We develop a model to examine implications of empowering shareholders to replace directors. We find that shareholder empowerment functions as a double‐edged sword. On the one hand, it can weaken ineffective boards' incentive to hold on to their position. On the other hand, it can induce both effective and ineffective boards to behave strategically to avoid a potential dismissal. As a result, empowerment does not necessarily increase firm value; in some cases, empowerment exacerbates the agency problem it is intended to address. Giving shareholders the power to set board compensation (have a “say on pay”) can mitigate these problems. However, even when empowerment benefits (harms) the shareholders, firm value may decrease (increase). Finally, we discuss empirical and policy implications of the main findings.
Boards of directors play their role in corporate governance by advising and/or monitoring managers. In the corporate disclosure literature, prior research has documented directors' monitoring role, yet empirical evidence on directors' advising role is limited. Since the advising role often entails information transfer, we examine directors who concurrently serve as directors or executives in the firms' related industries (DRIs) and hence possess valuable information about the firms' external operating environment. We hypothesize and find that more DRIs on boards are associated with more accurate management forecasts. This association is stronger when firms face greater uncertainty, and holds in settings where DRIs are unlikely to monitor managers, suggesting a distinct advising role of DRIs. Our study highlights directors' role as information suppliers and advisors who help shape corporate voluntary disclosure.
This study uses insights from tax practitioners and tax authorities to define and develop an estimate of ex ante tax risk that is independent of common tax outcomes studied in prior literature. Validation tests confirm that our tax risk measure (i) represents the predictable and unpredictable uncertainty inherent in the three sources of tax risk (i.e., economic risk, tax law uncertainty, and inaccurate information processing) and (ii) is a construct different from tax avoidance, tax uncertainty, and general business risk. Using our tax risk measure, we address two research questions of interest to academics and practitioners. First, we examine the association between tax risk and long‐run tax avoidance and find a negative association between tax risk and future long‐run cash effective tax rates (ETRs). Second, we consider the extent to which unrecognized tax benefits (UTBs) reflect tax risk, tax avoidance, or financial reporting incentives and demonstrate that our tax risk measure explains a substantial portion of UTBs, incremental and relative to measures of information risk, conditional conservatism, unconditional conservatism, and tax avoidance. Our study offers a measure of tax risk that, consistent with the Scholes‐Wolfson paradigm, reflects the tax risk inherent in all business activities, not just tax avoidance activities; has unique industry effects; and contributes to our understanding of the factors that affect tax planning decisions and result in variation in firms' ETRs. Our findings will help managers and tax practitioners focus on industry‐specific tax risk components, assess risk during tax planning initiatives, exercise caution when engaging in additional risk if ETRs are low, and adapt tax risk strategies to fit specific company needs. We enhance future tax research by improving the definition and measurement of tax risk.
Auditees can play an active role in influencing staff auditors' professional judgment and skepticism. Yet, although it constitutes one of the main threats to auditor independence, very little is known about the means and extent of auditees' power during the audit engagement. To address this knowledge gap, our study focuses on a specific category of auditees, namely, auditees who have worked as auditors in large accounting firms. We interviewed 36 of these auditees and triangulated our findings with 11 interviews conducted with auditors. At the theoretical level, we conceptualize auditees' influence over auditors as intentional and active through the notion of “social power.” Overall, our analysis shows that the efficacy of auditees' power during the engagement materializes through the mobilization of two main power resources developed during their time at the firms: (i) expert knowledge of auditing techniques and (ii) social capital. On the one hand, relying on their cognitive authority, auditees' employ three different power strategies to constrain staff auditors' operational independence: stage‐setting , teaching , and questioning . On the other hand, auditees' social capital can support the use of two additional strategies: attracting and monitoring . Our triangulation analysis confirms our findings and suggests that auditors may be aware of the threats to independence that auditee expertise and social capital pose. By focusing on auditees' agentic capabilities—that is, individuals' capabilities to consciously exert influence over the course of events—we reinterpret the pressures exerted by clients on auditors as the product of strategic actions and discuss substantive consequences for independence risk.
This study examines whether the perceived independence and financial expertise of audit committee members affect external auditors' exposure to legal liability. We use an experiment in which potential jurors make judgments about auditor independence and legal liability for a case involving an audit failure. We find that perceptions of audit committee independence from management are positively associated with judgments of auditor independence and negatively associated with auditor liability. However, financial expertise of audit committee members can be a double‐edged sword. Our experiment finds that judgments of auditor liability are higher when the audit committee is perceived to have higher financial expertise but lower independence from management. In assessing litigation risk of current and prospective clients, auditors may want to carefully consider the independence of audit committee members from management, particularly when audit committee members have financial expertise. In the event of an audit failure, the financial expertise of nonindependent audit committee members can negatively affect jurors' perceptions of auditor independence and liability.
Research on the determinants of tax avoidance have relied on tests using GAAP and cash effective tax rates (ETRs) and total and permanent book‐tax differences. Two new proxies have emerged that overcome documented limitations of these proxies: one, developed by Henry and Sansing (2018), allows for more meaningful interpretation of results estimated in samples that include loss observations. The other, reserves for unrecognized tax benefits (UTB), provides new data on tax uncertainty. We offer empirical evidence on how well tests using these new proxies perform relative to those extensively used in prior research. The paper finds that tests using the proxy developed by Henry and Sansing (2018) have lower power relative to those using other proxies across all samples, including a sample that includes loss observations. In contrast, when firms accrue reserves for uncertain tax avoidance, tests using the current‐year addition to the UTB have the highest power across all proxies, samples, and levels of reserves. In the absence of reserves, tests using the GAAP ETR best detect uncertain tax avoidance, on average. This study contributes to the literature by using a controlled environment to provide the first large‐scale empirical evidence on how the power of tests varies with the use of relatively new proxies, the inclusion of loss observations, and the advent of FIN 48.
We present experimental evidence suggesting that critical audit matter (CAM) disclosures in the auditor's report involving areas of high measurement uncertainty forewarn users of misstatement risk. Specifically, in our first study with MBA students, financial analysts, and attorneys, we find that CAMs (i) lower premisstatement assessments of confidence in the financial statement area disclosed as a CAM, and (ii) lower assessments of auditor responsibility for a subsequently revealed misstatement in a CAM‐related area. In our second study with student participants proxying as mock jurors, we find that the responsibility‐mitigating effect of CAM disclosure is driven by CAM disclosures involving measurement uncertainty, as opposed to CAM disclosures involving categorical determinations. Combined, our findings help reconcile mixed evidence from prior research, supporting the view that the forewarning effect of CAM disclosures involving measurement uncertainty could mitigate perceived auditor responsibility for CAM‐related material misstatements.
The SEC has long asserted that earnings management practices result in adverse consequences for investors. We examine whether SEC oversight affects firms' accounting quality in terms of earnings management trade‐offs. We expect that increased firm‐specific regulatory scrutiny, in the form of an SEC comment letter, will induce management to switch from accrual‐based earnings management (AEM), which is a main focus of the SEC, to real‐activities‐based earnings management (REM), which is not likely to be commented on in the SEC's review process. Consistent with our predictions, we find that AEM is lower and REM is higher following the receipt of a comment letter, relative to non‐comment‐letter years and a propensity‐score‐matched sample of non‐comment‐letter firms. However, we do not find a significant difference in total earnings management (i.e., the sum of AEM and REM), suggesting that the higher REM acts as a substitute for lower AEM activity. We further find that our results are driven by accounting comments relating to estimates and accruals and not by classification‐only comments, which suggests that a comment letter that does not question specific issues associated with estimates and accruals is not a strong enough signal to induce the firm to change earnings management behavior. Additionally, the shift to REM is attenuated for firms with high institutional ownership. These results collectively suggest that the comment letter process effectively constrains AEM but has the unintended consequence of firms, on average, switching to REM.
This study examines the effect of the Tax Cuts and Jobs Act of 2017 (TCJA) on corporate defined benefit pension contributions. The TCJA decreases the corporate tax rate from 35 percent in 2017 to 21 percent in 2018 and thereafter. This change incentivizes firms to increase 2017 pension contributions to take advantage of tax deductions at a higher rate. Consistent with this incentive, we find firms increase defined benefit pension contributions by an average of 25 to 31 percent in 2017 compared with earlier years. We also find that taxpaying firms are the primary contributors. Further, taxpaying firms with high levels of pension‐related deferred tax assets contribute over three times as much as taxpaying firms with low levels of pension‐related deferred tax assets. We also find firms that increase pension contributions in 2017 reduce 2018 contributions, consistent with intertemporal income shifting rather than a permanent change in pension funding strategy.