Knowledge that Transforms

This study examines recent regulatory and practitioner concerns that managers provide more (less) information to analysts with more (less) favorable stock recommendations. We examine the relative forecast accuracy of analysts before and after a recommendation issuance under the assumption that increases (decreases) in management‐provided information will increase (decrease) analysts' relative forecast accuracy. We find that analysts issuing more favorable recommendations experience a greater increase in their relative forecast accuracy compared with analysts with less favorable recommendations. Additional tests on the change in frequency with which analysts issue forecasts independent of or in conjunction with other analysts after their recommendation change yield corroborating results. In addition, we find that the greater increase in relative accuracy for analysts with more favorable recommendations exists prior to the passage of Regulation FD but not after. The combined results are consistent with analysts receiving relatively more management‐provided information following the issuance of more favorable recommendations.

This study investigates how companies' threats to dismiss auditors and their engagement in opinion shopping influence auditor independence and audit quality, which in turn affect misstatements in financial statements. It also examines how outsiders' reactions to auditor switching influence opinion shopping. The results indicate that neither the predecessor auditor's nor the successor auditor's independence is compromised by dismissal threats and opinion shopping. Further, the successor auditor's audit quality exceeds the predecessor auditor's audit quality. In addition, auditor switching decreases potential understatements and increases potential overstatements in financial statements, and the capital market's and the successor auditor's reactions to auditor switching reduce the benefits of opinion shopping to companies. Additionally, the study sheds some light on the potential effects of both the Sarbanes-Oxley's restriction on non-audit services and mandatory auditor rotation or retention. The paper also derives a rich set of empirical implications.

This paper examines the relationship between post–earnings announcement returns and different measures of volume at the earnings date. We find that post-event returns are strictly increasing in the component of volume that is unexplained by prior trading activity. We interpret unexplained volume as an indicator of opinion divergence among investors and conclude that post-event returns are increasing in ex ante opinion divergence. Our evidence is consistent with Varian [1985], who suggests that opinion divergence may be treated as an additional risk factor affecting asset prices.

Disclosures play an apparently critical role in the empirical regularity of the short‐run momentum and long‐run reversal in stock returns. Motivated by this evidence, this paper integrates an analysis of disclosures within an asset pricing model to arrive at a framework in which disclosures and asset returns are jointly determined. Disclosures resolve uncertainty, but the increased information flow also raises the risks during the disclosure period. When disclosures and asset returns are modeled jointly, apparently good news is associated with the upward revision of future disclosure risks. The model generates predictions that have the outward appearance of short‐run momentum and long‐run reversal.

We investigate the role of accrual accounting in the asymmetrically timely recognition (incorporation in reported earnings) of gains and losses. Timely recognition requires accruals when it precedes complete realization of the gains and losses in cash. We show that nonlinear accruals models incorporating the asymmetry in gain and loss recognition (timelier loss recognition, or conditional conservatism) offer a substantial specification improvement, explaining substantially more variation in accruals than equivalent linear specifications. Conversely, conventional linear accruals models, by omitting the loss recognition asymmetry, exhibit substantial attenuation bias and offer a comparatively poor specification of the accounting accrual process. Linear specifications also understate the ability of current earnings to predict future cash flows. These findings have implications for our understanding of accrual accounting and conservatism, as well as for researchers estimating discretionary accruals, earnings management, and earnings quality.

This paper extends the literature on the role of political economy in financial reporting and auditing by testing two hypotheses. The first hypothesis predicts that there will be a greater increase in audit effort and audit fees for Malaysian firms with political connections, as a result of the Asian financial crisis, than for non‐politically connected firms because these firms have a higher risk of financial misstatements. The second hypothesis predicts that the audit fees of politically connected firms will decline when capital controls are introduced by the government as a ploy to financially assist politically connected firms to rebound from the crisis, and thus reduces the risk of financial misstatements. The results show that there is a greater increase in audit fees for firms with political connections than for non‐politically connected firms as a result of the Asian financial crisis. However, there is a decline in audit fees for politically connected firms after the capital controls are implemented.

This study examines associations between measures of stock exchange disclosure and market development at 50 of the member stock exchanges of the World Federation of Exchanges. We focus on stock exchange disclosure systems (rather than actual company disclosures) because this approach links stock exchange policy with desired outcomes related to market development (such as liquidity, trading activity, and market size relative to gross domestic product). We find strong support for the hypothesis that the strength of the disclosure system (disclosure rules, monitoring, and enforcement) is positively associated with market development, after controlling for legal system, legal protection of investors, market size, and several other potentially relevant explanatory variables.

We rely on a unique data set to estimate the impact of disclosure standards and auditor‐related characteristics on ownership concentration in 190 privatized firms from 31 countries. Accounting transparency can help alleviate the agency conflict between minority investors and controlling shareholders, which is evident in the extent of ownership concentration, since the expropriation of corporate resources hinges on these private benefits remaining hidden. After controlling for other country‐level and firm‐level determinants, we find weak (no) evidence that extensive disclosure standards (auditor choice) reduce ownership concentration. In contrast, we report strong, robust evidence that ownership concentration is lower in countries with securities laws that specify a lower burden of proof in civil and criminal litigation against auditors, consistent with Ball's [2001] predictions. Collectively, our research implies that minority investors worldwide value legal institutions that discipline auditors in the event of financial reporting failure over both the presence of a Big 5 auditor and better disclosure standards. Re‐estimating our regressions on a broad sample of western European public firms provides similar evidence on all of our predictions.

We investigate the stock returns subsequent to quarterly earnings surprises, where the benchmark for an earnings surprise is the consensus analyst forecast. By defining the surprise relative to an analyst forecast rather than a time‐series model of expected earnings, we document returns subsequent to earnings announcements that are much larger, persist for much longer, and are more heavily concentrated in the long portion of the hedge portfolio than shown in previous studies. We show that our results hold after controlling for risk and previously documented anomalies, and are positive for every quarter between 1988 and 2000. Finally, we explore the financial results and information environment of firms with extreme earnings surprises and find that they tend to be “neglected” stocks with relatively high book‐to‐market ratios, low analyst coverage, and high analyst forecast dispersion. In the three subsequent years, firms with extreme positive earnings surprises tend to have persistent earnings surprises in the same direction, strong growth in cash flows and earnings, and large increases in analyst coverage, relative to firms with extreme negative earnings surprises. We also show that the returns to the earnings surprise strategy are highest in the quartile of firms where transaction costs are highest and institutional investor interest is lowest, consistent with the idea that market inefficiencies are more prevalent when frictions make it difficult for large, sophisticated investors to exploit the inefficiencies.

We examine the associations among leverage, corporate and investor level taxes, and the firm's implied cost of equity capital. Expanding on Modigliani and Miller [1958, 1963], the cost of equity capital can be expressed as a function of leverage and corporate and investor level taxes. Based on this expression, we predict that the cost of equity is increasing in leverage, and that corporate taxes mitigate this leverage-related risk premium, while the personal tax disadvantage of debt increases this premium. We empirically test these predictions using implied cost of equity estimates and proxies for the firm's corporate tax rate and the personal tax disadvantage of debt. Our results suggest that the equity risk premium associated with leverage is decreasing in the corporate tax benefit from debt. We find some evidence that the equity risk premium from leverage is increasing in the personal tax penalty associated with debt.