Knowledge that Transforms

The question we address is whether mandated disclosure about dispersion of nonfinancial asset values can provide information relevant to assessing firm risk. Using a sample of Canadian oil and gas (O&G) firms between 2004 and 2011, we find that the difference between the disclosed 10th and 50th percentiles from the O&G reserves distribution, which measures dispersion of the distribution, is positively associated with future total and idiosyncratic equity return volatility, systematic risk, and credit risk. We also find that disclosure of increased reserves dispersion is associated with weaker stock price reactions to increases in reserves and with increases in bid-ask spreads, both of which indicate the disclosures convey information about risk associated with reserves. Additional tests reveal little evidence of managerial opportunism in the reserves disclosures. Taken together, our evidence suggests that quantitative disclosures about the dispersion of nonfinancial asset values can provide information relevant to assessing firm risk.

We investigate the determinants of analysts' target price implied returns and the implication of our findings for investment decision-making. We identify four broad sets of factors that help explain the cross-sectional variation in target price implied returns: future realized stock returns, errors in forecasting fundamentals, errors in forecasting the expected return to risk, and biases relating to analysts' incentives. Our results suggest that all four sets help explain target price implied returns, with errors in forecasting the expected return to empirical risk proxies having the greatest impact. Collectively, these variables explain nearly a quarter of the cross-sectional variation in target price implied returns. We use our model to predict the optimistic bias in target price implied returns and evaluate whether investors correctly ignore the predictable bias. The results suggest that investors make similar valuation errors to analysts and/or do not perfectly back out the predicted bias in target prices.

We examine whether customer-base concentration has a differential impact on profitability for firms contracting with major government customers versus firms contracting with major corporate customers. We document that firm profitability increases with the concentration of major government customers, but decreases with the concentration of major corporate customers. We attribute the contrasting results to the differential impact of major government and corporate customers on demand uncertainty. Specifically, firms contracting with major government customers face lower demand uncertainty that enables them to realize more efficiency gains from customer-specific investments, whereas firms contracting with major corporate customers are exposed to higher demand uncertainty that reduces the efficiency of customer-specific investments. Overall, our study suggests that major government customers are unique and important in the composition of customer base, and they impact firm outcomes in a significantly different way than major corporate customers.

During a look-back analysis, auditors review prior-period evidence to understand estimation inaccuracies and assess the reliability of management's estimation process. We find that evidence specificity moderates the relation between the consistency of an estimation inaccuracy with management's incentives and auditors' reliability assessments. The direction of an estimation inaccuracy has no effect on auditors' reliability assessments when the prior-period evidence is less specific. When prior-period evidence is more specific, auditors report the highest (lowest) reliability assessments of management's estimation process when an estimation inaccuracy is inconsistent (consistent) with management's incentives. Auditors' low reliability assessments in the more specific, consistent condition, however, do not translate to high risk assessments. Instead, specificity has a main effect on auditors' risk assessments. A follow-up experiment reveals, though, an inverse relation between auditors' reliability and risk assessments when auditors are provided procedures to address various levels of assessed misstatement risk.

To explain the empirically documented nonlinear, non-monotonic relationship between earnings and firm value, it suffices to assume that firms continually take profit-maximizing decisions in response to newly arriving investment opportunities. The real options embedded in these opportunities create hysteresis effects that lead to the well-known, but so far poorly understood, negative earnings-to-value relation among loss-making firms. Optionality also predicts the future growth component of firm value to be a decreasing function of earnings among highly profitable firms. More generally, the dynamic options model implies an earnings-to-value mapping that can be non-monotonic even over narrow earnings intervals. The commonly used linear earnings-response estimation may, therefore, be a poor approximation even locally. These phenomena arise because optionality makes past and future earnings the product of an unobservable flow of opportunities and decisions whose time dynamics cannot be described by direct linear past-to-future extrapolation.

We study the effects of visits by headquarters' managers on facility-level misconduct. These visits are central to monitoring, but are difficult to observe for a large sample of firms. We use the staggered introduction of airline routes to identify exogenous reductions in travel time between headquarters and facilities as our measure of visits and test whether the reductions affect misconduct. We find that for the at-risk sample, travel-time reductions decrease the number of violations by 2 percent and penalties by 23.4 percent, suggesting that management focuses on reducing costlier violations, as opposed to simply reducing the number of violations. These effects are concentrated in firms with weaker control systems, suggesting that strong controls can act as substitutes for visits. Furthermore, the introduction of broadband internet attenuates, but does not eliminate the effect of reductions on misconduct. Finally, we find that reductions result in greater misconduct when firms are subject to performance pressure.

We examine the relation between information externalities along the supply chain and voluntary disclosure. Information transfers from a major customer's earnings announcement (EA) can substitute for its supplier's disclosure. Conversely, if the customer's EA increases uncertainties regarding the supplier's future prospects, it can increase the demand for disclosure. After controlling for information incorporated in supplier returns, we find that the supplier is more likely to issue earnings guidance after the customer's EA when the EA news deviates more from the market's expectation. The positive effect of the customer's news on earnings guidance is weaker when common investors, supply-chain analysts, or a common industry allow investors to better understand the value implications of the news, while the effect increases with the importance of the customer to the supplier. The effect is also stronger when EA news is negative rather than positive. Collectively, the results suggest that supply-chain relationships influence voluntary disclosure. Data Availability: All data are publicly available from sources indicated in the text.

I investigate whether the financial reporting quality (FRQ) of a firm influences the propensity of institutional investors to simultaneously hold the firm's debt and equity (dual-holding). I predict that the underlying reason for institutional dual-holding is access to the better information that is available to lenders in firms with low FRQ. Accordingly, I find that dual-holders are more likely to participate in firms with low FRQ. Additionally, I predict and find that dual-holders trade on the additional information received from borrowers. I find that dual-holders achieve excess returns of 8 percent on their trades in the borrower's equity, and that the direction of their trades predicts the direction of borrowers' news on the earnings announcement day. Finally, I demonstrate that dual-holders' trades generate excess returns only in firms with low FRQ, suggesting that investors become dual-holders in firms with low FRQ because informed trades in such firms offer higher returns.

Companies are adopting executive compensation recoupment (“clawback”) policies to discourage aggressive financial reporting choices. Recent research suggests clawback policies encourage other means of meeting earnings expectations. We suggest that reducing income tax expense is a means of meeting earnings expectations. We find that effective tax rates are lower after clawback adoption due to increased investments in tax planning. We identify three tax planning activities that clawback companies invest in to lower effective tax rates: purchases of auditor-provided tax services, increased connections to other low-tax companies, and use of tax havens. We provide evidence that effective tax rate decreases do not result from use of opportunistic income tax accruals, and that decreases are stronger among companies that adopt robust clawback policies. Additional tests indicate lower tax outcome volatility and longer, more readable tax footnotes following clawback adoption. Our results suggest a positive spillover effect of clawback adoption on corporate tax policy.

On September 20, 2012, the rewards-based crowdfunding platform Kickstarter.com added a “risks and challenges” section to all project pages. While the section header became a mandatory part of the platform, discussion of risks within that section is voluntary and unverified, making this setting particularly useful for identifying the effects of disclosure on both crowdfunders and entrepreneurs. Consistent with increased salience of risks, we find that backer support for high-risk projects decreases after the introduction of this section, but that lengthier risk disclosures mitigate this decrease in backer support. Further analysis reveals that creators who provide lengthier risk disclosures also increase other non-risk disclosures, and that these non-risk disclosures are primarily responsible for the increased backer support. Collectively, we provide evidence that the introduction of a voluntary and unverified risk disclosure reduced information asymmetry within this unregulated market.