Knowledge that Transforms

Abstract We investigate whether U.S. House representatives and their staff seek financial information from constituent firms to inform their legislative decisions. We exploit shifts in U.S. congressional districts (i.e., the reconfiguration of federal district lines or redistricting) that introduce new constituent firms to legislators’ districts. To the extent that legislators and their staff collect and rely on firms’ financial statement information, we expect that a change in representation as a result of redistricting will result in a significant and observable change in searches for information about new constituent firms. Our evidence supports this prediction. We also find that the timing of searching coincides with legislators’ roll call votes, particularly ahead of more controversial bills and for bills lobbied by sample firms. Finally, we find that new constituent firms respond to increased information demands after a redistricting event by supplying more policy-relevant disclosures and increasing lobbying.

Abstract We exploit differences in two industry classification schemes to distinguish between industry classification misfits and industry core firms. We posit that misfits differ from their industry peers, and we document consequences of this heterogeneity. Misfits have larger absolute abnormal accruals, firms in industries with a greater proportion of misfits have larger absolute abnormal accruals, and contemporaneous abnormal accruals are associated with future restatements for industry core firms but not for misfits. We attribute these results to measurement error generated by the inclusion of misfits in the estimation of accrual models. We then provide guidance to alleviate this issue. For both misfits and industry core firms, using fixed peer groups based on the largest firms in a given industry significantly outperforms other peer selection methods in detecting abnormal accruals. In additional analyses, we highlight other economic consequences of industry classification misfits such as higher information processing costs.

Abstract This study examines whether the revised lease standards (ASC 842 and IFRS 16) make U.S. GAAP-based accounting amounts more comparable with IFRS-based accounting amounts. Our study is motivated by the FASB and the IASB’s call for research on the comparability of the revised lease standards. We find that U.S. GAAP and IFRS pairs that are high operating lease users experience a larger increase in accounting comparability after the adoption of revised lease standards than low operating lease U.S. GAAP-IFRS pairs. Additionally, our results suggest that the improvement comes more from the changes to the balance sheet rather than the income statement and is more pronounced for IFRS firms from countries with stronger accounting enforcement. Lastly, we show that analysts who are more GAAP-focused (IFRS-focused) prior to the standard change are more likely to increase their forecasting of book value per share for IFRS (U.S. GAAP) firms.

Abstract This paper investigates how competition for scarce corporate resources impacts innovation incentives within multidivisional firms and, consequently, shapes firms’ preferences for fostering or restricting intra-firm competition. In our model, divisions become privately informed about the potential value of new investment opportunities generated through their innovation initiatives. We demonstrate that intra-firm competition unambiguously reduces divisions’ ex ante innovation incentives. However, it benefits ex post resource allocation by enabling the firm to (i) select the most promising project and (ii) limit the rents divisions earn from their private information. Consequently, a firm’s preference to limit or encourage interdivisional competition hinges on balancing ex post allocative efficiency, which favors increased intra-firm competition, against ex ante innovation incentives, which favor reduced competition. Our analysis identifies plausible conditions under which each organizational design—competitive or exclusive innovation—emerges as the optimal choice.

Abstract Pre-IPO firms may “test the waters” by meeting privately with investors in order to allow access to management and more time to make an investment decision. However, these meetings have the potential to undermine the SEC’s objectives of protecting investors and supporting market efficiency by allowing institutional investors, but not retail investors, private access to management. We find lower retail trading after IPOs of firms that held testing-the-waters meetings, consistent with the meetings reducing retail investor participation. Moreover, retail investors that still participate in the market in the presence of testing-the-waters meetings have inferior investment outcomes. Nonetheless, we find no evidence of lower overall market liquidity or slower price discovery following testing-the-waters meetings. In fact, we observe a reduction in stock return volatility. Overall our evidence suggests that, while testing-the-waters meetings may harm retail investors, there does not appear to be a negative impact on overall market function.

Abstract A few highly successful firms (“superstar firms”) have captured large market shares and earned massive profits in recent decades. We examine whether superstar firms are associated with a greater likelihood of financial distress for firms exposed to them in product markets. Building on recent research, we identify superstars as firms with the highest markups in the industry and whose industry markup share increases over time. We then measure, with product similarity scores, a firm’s overall product market exposure to superstars. We document that firms with greater exposure are more likely to file for bankruptcy. We examine why superstar exposure is associated with bankruptcy and show that firms with the greater superstar exposure exhibit weaker financial performance and greater riskiness. Furthermore, we show that the association between superstar exposure and the likelihood of bankruptcy strengthens when superstars have greater market power.

This study investigates the role of individual managers in banks' financial reporting. We exploit the connectedness between different managers and find that individual bank managers explain approximately 19 percent of banks' loan loss provisions. This observation is consistent with the substantial reporting discretion that individual bank managers use in the estimation of loan loss provisions and that is increasingly subject to financial stability concerns by prudential supervisors. Our results suggest that these concerns are valid, as individual management discretion is associated with greater discretionary loan loss provisions and proxies for opportunistic accounting, especially the reduction in the timeliness of these provisions and the lesser degree to which the allowance for credit losses maps into future charge-offs. These findings are relevant for the design of regulatory measures aimed at limiting the managerial influence on accounting choices in banking and can inform debates on the desirability of discretion within the reporting process of banks.

The new lease standard (ASC 842) allows firms to keep variable leases off balance sheet, in part based on the assumption that future expenses are difficult to estimate reliably. We show that variable lease expenses are both prevalent and substantial, exhibiting persistence and predictability comparable to operating lease expenses while showing limited sensitivity to revenue changes. These patterns are consistent with variable lease payments being based on stable drivers. Following ASC 842 adoption, firms report lower minimum operating lease commitments and higher variable lease expenses, suggesting a substitution from operating to variable leases. Neither equity betas nor credit ratings reflect potential variable lease liabilities. Conservative estimates show that recognition of variable lease liabilities would increase debt by 7.1% on average. Our findings provide evidence on the properties of variable leases and the potential implications of keeping them off balance sheet.

Abstract We study the extent to which creditors shape the executive bonus plans of their financially distressed borrowers. Financial distress can exacerbate agency conflicts between creditors and borrowers as concerns with underinvestment become more acute due to managerial myopia and debt overhang. Consequently, we expect creditors to exert their influence to ensure that these managers’ incentive-compensation plans encourage longer-term investments and directly reward outcomes that benefit creditors without exposing managers to unnecessary risk. We argue that bonus plans are an especially important way to provide these incentives because their flexibility allows creditors to more precisely target specific investment objectives. We find that borrowers’ bonus plans tend to have longer horizons and more convex payouts following covenant violations, especially when bonus plans can be a particularly effective way to address distress-related agency conflicts. Our evidence suggests that creditors protect their interests by exercising their control rights to shape their borrowers’ incentive-compensation plans.