Knowledge that Transforms

In within-firm analysis of 1,805 executives, executives implicated in financial reporting fraud cases have significantly stronger equity incentives than their within-firm peers who are not implicated in the fraud. Executives implicated in fraud cases also have significantly stronger equity incentives than executives at non-fraud firms in similar roles. However, the equity incentives of non-implicated executives at fraud firms are no different than those for executives at non-fraud firms. The results are significant across executive roles and for equity incentives measured as wealth sensitivity to changes in stock price or stock price volatility. Executive-level analysis that considers which executives are implicated in the fraud may provide more precise measurement of the association and statistical significance of the relationship between equity incentives and fraud. Finally, firm-level measures that consider the equity incentives of all members of the top management team may better identify fraud firms than do measures focusing on one executive.

Do accruals-based earnings provide better information about future operating cash flows than do operating cash flows themselves, as predicted by the Financial Accounting Standards Board's conceptual framework (FASB, 1978)? While this is a foundational issue in accounting, because it addresses the information added by accrual accounting methods, testing it remains unsettled. We show that when comparing the predictive ability of operating cash flows with that of an equivalent earnings measure calculated on an accrual basis, earnings outperform operating cash flows. The result becomes more pronounced when allowance is made for cross-sectional differences in the relation between firms' earnings and future cash flows. In fact, even “bottom line” earnings then have similar explanatory power as operating cash flows.

Pressure from short-horizon investors can hurt investments in innovative, long-run value-increasing projects. We explore the efficacy of a commonly proposed tax-based policy tool to mitigate this problem: the imposition of differentially greater taxes on short-term capital gains vis-à-vis long-term capital gains. Using a panel of 30 OECD countries in which seven countries exhibit 21 changes to differential capital gains taxation over 1991–2006, we find that rewarding longer-term ownership through lower taxes is associated with greater innovation. The evidence adds to our understanding of the real effects of taxation on investor trading and informs the debate on the use of capital gains taxes to address corporate myopia.

We investigate whether international income-shifting aggressiveness affects local investments. Amid heightened scrutiny of international activities by tax authorities, firms can support income-shifting goals by locating investments consistent with reported income. As a consequence, we predict firms that aggressively shift income will make affiliate-level investment decisions less influenced by local investment opportunities than firms that do not aggressively shift income. We use affiliate-level data from multinational corporations to develop a firm-year proxy for the sensitivity of reported income to cross-border tax incentives. Results suggest firm-years with below-median income-shifting aggressiveness exhibit a typical responsiveness of local investments to investment opportunities, but firm-years with above-median income-shifting aggressiveness exhibit no statistical relation. Consistent with expectations, these results are stronger for firms with better governance or subject to greater tax authority scrutiny. Our tests extend the literature on investment distortions by documenting that multinational corporations’ international tax considerations alter their local tangible investment decisions.

Information gathering is an instinctive response to uncertainty, but such efforts may not fully resolve the uncertainty that prompted them. This implies that proxies for investor information gathering may endogenously reflect investor uncertainty, not only before but also after information collection. I find evidence consistent with this pattern using data on public internet access of SEC filings around firms’ earnings announcements. My findings suggest that proxies for investor search and information gathering can capture both information demand and unresolved uncertainty, which has implications for the interpretation of common empirical tests involving such proxies. Controlling for the uncertainty that motivates information gathering is a potential approach for addressing this endogeneity issue. However, my findings indicate that firm-specific information gathering reflects unique information about firm-level investor uncertainty not captured by common controls for uncertainty. Analyses that exploit plausibly exogenous variation in information gathering suggest a promising direction for future research.

SEC rules require managers to reconcile their non-GAAP earnings forecasts with the most directly comparable GAAP forecasts unless doing so would entail ‘unreasonable effort.’ A significant number of managers rely on the unreasonable efforts exception to justify the omission of comparable GAAP forecasts. We analyze firms that rely on the unreasonable efforts exception and find that their non-GAAP earnings forecasts are more likely to exclude significant recurring expenses that are not excluded by analysts. Our results suggest that almost a third of managers exploit the unreasonable efforts exception to exclude significant recurring expenses from their earnings guidance.

This paper recasts the consumption asset pricing model in terms of accounting numbers that connect to consumption and the risk to consumption under accounting principles. The modeling yields an expected return measure that forecasts realized returns and the risk to those returns. It leads to the construction of a pricing factor from the accounting information. The factor performs well relative to extant factors in explaining cross-sectional returns. The factor return has negative correlation with the market portfolio and exhibits the property of protecting payoffs in bad states when consumption is low. This then prompts a two-factor representation that combines the market portfolio with a hedge portfolio against loss to consumption.

Firms that wish to raise capital from external investors can signal favorable private information about their long-term prospects by publicly adopting a liberal accounting system that increases the probability of an overstated financial report. All else equal, the liberal bias deteriorates investors' ability to make efficient investment decisions, which increases the firm's cost of raising capital as investors price protect. But the fact that the firm is willing to adopt such a bias signals booming long-term prospects, which ultimately allows the firm to raise capital at more favorable terms. We also study the effects of accounting standards that require firms to generate unbiased financial reports. Unbiased reporting leads to efficient investment decisions but prevents firms from signaling private information, which reduces their incentive to improve long-term prospects. We find that giving firms discretion over reporting choices is optimal in innovative industries, whereas enforcing unbiased reporting is optimal in traditional industries.

We survey 170 inspectors, representing 27% of the inspection staff, from auditor public oversight boards (POBs) in 20 countries to understand whether, how, and why auditors respond to POB oversight. We find that a large majority of inspectors believe that auditors frequently respond to their feedback by changing audit procedures and quality control systems. Inspectors perceive inspections to have broad effects on several aspects of auditing, ranging from documentation to the removal of partners. Some inspectors perceive that auditors place greater weight on keeping fees low than on increasing audit quality. Inspectors also believe that auditors on occasion ‘fix’ closed audit files before an inspection, and in rare instances obtain confidential information about upcoming inspections. Inspectors think that the primary reasons why auditors respond to POB feedback are (1) public disclosure, (2) enforcement capabilities, (3) POBs being perceived as authoritative, and (4) POBs having a culture for detecting auditing deficiencies.

A global field experiment with Seeking Alpha shows that textual complexity affects investor attention to news and market outcomes. Investors were randomly assigned different titles for the same news article. Holding the article fixed, a one-standard-deviation increase in complexity leads to 6.1% fewer views. Complexity is more off-putting for less-sophisticated investors, when attention is more limited, and when the news is likely less important. Exploiting an arbitrary rule for breaking ties between tested titles, I find that title complexity affects markets—lowering announcement turnover and volatility.