Knowledge that Transforms

This study examines whether and when real earnings smoothing influences firm‐specific stock price crash risk. Using a sample of U.S. public firms for the years 1993 through 2014, we find real earnings smoothing to be positively associated with firm‐specific stock price crash risk. This finding is consistent with the view that real earnings smoothing helps managers withhold bad news, keep poor‐performing projects, conceal resource diversion, and engage in ineffective risk management, which increases crash risk. Further, we find a stronger relation between crash risk and real earnings smoothing when firm uncertainty is higher, product market competition is lower, and balance sheet constraint is higher. Overall, our study suggests that real earnings smoothing destroys shareholder value in that it increases stock price crash risk.

Using hand-collected CEO education data of 3574 CEOs over the period of 2000 to 2015, we document that CEOs are significantly more likely to acquire targets that are headquartered in those states where the CEOs received their undergraduate and graduate degrees. Education-state deals are larger, have higher completion rates, and exist with both public and private targets. Acquirers pay a lower target premium for education-state deals and the cumulative abnormal announcement returns are positive. The combined evidence suggests that education-state acquisitions are more likely to be driven by bidder CEO's information advantage toward firms headquartered in the education state.

When targets depend on past performance, incentives are adversely affected by the ratchet effect. We provide theory and evidence that incorporating past peer performance into targets can alleviate this adverse incentive effect. In particular, we present an analytical model that characterizes optimal target revisions as a function of past own and past peer performance. We then test the predictions of our model using data on 2008–2010 performance targets from 354 units of a governmental agency responsible for reintegration of the long‐term unemployed into the labor market. As a unique feature of our data, we have information on peer group quality, defined as the extent to which peer performance is informative about common shocks. Consistent with our model, we find that higher peer group quality (a) increases sensitivity of target revisions to past peer performance, (b) reduces sensitivity of target revisions to past own performance, and (c) reduces the ratchet effect as reflected in managerial incentives to withhold end‐of‐year effort.

We examine the effects of organization capital—evident in management quality practices—on firms’ implied cost of equity. We show that superior management practices decrease firms’ cost of equity capital. This novel finding, robust to a battery of sensitivity analyses and to endogeneity bias, highlights the importance of superior management practices in improving firms’ financing conditions. In sum, this study demonstrates that the quality of management practices maps onto firms’ financing conditions, stressing the value relevance of intangible assets.

This study investigates whether and how a firm's real earnings management (REM) is influenced by the strength of a country's legal regime and the presence of a Big 4 auditor. In a cross‐country examination using data from 22 countries, we find that REM increases in countries with stronger legal regimes as firms switch from accrual‐based earnings management (AEM) to REM. The presence of a Big 4 auditor reduces REM (as well as AEM) and attenuates the positive relation between legal regime strength and REM. Our results suggest that higher‐quality auditors limit client firms’ use of REM, especially in countries with a strong legal regime.

We find that non‐Big 4 audit offices with greater awareness of SEC enforcement are more likely to issue first‐time going‐concern reports to distressed clients; where SEC “awareness” is measured using (i) audit office proximity to SEC regional offices, and (ii) proximity to specific SEC enforcement actions against auditors. We also show that these non‐Big 4 audit offices issue more going‐concern opinions to clients who do not subsequently fail, indicating a conservative bias that reduces the informativeness of audit reports. This conservative reporting bias is also associated with higher audit fees and higher auditor switching rates. These findings are important because non‐Big 4 firms now audit 39 percent of SEC registrants and issue 88 percent of going‐concern audit reports. For Big 4 offices, we find some evidence that awareness of SEC enforcement may improve reporting accuracy by reducing Type II errors (failing to issue a going‐concern report to a company that fails), although the number of cases is small.

In this study we use the recently mandated risk factor disclosure to examine the spillover effect of the Securities and Exchange Commission (SEC) review of qualitative corporate disclosure. We find that firms not receiving any comment letter (“No‐letter Firms”) modify their subsequent year's disclosures to a larger extent if the SEC has commented on the risk factor disclosure of (i) the industry leader, (ii) a close rival, or (iii) numerous industry peers. We refer to this effect as “spillover.” Further, we find that after SEC comments on the industry leader's disclosure, No‐letter Firms also provide more firm‐specific disclosures in the subsequent year. The increased disclosure specificity reduces these firms’ likelihood of receiving SEC risk disclosure comments on their new filings. Our evidence suggests an indirect effect of the SEC review of qualitative disclosure.

Information about an executive's decisions at his/her former employer can have a significant impact on the stock returns of his/her current employer, even after the job change occurs. In this article, we analyze transfers of information, which, we argue, reflect executive decision‐making ability as executives change jobs. We examine information about restructurings and write‐downs at the new employer emerging after the executive has left an employer that indicates the executive is of lower ability than investors had expected at the time of the hiring. Our results show that such signals are associated with significant negative returns to the current employer's shares, particularly for within‐industry job changes. We distinguish between restructurings at firms with and without departing executives and find that following an executive's departure, firms that had executives depart experience negative market reactions.

This paper examines whether the increased accounting guidance and reporting requirements of FIN 48 impact the adequacy and accuracy of tax reserves and the effect of auditor‐provided tax services on tax reserves. While we do not find FIN 48 affected the adequacy or accuracy of tax reserves on average, FIN 48 eliminated the differences in the tax reserve adequacy of firms with and without auditor‐provided tax services that existed prior to its adoption. We also find evidence of less premature releasing of tax reserves post‐ FIN 48. Our evidence is consistent with an increase in the comparability of reserves for firms that do and do not purchase auditor‐provided tax services, consistent with one of the FASB 's objectives for FIN 48.

Investors and analysts are designated as the primary users of financial reports by standard setters, yet we know very little about their use of accounting information and about their relationship with standard setters. This paper explores how investors and analysts evaluate the usefulness of fair values to their work. Standard setters typically presume that investors and analysts view accounting as a practice of valuation and, therefore, favor the greater use of fair value measurement. However, using interview evidence, it is shown here that investors and analysts expect accounting to provide them with insights into the performance of a business, and are quite cautious about the limits of using fair values in financial reports. Overall, the paper contributes to a better understanding of the relationship between accounting and its users. It adds specifically to research which has analyzed the disconnect between users and standard setters in terms of standard setters ignoring user needs (Young ), and in terms of users being indifferent about, or uncritical of, outcomes of standard‐setting processes (Durocher, Fortin, and Cote ; Durocher and Gendron ). The paper suggests a re‐theorization of the disconnect between the two groups that involves thinking away from tension, or blame. Drawing on the work of David Stark ( ), the situation observed is conceptualized as one of “dissonance,” where the different ways of evaluating fair values coexist without being involved in a fierce contest. That is, even though the principles of valuation and performance differ, this difference does not lead to open disagreement and political lobbying from investors and analysts. Consequences of this dissonance to our understandings of the (absence of) worth of fair values in capital markets are discussed.