Knowledge that Transforms

One of the prime responsibilities of the board of directors is to understand and oversee its firm's risk profile. We exploit a recent European Union (EU) regulation, the General Data Protection Regulation (GDPR), as a quasi‐exogenous shock to the cyber risk landscape to assess whether boards of US firms changed their focus and governance structures to deal with this new challenge. The GDPR encompasses a sweeping set of regulations aimed at protecting EU citizens from unwanted uses of their personal Internet data. Although an EU regulation, the GDPR applies to all US public firms with at least one EU user. Adopting a difference‐in‐differences methodology, we use firms that already fall under a US data privacy regulation as a control group and find that boards of treated US firms, on average, increase their focus on cyber risk, add more directors with cyber/IT expertise, and more frequently assign cyber risk oversight to the board or to a board committee. In cross‐sectional tests, we show that these changes are positively associated with a firm's ex ante cyber risk, but are unrelated to whether a firm had a large EU presence, suggesting a more global reaction to the GDPR. In addition, we examine some of the consequences of these board changes. We find boards that promptly responded by changing their board focus, expertise, and monitoring assignment of cyber risk around the passage of GDPR had fewer future cyberattacks/data breaches and less related media attention. Our findings suggest that, on average, American corporate boards promptly responded to changes in the cyber risk environment in ways that reduced their firms' overall future cyber risk. Our results have implications for the efficacy and flexibility of US corporate boards to respond to unexpected changes in risk.

Although firms are encouraged by the SEC and Department of Justice to conduct internal investigations following financial misconduct, prior research finds few benefits for investigating firms. This study examines a novel aspect of internal investigations—namely, whether the investigation is conducted by independent versus nonindependent teams—and explores the impact of these teams on investigation outcomes. Consistent with our predictions, we find that firms whose internal investigations are led by independent teams are more likely to retain external advisors, have a higher likelihood of CEO turnover, and face a lower likelihood of an SEC enforcement action than do firms whose investigations are led by nonindependent teams. Our findings demonstrate that the SEC grants enforcement leniency to firms that conduct an internal investigation, but this finding only holds when the investigation leader is considered independent. These results also suggest that appointing independent groups to lead internal investigations protects the firm, at the expense of the CEO, following accounting fraud. Our paper has important implications for researchers studying accounting irregularities as we are the first to show that independent board members and external advisors play a direct role in the resolution of financial misconduct through their job on the internal investigation team.

Literature to date reveals relatively little about the role of expertise in auditor selection beyond basic preferences for Big 4 and industry specialist auditors. We hypothesize that audit committees whose members have no Big 4 auditing experience are likely to struggle when interviewing prospective Big 4 partners, leading such committees to draw on superficial, heuristic cues in lieu of conducting more substantive evaluations. To test this prediction, we obtain independent ratings of the facial attractiveness of audit partners identified from Form AP filings recently mandated by the US PCAOB. Our primary finding is that audit committees with no Big 4–experienced members are more likely to favor partners whose photographs raters view to be highly attractive. We characterize attractiveness as a superficial attribute for auditor selection because we detect no relation between attractiveness and accruals‐ or restatement‐based measures of financial reporting quality for audit committees with one or more Big 4–experienced members. We do find an inverse association between attractiveness and financial reporting quality for committees without this experience, likely reflecting the statistical implication of a selection bias. We conclude that auditing expertise mitigates the influence of superficial considerations in auditor selection, enabling audit committees to fulfill their stewardship role more effectively.

Knowledge is key to success in the modern business landscape. Firms invest billions of dollars every year in knowledge management systems, which commonly use artificial intelligence to allow within‐firm knowledge transfer to occur automatically. Despite this investment, these systems often fall short of producing expected results. Using psychology theory on goal dilution, we argue that a potential cause of the failure is that the prospect of knowledge transfer has a negative effect on knowledge creation. We further propose a mechanism to mitigate that effect. Specifically, we predict that the negative effect of knowledge transfer on knowledge creation will be mitigated when the linkages among firm‐ and unit‐level goals are communicated. We conduct an experiment and find that while, as predicted, the prospect of knowledge transfer has a negative effect on knowledge creation when the linkages among firm‐ and unit‐level goals are not communicated, it has the predicted positive effect when the linkages among firm‐ and unit‐level goals are communicated due to increased goal congruence. Additional analyses provide support for our underlying theories. Our results suggest that firms can adopt and communicate strategic performance measurement systems to improve the knowledge creation in a firm.

We examine the determinants and consequences of the severity of executive compensation clawbacks. As one of the most substantial, prolonged, and controversial proposals to reform executive compensation, clawback rules recently regained the SEC's focus. We construct an intuitive clawback severity score and find that clawbacks are considerably heterogeneous and not homogenous as assumed in the literature. Our determinants analyses suggest that clawback severity is increasing in firms with greater board effectiveness and with higher cash and stock awards in director compensation. In contrast, higher director stock option compensation and more powerful CEOs attenuate the severity of clawbacks. The consequences analyses indicate that while severe clawbacks deter financial restatements, management circumvents severe clawbacks by reducing R&D expenses to avoid earnings decreases. One consistent finding throughout our analyses is that the associations are entirely driven by more severe clawbacks. However, we observe that the financial reporting benefits of severe clawbacks can be diminished by the dynamics in the boardroom. Our study extends extant clawback literature, makes a timely contribution to the SEC's decision to reinitiate discussion on clawbacks, and informs various stakeholders interested in the efficacy of clawbacks. Finally, our clawback score can be used to evaluate clawback policies.

Because of clear economic links among industry peers, prior work has focused on documenting industry peer effects in various settings. Yet, while links also exist among firms in the same geographic area, few studies document geographic peer effects. We fill this gap by examining whether there are geographic peer effects in management earnings forecasts. We find that the likelihood that a firm voluntarily provides an earnings forecast is sensitive to the extent to which other firms in the same geographic area provide earnings forecasts. This geographic peer effect in forecasting is stronger for firms with greater exposure to local institutional investors, and when firms do forecast, liquidity improves more when a larger fraction of their geographic peers forecast. Furthermore, we use instrumental variable techniques to help alleviate the concern that these geographic peer effects are driven by omitted local economic factors that can lead firms to make similar disclosure decisions. Overall, our findings suggest that geographic peer effects in disclosure choices arise in part due to firms responding to capital market incentives created by local investors. Our study, therefore, contributes to the literature by documenting a unique dimension of forecasting decisions.

Growing calls for expanded disclosure on managerial stewardship raise important questions about how finer (i.e., disaggregated) reporting, when paired with discretion over classification, will influence managerial behavior. To study this question, we develop an investment game in which, if the investor chooses to invest, the manager privately observes production costs, chooses their personal pay, and provides a cost report in one of three reporting regimes: aggregated, disaggregated without discretion, or disaggregated with discretion. In Experiment 1, as predicted, managers report lower personal pay under both disaggregated regimes than what they consume under the aggregated regime. Yet, when disaggregated reports allow for discretion, managers misclassify personal pay as production costs to such an extent that their actual consumption is no different than in the aggregated condition. In Experiment 2, we allow managers to choose either an aggregated report or a disaggregated report with discretion. We find that, rather than remaining silent, the vast majority of managers still prefer the opportunity to report on their pay explicitly so that they can use their reporting discretion to appear trustworthy, despite not actually being so. In summary, our evidence suggests a strong weight of preferences for appearing trustworthy in the managers' utility function, a much lower weight for actually being trustworthy, and little evidence that preferences for being honest are strong enough for discretionary disaggregated reporting to curb agency costs. In other words, whether disaggregation can reduce agency costs will depend on managers' reporting discretion. Our findings have important implications for control system designers, financial and sustainability accounting standard setters, and regulators.

Performance evaluations are typically based on a formula that specifies in advance all performance measures, their relative incentive weights, and targets to be met. However, beginning‐of‐year performance targets can become outdated due to unforeseen events that call for ex post adjustments to formula‐based incentive plans to restore incentives. We discuss three types of ex post incentive plan adjustments—end‐of‐year subjective performance evaluation, changes in next‐year relative incentive weights, and changes in next‐year performance targets—and empirically examine the extent to which they are used to discourage failure to meet a target by a wide margin. Specifically, we use 2004–2015 data on formula‐based bonus plans, subjective performance evaluations, and performance in Korean state‐owned enterprises. Consistent with our predictions, we find that very low performance relative to target is associated with (i) low subjective evaluations and (ii) an increase in next‐year incentive weights, conditions that render areas with poor performance more important in future evaluations. These findings are more pronounced on performance dimensions of high importance and less pronounced when very low performance is due to an adverse uncontrollable shock. Finally, we find evidence that ex post incentive plan adjustments are associated with future performance improvements. Combined, our findings suggest that ex post incentive plan adjustments can be used to strengthen incentives when performance targets get outdated.

How employees mentally break up or segment time likely influences key performance behaviors. Thus, it is important to understand how features of the work environment influence the mental time segments employees create. Consistent with my predictions, I provide evidence across four experiments that feedback systems can alter the way employees segment their work time—a process that I refer to as feedback‐driven time segmenting. Consistent with the theory of feedback‐driven time segmenting, the experiments demonstrate that more (less) frequent feedback leads employees to create smaller (larger) mental time segments. Furthermore, the results indicate that employees who create smaller mental time segments are less likely to find efficiencies at work, suggesting an unintended cost of increasing feedback frequency. However, I also find that employees with smaller mental time segments work with higher levels of effort intensity. Together, these experiments provide evidence that the economically meaningless time segments employees create can significantly influence their behavior. Consequently, firms and future researchers should carefully consider how features of the work environment influence the mental time segments employees create.

Asymmetric information is a fundamental friction that results in mismatches and efficiency losses in the labor market. In this study, we posit that more disaggregated financial disclosure by a CEO candidate's prior employer can help the hiring firm better assess the possible fit between its operational needs and the candidate's skill set. Using a mandatory segment reporting reform in the United States (SFAS 131) as an exogenous shock to disclosure disaggregation, we find a significant increase in the firm‐CEO match quality when the hiring firm has access to more disaggregated segment information about the external candidate's past employment. Furthermore, the improvement in firm‐CEO matching is greater when segment information is incrementally more useful for evaluation of candidate skills. These findings reveal a novel labor market benefit of disaggregated financial disclosure: alleviating pre‐hiring information deficiencies and facilitating efficient allocation of CEO talent across firms.