Knowledge that Transforms

ABSTRACT We examine how the threat of exit by non‐blockholders (investors with ownership <5%) relates to firms' income smoothing. Unlike informed blockholders, non‐blockholders lack private information and therefore rely more on reported accounting numbers to evaluate firm performance. To isolate the exit threat, we use the unique setting in Japan where strong firm‐centric social norms and lack of insider access lead non‐blockholding foreign institutions to influence management primarily through the threat of exit. We predict and find that foreign non‐blockholders' exit threat is positively associated with the extent of income smoothing. This effect is more pronounced for firms less embedded in Japan's stakeholder‐based system, firms with greater stock liquidity, and firms with higher US institutional ownership. In addition, smoothing associated with such an exit threat, on average, is informative. Our findings suggest that Japanese firms under non‐blockholders' exit threat increase income smoothing to reduce perceived uncertainty and that such smoothing generally meets non‐blockholders' information needs.

ABSTRACT Although recent evidence suggests that individual audit partners explain a substantial portion of the variation in audit quality proxies, much less is known about what determines an audit partner's quality. Psychology and behavioral economics theories hold that an individual's experiences can have enduring impacts on subsequent behavior. We examine whether auditors' direct exposure to Arthur Andersen's collapse has a long‐term impact on the quality of their audits. Our evidence implies that audit partners who directly experienced Andersen's demise impose stricter monitoring evident in their clients exhibiting a lower propensity for misstatements and small profits, and paying higher audit fees. Importantly, these findings reconcile with research in finance and economics implying that firsthand experiences matter more to subsequent behavior than general economic conditions or secondhand or thirdhand experiences. Collectively, the results shed light on one facet of how partners' audit quality evolves over time. Our findings suggest that major failures associated with the audit firm in which an auditor works can ultimately result in these affected individuals later delivering higher audit quality, which should benefit audit committees in partner selection decisions and audit firms in designing partner assignment policies.

ABSTRACT As part of its goal to monitor and enhance the quality of information available to investors, the SEC reviews companies' filings to ensure compliance with applicable financial reporting and disclosure requirements. Increased public interest and the substantial costs for both the SEC in reviewing and the companies in responding have led to a rapidly growing body of accounting literature that examines the filing review process. We survey and comment on 80 published and unpublished academic research papers in this literature and identify significant gaps that future research should address. We also summarize the institutional features of the filing review process, aiming to inform future academic studies. Our survey should be of interest to both academics and market participants evaluating the effectiveness and efficiency of the filing review process.

ABSTRACT This article explores how valuers construct value opinions. Although some implications of outsourcing valuation to valuers for accounting purposes have been highlighted in the literature, we add a valuer perspective complementing the accountant's standpoint in order to obtain a fuller picture of these ramifications. Drawing on 62 interviews, we study the role of judgment in valuation and find that judgment is largely tied with the sensemaking of valuers. By examining the valuation activities of art and real estate valuers, we show that these specialized valuers follow a similar valuation process which allows them to grasp how to go on with valuation . This four‐phase process starts and ends by situating the opinion in its specific valuation context and is centered on iterations between researching, analyzing, and relativizing comparable data that may be adjusted to connect with a sense of what the value should be. Overall, judgment is shown to be enacted based on a practical sense of conducting valuation that includes a “gut feeling” of what represents a plausible value. This study suggests that the valuer's input should be recognized as situated, sense‐contingent, and vulnerable to the underlying politics and risks tied to providing an opinion. Our results also point to stark differences between how valuers approach the use of judgment compared to how judgment is typically exercised by accounting specialists.

ABSTRACT Focusing on mandatory partner rotations, we examine the importance of within‐firm network connections to the selection of successor partners and the impact of those connections on post‐rotation audit performance. Using data from China, we track partners' history and identify incumbent‐successor connections stemming from jointly conducted prior engagements. Although these connections can enhance incumbent‐successor information transfers and thus post‐rotation audit performance, they may also pose a threat to quality by compromising the successor's independence. Among the pool of replacement candidates, we find that individuals with stronger connections with the incumbent are more likely to be appointed as successors. This finding is more pronounced when the audit engagement is more complex, client‐specific knowledge is not readily available to the succeeding partner, and the engagement is more valuable to the audit firm. We also document that successor‐incumbent connections are associated with equal or better post‐rotation audit quality and fewer client defections. These results suggest that the benefits of network‐based successor selection may outweigh its costs. By enriching our understanding of the partner transition process, this study contributes to the public policy discourse on partner rotation.

ABSTRACT This study examines whether auditors can improve their judgment by drawing on the crowd within—that is, making the same judgment twice and averaging the two responses. Improvements in judgment are of special interest to auditors given that poor judgment threatens audit effectiveness and efficiency. The results from my experiment suggest that drawing on the crowd within helps auditors better use their task‐relevant knowledge, leading to more accurate auditor judgments relative to the judgments of an expert panel. Also, auditors can employ different task‐relevant knowledge that leads to more justifiable judgments when they are prompted (vs. not prompted) to make a limited, intuitive initial judgment as they draw on the crowd within. Overall, auditors appear to increase their task‐relevant knowledge as they develop expertise but do not appear to better use that knowledge absent intervention. Auditors can manipulate how they draw on the crowd within to achieve different audit objectives—for example, accuracy versus justifiability.

ABSTRACT In this study, we provide theoretical guidance for both analytical research and empirical research by considering how changing expectations of earnings affect a dishonest manager's strategy to overstate earnings and an auditor's strategy to exert effort in a two‐period setting. We expect our study's insights on changing economic conditions to help shape future research. We model the manager type as either honest or dishonest, which allows us to differentiate audit risk from audit effort. The key takeaways for future research are the insights on how changes in payoffs and expected earnings affect the associations that involve earnings overstatements and audit effort with audit risk and market price. For instance, researchers typically assume audit effort and audit risk are negatively associated, but we find the association can be positive when, for example, the auditor chooses a period 2 strategy based on the changes in period 1 game parameters. The results of our study provide two additional key insights on the design of future empirical tests. First, by dichotomizing, we show the importance of estimating the intercept in the market pricing equation when studying earnings quality, because market price also adjusts for expected bias through changes in the intercept. Second, our multiperiod setting demonstrates that the effects from a change in the manager's or auditor's incentives in period 1 may reverse in period 2. Empirical studies typically examine the contemporaneous effects of these changes on market price and/or audit risk but fail to identify the cross‐temporal effects we document in our study.

ABSTRACT We examine whether firms with managers that have prior internal audit experience are less likely to manage earnings. This examination is important because the internal audit function (IAF) is uniquely positioned to provide experiences that could influence future managerial behavior, including limiting the potential negative repercussions of earnings management. We find that firms with managers that have internal audit experience are associated with lower real earnings management (REM) but not accruals‐based earnings management. Effects are strongest when managers with internal audit experience have greater power or currently hold financial roles, or when there are a greater number of managers with internal audit experience. The results are robust to including firm fixed effects, using entropy‐balancing and performance‐matching approaches, using a subsample of firm‐years required to have an IAF, using a subsample of firms for which we can measure IAF quality, and measuring internal audit experience at a previous employer. These results point to an important benefit of manager internal audit experience, as research suggests that REM is common, difficult to detect, not always within the scope of financial reporting regulators, and detrimental to future performance.

ABSTRACT We provide evidence on the effect of political connections on the trade‐off between real and accrual‐based earnings management in the United States. This evidence is important because prior literature documents mixed evidence on whether political connections reduce the threat of SEC enforcement. By studying earnings management with a large sample, our study provides more generalizable insights into the effects of political connections on enforcement. We argue that politically connected firms face a lower threat of enforcement, which reduces the costs of accrual‐based earnings management and alters the trade‐off between real and accrual‐based earnings management. Consistent with our predictions, using a single‐step estimation method as well as a difference‐in‐differences test based on an exogenous shock, we find that connected firms engage in more accrual management and less real earnings management. Our results are driven by firms that have relatively high costs of real earnings management. Furthermore, we find that political connections mitigate the relation between SEC comment letters and earnings management. Overall, the evidence is consistent with politically connected firms facing a lower threat of regulatory enforcement and using this flexibility to increase accrual‐based earnings management and reduce real earnings management that is potentially value destructive. Our study complements and strengthens inferences in prior work that documents evidence of lax SEC enforcement for politically connected firms using small samples. Our findings should be of interest to policy‐makers, regulators, and other professionals that are interested in understanding the effects of political connections.

ABSTRACT I propose an explanation for the positive relation between R&D, future earnings, and future stock returns based on the fixed‐cost qualities of R&D. If R&D is relatively fixed over short horizons, demand shocks realized by some R&D firms will push these firms into R&D intensity levels that are suboptimal as common scale proxies—market equity, assets, and sales—respond more quickly to demand shocks than R&D. In response, R&D firms realizing negative demand shocks reduce future expenses and capital expenditures, producing higher future profitability on lower sales growth. Consistent with the fixed‐cost hypothesis, I find the higher future profits of high R&D firms are explained by cost cutting, not revenue growth. Collectively, the restructuring of cost and capital structures of the subset of high R&D firms realizing demand shocks explains the future profit and investment patterns of R&D firms, while the fixed‐cost qualities of R&D seem to explain patterns in future stock returns. My results have implications for literatures that examine how decisions on R&D investment levels affect future firm performance, growth, and stock returns.