosure as a credible mechanism to reduce information asymmetry in bond markets.

Views Icon Views Article contents Figures & tables Video Audio Supplementary Data Peer Review Share Icon Share Facebook Twitter LinkedIn MailTo Tools Icon Tools Get Permissions Search Site Cite View This Citation Add to Citation Manager Citation Dan A. Simunic, Gary C. Biddle; The Big Four: The Curious Past and Perilous Future of the Global Accounting Monopoly. The Accounting Review 1 January 2019; 94 (1): 353–356. https://doi.org/10.2308/accr-10638 Download citation file: Ris (Zotero) Reference Manager EasyBib Bookends Mendeley Papers EndNote RefWorks BibTex toolbar search Search Dropdown Menu toolbar search search input Search input auto suggest filter your search All ContentThe Accounting Review Search Advanced Search

We develop a model to evaluate the costs and benefits of disclosing information about audit quality. Specifically, we examine whether audit quality disclosure affects auditors' effort and investors' investment efficiency. In our setting, an auditor exerts unobservable effort to influence audit quality and is motivated by liability in the event of audit failure. The usefulness of audited financial reports for investors depends on both the quality of the underlying financial reporting (e.g., as embodied by GAAP) and the quality of auditors' reports (i.e., the likelihood with which audit evidence uncovers managerial misreporting). We show that audit quality disclosure increases auditors' effort incentives if and only if the underlying financial reporting quality is relatively weak. We also show that such disclosure can actually reduce investment efficiency. Our analyses contribute to the debate about policies aimed at improving audit transparency.

We investigate whether aggressive tax planning firms have a less transparent information environment. Although tax planning provides expected tax savings, it can simultaneously increase the financial complexity of the organization. And to the extent that this greater financial complexity cannot be adequately clarified through communications with outside parties, such as investors and analysts, transparency problems can arise. Our investigation of the association between tax aggressiveness and information asymmetry, analysts' forecast errors, and earnings quality suggests that aggressive tax planning is associated with lower corporate transparency. We also find evidence that managers at tax-aggressive firms attempt to mitigate these transparency problems by increasing various tax-related disclosures. Overall, our results suggest that firms face a trade-off between tax benefits and financial transparency when choosing the aggressiveness of their tax planning.

We investigate the relation between tax avoidance and tax uncertainty, where tax uncertainty is the amount of unrecognized tax benefits recorded over the same time period as the tax avoidance. On average, we find that tax avoiders, i.e., firms with relatively low cash effective tax rates, bear significantly greater tax uncertainty than firms that have higher cash effective tax rates. We find that the relation between tax avoidance and tax uncertainty is stronger for firms with frequent patent filings and tax haven subsidiaries, proxies for intangible-related transfer pricing strategies. The findings have implications for several puzzling results in the literature.

Prior evidence shows a reduction in leverage after covenant violations, but we do not know whether covenants affect leverage before they are violated. In this study, we use an exogenous accounting-based shock to debt covenants that relaxed covenant tightness (SFAS 160) and examine whether covenants constrain leverage for borrowers that are close to violation, even when the borrower is financially healthy. We find that SFAS 160 increased debt levels in firms that were close to violation. This increase in debt was driven by financially healthy firms, suggesting the likelihood of future covenant violations could impede borrowing by firms. We also find an increase in investment sensitivity to Q after SFAS 160 in firms close to violation, suggesting the additional debt was used to make legitimate investments. Because SFAS 160 was passed in the midst of the financial crisis, it is difficult to generalize our findings to more normal financial periods.

We investigate whether tax avoidance becomes more uncertain as the rate of tax avoidance increases. We estimate a system of equations to demonstrate that as firms' pretax income increases, each additional dollar of potential tax results, on average, in 32.8 cents of tax avoided, which we refer to as incremental tax avoidance. Of the incremental tax avoided, 1.4 cents represent additions to the reserve for uncertain tax benefits (UTB reserve), or 4.3 percent of the total incremental tax avoided. We then partition sample firms into groups that prior research suggests engage in higher rates of tax avoidance, and examine the amount of incremental tax avoidance that results in additions to the UTB reserve. Results demonstrate that the percentage of incremental tax avoidance reflecting additions to UTB reserve is not larger for groups engaging in higher rates of tax avoidance, suggesting higher rates of tax avoidance may not be more uncertain.

Auditors frequently use benchmarking analysis to evaluate the appropriateness of a client's estimates. Client management may strategically select benchmark data, making an auditor's evaluation task more difficult. Psychology research suggests that the composition of the benchmark set can lead to contrast effects, because evaluations of an option in a choice set can change based on the inclusion of other options in the set. In Experiment 1, we examine and find that auditors' judgments of the reasonableness of a client-preferred discount rate for a Level 3 investment are inappropriately influenced by the set of peer companies provided by the client as justification. In Experiment 2, audit managers performing the same task similarly exhibited contrast effects. However, as managers' investment experience increased, the influence of contrast effects from the benchmark set decreased. Given the widespread use of benchmark data, contrast effects from benchmark set composition have implications for accounting and auditing contexts.

In their classic text Security Analysis, Graham and Dodd (1934) warn investors against sole reliance on a few quantitative factors in investment decisions. Instead, they recommend that investment decisions be based on a comprehensive fundamental analysis of the underlying securities. While their views held sway for many decades, recent years have witnessed a sharp reversal. Scholars of finance often overlook fundamental analysis, and their influence has led to a surge of investment products relying solely on a few quantitative factors. These products often have names that appeal to fundamental analysis, such as “value” and “quality.” I argue that Graham and Dodd's (1934) recommendations continue to have merit. I show how popular quantitative approaches to investing overlook important information and select stocks with distorted accounting numbers rather than temporary mispricing. I conclude that informative financial reporting and comprehensive fundamental analysis are essential for the efficient functioning of capital markets. Data Availability: Data are publicly available from sources indicated in the text.

We exploit a regulatory change in Singapore to analyze the capital market effects of mandatory quarterly reporting. The listing rule implemented in 2003 has required firms with a market capitalization above S$75 million—but not firms with a market capitalization below this threshold—to publish quarterly financial statements. Using regression discontinuity analysis for our identification, we provide novel evidence of the causal effects of mandatory quarterly reporting on small firms. We find a 5 percent decrease in firm value, consistent with the notion that mandatory quarterly reporting is perceived as a net burden for small firms. Contrary to popular belief, we cannot find evidence of informational benefits or myopic investment for firms around the threshold. Additional tests suggest positive information spillover effects from large mandatory quarterly reporters to non-quarterly reporting firms.