Knowledge that Transforms

We examine the relationship between a firm's disclosure quality and equity‐based compensation of independent members of the board of directors. The dimensions of disclosure quality we focus on are management's earnings guidance and information flowthrough financial analysts. Using both levels and changes specifications, we find the average ratio of equity‐based pay to total pay of independent board members to be positively related to a firm's disclosure quality. Our findings are robust to the inclusion of management's equity‐based compensation, other governance measures, and financial controls, and robust to instrumental variable tests of endogeneity. Furthermore, we find directors’ equity‐based compensation to be negatively associated with the firm's cost of equity capital. Our results are consistent with equity‐based compensation providing incentives to independent directors to push for better disclosure quality.

Since the Split Share Structure Reform took effect in China in 2005, holders of nontradable shares (controlling shareholders) have had to negotiate with holders of tradable shares (minority shareholders) to gain the liquidity right. In a typical deal reached, the controlling shareholder agrees to pay share compensation to minority shareholders and, in many cases, also pledges to meet a specific firm performance target (performance commitments). Using this reform setting, we examine the impact of performance commitments on earnings management behavior, and find the following results. First, less profitable firms have greater incentives to make performance commitments that help to reduce the share compensation that controlling shareholders have to pay. Second, firms entering into such commitments engage in earnings management to meet the promised performance target when actual performance falls short, and firms facing greater default costs tend to manage earnings more aggressively. Third, depending on the performance metric stipulated in the commitment contract, firms employ varying methods to manage earnings. We also find that firms that rely on earnings management to meet their performance targets display inferior performance in the postcommitment years relative to firms that do not. Overall, our evidence is consistent with performance commitment contracts (with costly defaults) between a firm's controlling and minority shareholders causing incentives for earnings management.

This paper employs the firm life‐cycle concept to extend our understanding of the mispricing of accrual and cash flow information by the stock market. We find that accruals and free cash flows are strongly (negatively) correlated in the maturity and decline stages of a firm's life cycle but not in the growth stage, suggesting that they capture unique information in the growth stage of the firm's life cycle but more correlated information in the later stages. Consistent with this finding, we show that the cash flows anomaly subsumes the accruals anomaly in maturity and decline stages, but not in the growth stage. Our findings contribute to the debate regarding the overlap between the two anomalies.

It is frequently observed that fraud has a greater economic impact on society than any other category of crime. Arguing that both research and practitioner frameworks in auditing and forensic accounting have tended to adopt an individualizing perspective predicated primarily on solo offending, this article adopts an inductive approach to consider why individuals co‐offend in fraud. It reports the results of a set of interviews with 37 individuals convicted of a range of frauds including financial statement fraud, insider trading, credit card fraud, money laundering, and asset misappropriation. In each instance, the fraud was perpetrated by a group of two or more co‐offenders. Based on inductive, exploratory case coding, we find that reasons for co‐offending vary according to the type of bond that exists between co‐offenders. Two dimensions of fraudulent co‐offending are identified—the primary beneficiary of the fraud and the nature of group attachment—to derive three distinct archetypes of bonds between co‐offenders: (1) individual‐serving functional bonds, (2) organization‐serving functional bonds, and (3) affective bonds. Key elements of each archetype as well as their impact on the decision to co‐offend are examined. Our findings suggest that the social nature of fraud is not merely an incidental feature of the crime but is instead a potential key to understanding its etiology and some of its distinctive features. They also support the need for diagnostic tools to move beyond individualistic analyses of fraud toward a broader, group‐sensitive assessment of fraud risk.

The objective of this study is to examine managerial involvement in auditor selection decisions when audit committees are “directly responsible” for auditor relationships, including selection of the audit firm. The Sarbanes‐Oxley Act (SOX) of (2002) requires fully independent audit committees to be “directly responsible for the appointment, compensation, and oversight of the work of any registered public accounting firm” (Section 301). This statutory requirement is a regulatory attempt to eliminate management influence over the external auditor and align auditor incentives with those of the board and shareholders.1 While regulators largely assume that audit committees take responsibility for auditor selection in the post‐SOX period (Doty 2011), there exists no archival analysis testing this assumption. Therefore, the effectiveness of this regulation (SOX Section 301) remains uncertain. In this paper, we examine (a) whether contrary to the intent of SOX, managers continue to influence auditor selection decisions in the post‐SOX period, and (b) whether this influence subsequently impairs auditor independence as presumed in the legislation.

Hedge fund intervention has been associated with many positive corporate changes and is an important vehicle for informed shareholder monitoring. Effective monitoring has also been positively associated with accounting conservatism. Building upon these prior results, we predict an increase in accounting conservatism after hedge fund intervention. We use a large sample of hedge fund activist events and identify control firms with similar likelihoods of being targeted using the propensity score matching method to apply difference‐in‐difference tests. We find that when hedge fund activists have relatively large ownership and sufficient time to exert their monitoring power, target firms experience significant increases in conditional conservatism. CFO turnovers, upward/lateral auditor switches, and improvements in audit committee independence after intervention are accompanied by greater increases in conditional conservatism. Finally, we find greater increases in conditional conservatism when there is a lack of monitoring by dedicated institutional investors before the intervention. Our study suggests that hedge fund activists improve accounting monitoring tools and thus adds important new evidence on the effectiveness of shareholder monitoring on accounting practices.

We examine the determinants and outcomes of Chief Executive Officers ( CEO s) accepting a $1 salary, a compensation practice that occurs relatively frequently in high‐profile firms and is debated by regulators, investors, and the media. Using a hand‐collected sample of 93 CEO s from 91 firms between 1993 and 2011, we examine the triggers preceding the $1 salary decision, the factors associated with the decision, subsequent stock returns, and the outcomes for the CEO s. Our evidence is consistent with two explanations for the phenomenon: (i) it is a gesture of sacrifice by CEO s of firms in crisis, and (ii) it is a signal of better future performance by CEO s of growing firms. Our analyses highlight the two different circumstances and shed light on an interesting debate that has thus far been supported only by anecdotal evidence.

The SEC and FASB recently expressed concerns that investors do not fully assimilate all of the information provided by complex and incomplete derivatives and other comprehensive income ( OCI ) disclosures. My evidence supports these concerns. Specifically, I examine the information content of unrealized cash flow hedge gains/losses for future profitability and stock returns. An unrealized gain on a cash flow hedge suggests that the price of the underlying hedged item (i.e., commodity price, foreign currency exchange rate, or interest rate) moved in a direction that will impair the firm's profits after the hedge expires. Consequently, I find that unrealized cash flow hedge gains/losses are negatively associated with future gross profit after the firm's existing hedges have expired. This association only holds after the firm has reclassified its hedges into earnings, and is weaker for firms that can pass input price changes on to their customers. Finally, investors do not immediately price the cash flow hedge information. Instead, investors appear surprised by future realizations of gross margin, consistent with the view that complex and incomplete disclosures delay pricing. These results are relevant to policymakers involved in the current FASB and IASB project designed to simplify the accounting and disclosure for derivatives and, in particular, cash flow hedges.

We examine a routine and timely disclosure, earnings press releases, to determine the extent to which several novel qualitative elements of such disclosures are associated with changes in sell‐side financial analysts' information environment. Using a comprehensive set of GARCH‐based (generalized autoregressive conditional heteroscedasticity) proxies, we examine how disclosure readability's components, across‐document textual similarity, and within‐document lexical diversity alter analysts' information environment. We find that readability in the form of shorter sentences, textual similarity, and lexical diversity are strongly related to decreases in analysts' uncertainty. Further, shorter sentences and lexical diversity improve both public and private information precision, whereas similarity affects solely analysts' private information precision. While the GARCH ‐based proxies allow us to alleviate concerns regarding potentially spurious inferences (Sheng and Thevenot 2012), we note as a caveat that such an estimation restricts our inferences to large, stable, and heavily followed firms. These findings should be of interest to analysts who may wish to explore the latent information contained within the qualitative elements of disclosure, regulators who direct the form and content of disclosure, and academics who study the use (and possible misuse) of various forms of information and its presentation.

Using a novel data set that tracks all web traffic on the SEC 's EDGAR servers from 2008 to 2011, we examine the determinants and capital market consequences of investor information acquisition of SEC filings. The average user employs the database very few times per quarter and most users target specific filing types such as periodic accounting reports; a small subset of users employ EDGAR almost daily and access many filings. EDGAR activity is positively related with corporate events (particularly restatements, earnings announcements, and acquisition announcements), poor stock performance, and the strength of a firm's information environment. EDGAR activity is related to, but distinct from, other proxies of investor interest such as trading volume, business press articles, and Google searches. Finally, information acquisition via EDGAR , both to obtain earnings news and to provide context for it, has a positive influence on market efficiency with respect to earnings news. Overall, our results are important because they provide a unique, user‐based perspective on investor access of mandatory disclosures and its impact on price formation.