Knowledge that Transforms

This study provides the first large‐sample evidence on the economic tax effects of special purpose entities (SPEs). These increasingly common organizational structures facilitate corporate tax savings by enabling sponsor firms to increase tax‐advantaged activities and/or enhance their tax efficiency (i.e., relative tax savings of a given activity). Using path analysis, we find that SPEs facilitate greater tax avoidance such that an economically large amount of cash tax savings from research and development (R&D), depreciable assets, net operating loss carryforwards, intangible assets, foreign operations, and tax havens occur in conjunction with SPE use. We estimate that SPEs help generate over $330 billion of incremental cash tax savings, or roughly 6 percent of total U.S. federal corporate income tax collections during the sample period. Interaction analyses reveal that SPEs enhance the tax efficiency of intangibles and R&D by 61.5 percent to 87.5 percent. Overall, these findings provide economic insight into complex organizational structures supporting corporate tax avoidance.

We examine how compensation policies of audit firms are associated with audit quality. Specifically, we investigate the effects of the ratio of variable to fixed compensation and the size of the basis for profit sharing (i.e., whether partners share profits in a small or in a large profit pool). For our analyses, we use detailed mandatory disclosure of the compensation policies in German audit firms. We document that compensation policies vary considerably across audit firms. We find that profit sharing in a small profit pool and high variable compensation are two characteristics of auditor compensation associated with lower audit quality. We also find some evidence suggesting that audit quality may be most at risk in cases in which partners rely more heavily on variable compensation to divide a relatively small profit pool. In additional analyses, we find that these associations are more pronounced in medium‐sized audit firms. We argue that this finding may result from these firms being too large for audit partners to directly monitor each other effectively, yet simultaneously too small to have sophisticated centralized monitoring systems in place. Finally, we find that integrating partner‐specific, nonprofit‐related performance metrics into the compensation structure mitigates the adverse effects of small profit pools and high variable compensation.

Prior research indicates that most audit legal disputes settle. There is, however, little evidence of the factors that drive the settlement norm and its exceptions in audit legal disputes. To better understand these factors, we rely on theory related to how professionals manage risks and, as a result, how professions defend jurisdictional claims. We use this theoretical lens to help motivate four research questions that we probe by interviewing 27 prominent attorneys experienced in audit litigation. Consistent with our lens, our interview data indicate that attorneys manage their risks, including the risk of reputational loss, by settling based on their expectations of trial verdicts. Unlike trials, settlements simultaneously enable attorneys on both sides to limit costs and avoid catastrophic jury verdicts and, by doing so, claim “wins” for their clients. Attorneys also stress that they settle many audit disputes without any legal filings. Thus, a large subset of disputes is invisible to the public and researchers. Attorneys characterize trials as exceptions to the settlement norm that emerge due to abnormal conditions sometimes present in disputes. However, trial verdicts in these abnormal conditions help attorneys justify the use of settlements to clients, as attorneys stress that by settling they can avoid the dreaded possibility of extreme unfavorable verdicts. We conclude that as individual attorneys manage their risks, especially the risk of reputational loss, their profession maintains its public image and thereby defends its jurisdictional claims. Among the many questions we pose for future research is whether the settlement norm reduces society's ability to monitor the audit profession and, more generally, whether this norm's benefits outweigh its drawbacks.

We examine whether the joint provision of corporate social responsibility (CSR) assurance services and financial audit by the same audit firm influences auditors' assessment of going‐concern risk. We predict that the provision of CSR assurance and financial audit by the same audit firm creates CSR‐related knowledge spillovers from the CSR assurance team to the financial audit engagement team, which helps in the auditor's assessment of going‐concern risk. Using more than 28,000 firm‐year observations from 55 countries, we document that, relative to audit firms that provide only the financial audit, audit firms that provide both CSR assurance and financial audit for the same client (i) issue more frequent going‐concern opinions and have lower Type II going‐concern errors, (ii) have clients that book larger environmental and litigation provisions, (iii) report earnings that are more persistent and value‐relevant and are less likely to book income‐decreasing earnings restatements, and (iv) do not charge higher audit fees or total fees. Our results are important especially because of firms' increasing exposure to CSR risks and the growing number of countries that require assurance of CSR reports.

We study whether the effectiveness of corporate governance mechanisms varies depending on the characteristics of the executives subject to these mechanisms, namely their “psychological type,” as proxied by their history of legal infractions. In particular, we examine insider trading, where we can compare the trading behavior of different types of executives in the same firm. We find that “recordholder” executives, that is, those with prior legal infractions, earn significantly higher profits from purchases and sales than nonrecordholder executives. Furthermore, the profitability of both purchases and sales is significantly increasing in the severity of the infraction. Governance mechanisms, such as blackout policies, lower profits of executives with only traffic infractions; however, profits for executives with serious infractions appear insensitive to blackout policies. Insiders with serious infractions are also more likely to trade during blackout periods and before large information events and are more likely to report their trades to the SEC after the filing deadline. Collectively, our evidence suggests that while governance mechanisms can discipline executives with minor offenses, they appear largely ineffective for those with more serious infractions.

Recent research finds that investors' assessments of a stock's fundamental value are influenced by corporate social responsibility (CSR) performance through the affect‐as‐information heuristic. We extend prior research by examining two boundary conditions for the use of this heuristic: (i) whether the CSR performance relates to activities that are integrated in a firm's core business practices (material CSR issues) or not (immaterial CSR issues), and (ii) whether the CSR performance is positive or negative. Employing an experimental method, we find that the affect‐as‐information heuristic applies only to immaterial CSR issues but not to material CSR issues, and only to positive but not negative CSR performance. Our findings suggest that investors likely use a heuristic approach to process immaterial and positive CSR issues, and a more deliberate and systematic approach to process material or negative CSR issues. Our study has both practical and theoretical implications.

In measuring tunneling with intercorporate loans disclosed by Chinese listed companies, we analyze the underlying channels through which aggressive tax planning facilitates the diversion of corporate resources by firm insiders. Using path analysis, we document that the path from tax aggressiveness to related loans is mediated by both the additional cash flows from tax savings and the increased financial opacity from tax planning, and that additional cash flows plays a much more important role than opacity in helping controlling shareholders to divert corporate resources under the guise of tax aggressiveness. Beyond the two mediated paths, we also detect a residual, direct path from tax aggressiveness to related loans. After an exogenous shock from the government crackdown on diversionary related loans, we find the direct path is fully mediated by the two indirect paths, suggesting that tunneling via related loans only occurs at firms where insiders can mask tunneling under the cover of opacity or can justify related loans on grounds of abnormal cash flows from tax savings. Our evidence supports the notion that greater outside scrutiny increases the hurdle for, but does not entirely eradicate, diversion facilitated by tax aggressiveness. Collectively, our research lends some support to recent theory on the importance of taxes to corporate governance by demonstrating how the agency costs of tax planning allow certain shareholders to benefit from firm activities at the expense of others.

In an experiment including experienced managers, we investigate how supervisor and subordinate narcissism influence a supervisor's review of a subordinate's accounting estimate. While narcissistic supervisors express greater liking for narcissistic subordinates (narcissistic tolerance), they nonetheless reject and revise the accounting estimates of narcissistic subordinates to a greater extent than they reject estimates of non‐narcissistic subordinates (narcissistic hypocrisy), even when doing so inhibits the supervisor's ability to reach a profit target. Our findings contribute to extant research in accounting and psychology. We demonstrate that narcissistic hypocrisy extends beyond the evaluation of others and alters narcissists' willingness to rely on other narcissists in a meaningful financial reporting decision. We also find that narcissistic hypocrisy is robust across age, gender, and supervisory experience.

This paper demonstrates that measures of stock price synchronicity based on market model R 2 s are predictably biased downward as a result of stock illiquidity, and that previously employed remedies to correct market model betas for measurement bias do not fix R 2 . Using a large international sample of firm‐years, we find strong negative and nonlinear relations between illiquidity and R 2 across countries, across firms, and over time. Because variables of interest frequently relate to illiquidity as well, we illustrate the consequences of not controlling for illiquidity in synchronicity research. More generally, we demonstrate the importance of using nonlinear control variable methods. Overall, we conclude that the illiquidity‐driven measurement bias in R 2 provides an explanation for why prior research finds low‐ R 2 firms to have weak information environments, and suggest future research carefully evaluate the sensitivity of its results to nonlinear controls for illiquidity.

We investigate whether income smoothing affects the usefulness of earnings for contracting through the monitoring role of earnings‐based debt covenants. First, we examine initial contract design and predict that income smoothing will increase (decrease) the use of earnings‐based covenants if income smoothing improves (reduces) the usefulness of earnings to monitor borrowers. We find that private debt contracts to borrowers with greater income smoothing are more likely to include earnings‐based covenants. A structural model that explores the cause of this relationship provides evidence that smoothing improves the ability of earnings to reflect credit risk. Second, we examine technical default following contract inception. We find that income smoothing is associated with a lower likelihood of spurious technical default (when the borrower's economic performance has not declined but the loan nevertheless enters technical default). In contrast, we find no association between income smoothing and performance technical default (when the borrower's economic performance has declined). Collectively, this evidence is consistent with income smoothing improving the effectiveness of earnings‐based information in monitoring borrowers.