Our paper examines three related questions: Will directors who have friendship ties with the CEO manage earnings to benefit the CEO in the short term while potentially sacrificing the welfare of the company in the long term? Will public disclosure of friendship ties mitigate or exacerbate such behavior, and will disclosure of friendship ties influence investors' perceptions of director decisions? We conduct an experiment involving 56 active and experienced corporate directors from U.S. firms and a second experiment with M.B.A. students. We find that friendship ties caused directors to be more willing to approve reductions to research and development (R&D) expenses that cause earnings to rise enough to meet the CEO's minimum bonus target more often than when the directors and CEO were not friends. However, disclosing friendship ties resulted in even greater reductions in R&D expenses and higher CEO bonuses than not disclosing friendship ties. In a second experiment, we find that shareholders were more likely to agree with directors' decisions to approve cuts to R&D when friendship ties were disclosed. These findings have potentially important implications for corporate governance because they suggest that friendship ties between the CEO and board members can impair the directors' independence and objectivity, and that disclosure of the relationships can worsen this effect.

Using functional magnetic resonance imaging, we capture neural activity in the ventral striatum—a key area in the human brain's reward processing circuit—of 35 adult investors learning the earnings per share disclosed by 60 publicly traded companies. Before imaging, investors forecasted each company's earnings and took either a long or a short position in its stock. Consistent with prospect theory, we find strong neurobiological evidence of an asymmetric reaction to positive and negative earnings surprises. Moreover, investors' personality traits and investment positions, as well as firms' earnings predictability, modulate the brain's reaction to earnings news. We also find a strong association between the magnitude of the brain's reaction and risk-adjusted stock returns and abnormal share trading around earnings announcements for our sample firms; these findings evince the brain's reaction to earnings news as an alternative, biological measure of the information content of earnings. Data Availability: Data are available from the authors.

Current financial reporting guidance allows managers flexibility as to whether to disaggregate income statement items. Such flexibility is problematic if managers prefer to aggregate in some situations and disaggregate in others because we conjecture that investors' evaluations of firms will predictably differ depending on whether performance information is shown in an aggregated or disaggregated fashion. We conduct a series of related experiments within the context of compound financial instruments to investigate whether managers' preferences follow the predictions of mental accounting theory; specifically, that presentation preferences vary as a function of the sign and relative magnitude of the income statement items. Results reveal that managers' disaggregation preferences reflect mental accounting. Further, the effects of mental accounting are moderated only when managers feel high pressure to report transparently. Finally, and most importantly, the preferred presentations of managers result in the highest firm valuations from investors, indicating that investors also rely on mental accounting. Our study has implications for standard setters, regulators, and researchers.

We investigate analytically and empirically the relationship between demand uncertainty and cost behavior. We argue that with more uncertain demand, unusually high realizations of demand become more likely. Accordingly, firms will choose a higher capacity of fixed inputs when uncertainty increases in order to reduce congestion costs. Higher capacity levels imply a more rigid short-run cost structure with higher fixed and lower variable costs. We formalize this “counterintuitive” argument in a simple analytical model of capacity choice. Following this logic, we hypothesize that firms facing higher demand uncertainty have a more rigid short-run cost structure with higher fixed and lower variable costs. We test this hypothesis for the manufacturing sector using data from Compustat and the NBER-CES Industry Database. Evidence strongly supports our hypothesis for multiple cost categories in both datasets. The results are robust to alternative specifications. Data Availability: All data used in this study are available from public sources.

This study examines the conditions under which financial restatements lead corporate boards to dismiss external auditors and how the market responds to those dismissal announcements. We find that auditors are more likely to be dismissed after more severe restatements but that the severity effect is primarily attributable to the dismissal of non-Big 4 auditors rather than Big 4 auditors. We also document that among corporations with Big 4 auditors, those that are larger and more complex operationally are less likely to dismiss their auditors. Combined, this evidence suggests that firms with higher switching costs and fewer replacement auditor choices are less likely to dismiss their auditors after a restatement, which is informative to the debates about the costs and benefits of mandatory auditor rotation and limited competition in the audit market. Additionally, we examine contemporaneous executive turnover and find evidence that boards view auditor dismissals as complementary rather than substitute responses to restatements. Finally, we investigate the market reaction to auditor dismissals after restatements. The market reaction to the dismissal is significantly more positive following more severe restatements (5.9 percent) relative to less severe restatements (0.6 percent) when the client engages a comparably sized auditor. This positive market reaction is consistent with firms restoring financial reporting credibility by replacing their auditors and highlights the important role that auditors play in the financial markets. Data Availability: Data are available from public sources indicated in the text.

We examine (1) whether the accounting, governance, and investing practices of Berkshire Hathaway investees are consistent with Warren Buffett's public statements on what constitutes good accounting, governance, and investing practices and (2) whether these practices are associated with Berkshire's initial “selection” or Buffett's subsequent “influence.” Compared to control firms, we find that Berkshire investees are highly likely to follow Buffett's investment philosophy, somewhat likely to follow his preferred accounting, disclosure, and compensation policies, but unlikely to follow the board-related governance practices that we can measure. Second, we find some evidence that the business practices of future Berkshire investees are more aligned with Buffett's beliefs in the pre-investment period compared to control firms. Third, we find relatively modest evidence that investees improve a few of their business practices subsequent to Berkshire's initial investment. However, and overall, Buffett does not appear to be especially influential in the subsequent accounting, governance, and investing decisions of Berkshire investees, likely because he has already taken into account the attributes he cares most about in the initial investment decision. Data Availability: Except for the Gunning Fog Index and family firm status, other data in this study are available from commercial providers, e.g., CDA/Spectrum Institutional Money Manager Holdings, Compustat, CRSP.

According to auditing standards, explanatory language added at the auditor's discretion to unqualified audit reports should not indicate increased financial misstatement risk. However, an auditor is unlikely to add language that would strain the auditor-client relationship absent concerns about the client's financial statements. Using a sample of 30,825 financial statements issued with unqualified audit opinions during 2000–2009, we find that financial statements with audit reports containing explanatory language are significantly more likely to be subsequently restated than financial statements without such language. We find that this positive association is driven by language that references the division of responsibility for performance of the audit, adoption of new accounting principles, and previous restatements. In addition, we find that (1) “emphasis of matter” language that discusses mergers, related-party transactions, and management's use of estimates predicts restatements related to these matters, and that (2) the financial statement accounts noted in the explanatory language typically correspond to the accounts subsequently restated. In sum, our results suggest that present-day audit reports communicate some information about financial reporting quality.

Managers may rely on emotional reactions to a setting to the detriment of economic considerations (“System 1 processing”), resulting in decisions that are costly for firms. While economic theory prescribes performance-based incentives to align goals and induce effort, psychology theory suggests that the salience of emotions is difficult to overcome without also inducing more deliberate consideration of both emotional and economic factors (“System 2 processing”). We link these perspectives by investigating whether performance-based incentives mitigate the costly influence of emotion by inducing more System 2 processing. Using functional magnetic resonance imaging and traditional experiments, we investigate managers' brain activity and choices under fixed wage and performance-based contracts. Under both, brain regions associated with System 1 processing are more active when emotion is present. Relative to fixed wage contracts, performance-based contracts induce System 2 processing in emotional contexts beyond that observed absent emotion, and decrease the proportion of economically costly choices. Data Availability: Contact the authors.

This study investigates the role of the business press in the pricing of accounting information. Using a comprehensive dataset of more than 111,000 earnings-related business press articles published from 2000 to 2010, we find that press coverage of the annual earnings announcement mitigates cash flow mispricing, but has a negligible effect on accrual mispricing. We provide evidence that this impact is driven primarily by the press disseminating the information more broadly, rather than by the creation of new content that helps investors understand the implications of accounting information. Our results suggest that the business press plays an important role in facilitating the market's ability to efficiently impound accounting information into stock prices and provide new insights into the role of the business press as an information intermediary in capital markets.

Standard-setters and many investors argue that loan fair values provide more useful information about credit losses than historical cost information, while bankers and others generally disagree. We examine the ability of reported loan fair values to predict credit losses relative to the ability of net historical costs currently recognized under U.S. GAAP. Our analysis is important because credit losses in the banking sector can have severe and widespread economic effects, as the recent financial crisis demonstrates. Overall, we find that net historical loan costs are a better predictor of credit losses than reported loan fair values. Specifically, we find that historical cost information is more useful in predicting future net chargeoffs, non-performing loans, and bank failures over both short and long time horizons. Further tests indicate that the relative predictive ability of reported loan fair values improves in higher scrutiny environments, suggesting that a lack of scrutiny over reported loan fair values may contribute to our findings. Data Availability: Data are available from sources identified in the text.